Matteo Cidonio, managing partner at GWM Group, answers SCI's questions about European commercial real estate, real estate debt and CMBS

Q: The past couple of years have been a very difficult period for the CRE market globally. You recently said there are opportunities for investors who target the right real estate categories and more specifically segments, even in the current market. What would you see as being the top segments in Europe currently, and why?
A: Commercial real estate has been very much a stalled market since around the summer of 2022, when the first impact of interest rate movements started being felt. The initiation of the war in Ukraine brought consequences and the interest rate movement that followed was a clear dividing point for real estate across Europe. That essentially froze end markets for core longer-term investors who couldn't really price real estate as a direct consequence of the increase and volatility in interest rates and inflation, as well as prospects for the general economy.

There are still sectors that are relatively liquid and where we do see activity. Logistics is one, though it was a hot asset class before the most recent market turbulence. There have been and will be adjustments to valuations on logistics, mostly driven by cap rate expansion deriving from the increased interest rate environment, but the reality is that the fundamentals of the asset class are very strong. There's a lot of need for these types of assets, and it looks like demand for the space is going to increase a lot more with the advent of AI, so investors can and do take a view on the scarcity of the product.

Hospitality, in its different iterations, is another. It has benefited substantially from pent up demand from the lockdown and of the inherent increase in savings that happened during Covid. There is a combination of revived interest in hospitality where investors believe people will travel more, albeit more selectively, because of the experience of lockdown. 

But there has also been a systemic shift in interest in terms of types of hospitality. Traditional business hotels are more likely to be suffering because of reduced business travel and erosion of margins. The segments attracting investors’ interest are; efficient, cheap hotels also with smaller rooms and limited service; high-end hospitality; and lifestyle or experience hospitality driven by entertainment.

In addition to logistics and hospitality, the third area is anything related to new types of living, including student housing, senior accommodation, or build to rent. Across Europe, there's a need for renovation of residential stock and more energy efficient buildings. This is not just driven by ethical or emotional generational motivations, but by a strong economic component related to utility costs and consumption.

Q: The office space has been one of the hardest hit spaces in commercial real estate by the Covid-19 pandemic. A recent — albeit US-focused — report by DBRS Morningstar put the delinquency rate in CMBS portfolios at 4.03% in October, an increase of 121bp on the start of the year. What do you see as the current state of play in the European office space and the opportunities in the coming years?
A: What we've seen in Europe has been very different from what's happened in the US. In the US employers are having much greater difficulty in bringing employees back to the office. Generally this is less the case in Europe. Clearly there are exceptions, where greater challenges appear also in Europe, in locations such as Canary Wharf in London, La Défense in Paris and Frankfurt. But generally employees are happier going back to the office in Europe.

This is driven by the relatively smaller size of cities and the nature and quality of office stock, with either historic or relatively modern buildings, so people feel good in them. The US also has a much greater proportion of pure office districts compared to Europe. The greater work-life balance and attention to ESG criteria has brought the setup of office areas in town closer to where European cities have traditionally been.

Last but not least, transport infrastructure and commuting time are big factors. US employees typically face longer commuting times vis-à-vis their European peers, with relatively less capital invested to modernise non-road infrastructure in the US versus Europe. In Europe commuting is generally quicker and easier, and that is positive for the commercial real estate sector.

Q: You've spoken before about the need to distinguish between modern stock and stock that is perhaps a bit outdated. How does that factor in?
A: There obviously is that distinction, which will only increase, between modern office buildings and buildings that need to be modernised. There's a huge investment opportunity in the office sector to modernise buildings that are not up to standard and which institutional tenants would currently not want to move into.

Tenants have become very selective because — not only are they conscious of their communication strategies — but employees have become selective and employers need a best-in-class office to attract and retain office-based talent.

Speaking to various tenants of our office portfolio, we understand that typically senior management wants their teams back in the office. They value the social element of the office space, which helps foster corporate culture, internal and external networking and exchange of ideas — and generally contributes to the creation of value for the company. There is a feeling that, in order to enhance corporate culture and affiliation, and create that positive energy, people need to spend time together. 

We generally see a need to occupy similar or slightly reduced square footage as before — for a similar number of employees — but where the space is organised in a different way, and includes more social areas, including break areas, lounges, etcetera. 

The office sector is going to provide very interesting investment opportunities because of this dislocation between high-quality and low-quality offices and the possibility for experienced operators to shift an asset from one category to the other and create value. 

Q: To what extent are those opportunities that capital market investors are responding to?
A: Now that is the key question: When is the office sector overall going to be appealing again to long-term investors — to the insurance companies and pension funds of this world? They're cautious because of what's happening in the US and the impact of remote working, so there is a general feeling that there is a need to wait and see what happens. 

