Founder, CEO and Managing Partner of Persepolis, responsible for defining its strategy and the primary point of contact for investors.
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The general consensus in the real estate investment community is there will be a downturn in the second half of 2020 and well into 2021. The question, as far as the real estate market here in Spain is concerned, is the extent to which this cycle will be different from 2008. It wasn’t until 2014, when foreign capital flowed into the country, that the market started picking up again. This time around, the real estate sector is much better prepared to weather the storm because the market is structurally different in how it is regulated and financed, and how players operate.
The Banking Sector
The No. 1 factor that differentiates this cycle is how the banking sector operates in Spain. In contrast to other countries, real estate development in Spain is mostly a retail play. When a developer secures financing to fund the construction of a residential development project it will expect the bank to quote an interest rate spread in the range of 2% — a small compensation for the risk the bank undertakes, only justified by the long-term profitability of the loan. When financing a residential project, the bank will subdivide the mortgage of the building into pieces, one per residential unit — the bank expects a large portion of unit buyers to assume these mortgages, and that’s where the retail play begins. Each new mortgagee is a retail customer and a prospective purchaser of home and life insurance policies, credit cards, pension plans, vacation packages and all sorts of merchandise that bank branches sell these days.
This is still true today, but the cost in bank capital is much higher, owing to stricter regulations imposed by the Bank of Spain. The country’s lenders have become much more cautious in underwriting loans and are covering a much lower portion of the construction costs, whereas in the previous cycle, it was common for banks to fund the full amount of the project costs, including the totality of land, hard and soft costs, and the developer’s fees. In today’s market, developers are hard-pressed to obtain ratios in excess of 60% of costs, and it is nearly impossible to secure land financing, except for projects well located within the city center of Madrid. This small change has brought about a fundamental change in the market because developers have had to come up with large sums of equity to bridge the gap otherwise covered by the banking sector, which explains the advent of private equity funds operating in the market.
In addition, banks have added layers of protection that stand in contrast with the common practice of the last cycle, where projects were financed speculatively, with exceedingly high levels of leverage. All these factors have combined to dramatically reduce the number of development projects underway.
Private Equity
With banks to a large extent withdrawing from the market, private equity funds have stepped into the market, often by setting up joint ventures with sophisticated local operating partners. Considering the leverage ratios in the range of 60% mentioned above, real estate development loans today have substantial buffers that can absorb large variations in prices.
In a doomsday worst-case scenario, should real estate developers hand back the keys to their projects to banks, which end up foreclosing on all the development projects currently underway in the country, the price correction they could absorb would likely leave their loan books intact — an unlikely event, considering that most of the units under production already have locked-in buyers who have contributed down payments of at least 20% of the purchase price. The combination of private equity and homebuyer equity coupled with much stricter underwriting guidelines has virtually eliminated the possibility of a systemic baking failure such as the one witnessed in 2008.
Liquidity
With private equity players dominating the investment market, large teams on the ground and the accumulated expertise over many years of conducted business, these funds have come here to stay and the inflow of equity is unlikely to stop. Not only is the sector overall much better prepared to weather the storm, but there is much more liquidity available in the market because institutional investors have been preparing themselves for the downturn by raising substantial amounts of opportunistic capital with a view of benefitting from the upcoming downturn.
Conclusion
Opportunistic players waiting for deep market corrections may be sitting on the sidelines for a long time. As investment funds feel the pressure to deploy capital, very few will be able to resist buying into any dip in the market. Not only is the sector much less leveraged, more professionalized and less speculative, but the amount of liquidity in the market seeking returns will prevent a significant downturn.
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