We do not believe the sector in general will be under-invested for the long run, firstly because it still is the largest sector in commercial real estate, secondly because most investors — as most own offices in their portfolios — will be able to assess the performance of good quality assets. It will be a much shorter recovery, compared with how long the retail sector is taking to come back from the shadows of e-commerce and the pandemic. 

Q: In terms of your commercial real estate debt strategy, what parts of the capital stack are proving most popular with investors currently and what is driving that?
A: Given the increase in interest rates and the pressure from central banks, traditional banks in Europe are somewhat retrenching from commercial real estate lending. This is cyclical and it provides today for a great opportunity for alternative investors to gain exposure to the sector, whether that is senior debt, mezzanine, or pref equity. 

Real estate values have been and are still going down, mostly driven by the increased interest rate environment, but also the asset class has and will prove to go back to its fundamentals of providing a relatively safer haven for inflation protection. Pre-global financial crisis, we had higher interest rates and top real estate assets were trading at cap rates that were in line with long-term interest rates. I believe that once the market stabilises and volatility normalises, we will have to go back to that metric.

In the aftermath of the GFC, where interest rates trended to zero and commercial real estate debt was cheap, investors had been looking at real estate as a means to gain yield, as this could not be achieved in the credit markets. Even with a very low asset yield the investment would have generated a favourably comparable levered yield. We feel today we are back to the basics of real estate investment, where leverage on high-quality real estate is used mostly to boost its inflation protection nature as opposed to generating greater running yield. 

Q: How is that outlook reflected in your strategies?
A: We have been investors in real estate performing and distressed credit since inception. Today we manage two separate strategies, in two funds. The first is a commercial real estate senior lending fund, CREDO, which is lending on low risk strategies, and targets — on an unlevered basis — low double digit returns, with a quarterly yield distribution for our investors. The second is a real estate special situations fund, RESS 3, where we take more risk, and positions typically in the mezz and pref equity space, as well as distressed debt, which is targeting net high teen returns for our investors.

If you think about refinancing an asset of up to 60% to 65% loan to real value, that's suitable for a senior lending fund. In this case we would only finance assets where we see a minimal risk of default.

In our special situations strategy, with the RESS3 fund, we always assess the risk of potentially owning the asset if the loan goes into default, and investing through debt allows you to have a lower basis than the perceived fair market value of that asset today.

Of course, that's a very particular case. Generally, if you're backing a good sponsor they will be able to create value at the asset level. You're not really banking on the current value of the asset, but on the projected value of the assets. That would facilitate the repayment of the loan through a sale or refinancing.

Q: GWM’s Commercial Real Estate Debt Opportunity Fund realised its first investment last month with the full repayment of a €10m loan. To what extent do you view the securitisation market as a potential exit route going forward?
A: I don't see a big CRE securitisation market in Europe currently, with investors interested in buying tranches of different loans put together — what was the CMBS market. I believe longer-term investors that may previously have looked at the securitisation market may potentially invest as syndicated partners in larger loans. 

CMBS buyers may historically have been insurance companies and pension funds. A lot of these players today have their own debt strategies, either through their own fund or via a strategy where they participate side by side with banks or alternative lenders on selected loans.

The CMBS market in Europe is very different from the one in the US. It's a lot smaller and it's become a niche market after the global financial crisis when whatever was viewed as a structured product was considered toxic. A lot of investors backed out of the sector and have only just been coming back in the last few years.

But if you look at the universe of European CMBS, there are not many CMBS deals out there and most of them are fairly simple — either secured on one deal or for example on three loans from the same sponsor. They're almost like a syndicated loan in terms of collateral, in the form of a securitisation.

I don't envisage securitisation as a way of refinancing our commercial real estate debt portfolio. Syndication, bringing individual investors into a sub-portfolio, could instead be an option. It would likely be one or two investors and could even be through a securitisation structure, but I wouldn't call it a real securitisation.

As far as our credit exposure in CREDO, we always target assets that we believe may be in a position, at maturity of our loan, to either be sold or be refinanced on the traditional banking market. The assets we like lending to are transitional assets — assets where value is being created by the sponsor. We believe this strategy brings you more opportunity in terms of refinancing. 

If you're financing assets where there's an underlying strategy of value enhancement, you end up having a different product at the end of the lifecycle of the asset. If that revamp goes well, your loan to value is going to be substantially lower because the value of the asset has gone up. That puts you in a position to have both a sale opportunity and a refinancing opportunity.

Kenny Wastell