A complex and increasingly popular financing method known as “back leverage” is quietly reshaping how major commercial real estate projects in Europe are funded. This structure allows banks to re-enter the property market in partnership with private credit funds, filling a lending gap created by stricter post-financial crisis regulations.
A recent example is the £500 million financing package for the redevelopment of Deutsche Bank's former London headquarters. The deal, arranged by NatWest Group and Cheyne Capital Management, highlights a growing trend that is enabling large-scale projects while also raising new questions about market risk and transparency.
Key Takeaways
- Back leverage involves a bank and a private credit fund jointly providing a loan through a special entity, allowing for more favorable capital treatment for the bank.
- The use of this financing structure is growing rapidly in Europe, with at least €31 billion in loans already tied to it.
- Increased competition among lenders is leading to concerns about weakening creditor protections and lower profit margins.
- Experts warn that this model has not been tested in a major market downturn, posing potential liquidity risks for investors.
A New Era of Property Finance
In the wake of the 2008 financial crisis, stringent regulations required banks to hold more capital against direct real estate loans, making such lending less profitable. This created a vacuum in the market that private credit funds were quick to fill. Now, banks are returning to the sector through the side door using back leverage.
The structure typically works by having a bank and a private credit fund collaborate to finance a special-purpose vehicle (SPV). This SPV then issues the loan to the property developer. The bank provides the largest and safest portion of the debt, known as the senior tranche, while the private credit fund takes on the smaller, higher-risk junior portion.
This arrangement benefits all parties. Banks get exposure to real estate deals with less capital required, developers gain access to much-needed funding, and private credit funds can enhance their returns and deploy capital more efficiently.
Filling a Critical Funding Gap
The rise of back leverage is a direct response to a changed regulatory landscape. For developers undertaking ambitious projects, such as adding rooftop gardens and new floors to iconic buildings, traditional bank loans have become harder to secure. This alternative financing route has become essential for keeping large-scale urban redevelopment projects on track across the continent.
The Market Is Heating Up
The use of back leverage is no longer a niche strategy. A survey from CREFC Europe, a trade association, identified at least €31 billion ($36.4 billion) in loans connected to this type of financing, noting that the actual figure is likely much higher. The momentum is expected to continue, with a Knight Frank poll revealing that 90% of European banks using back leverage plan to increase their lending in the coming year.
Major financial institutions are actively participating. Besides NatWest, other prominent banks like Barclays Plc and Goldman Sachs Group Inc. have recently utilized back leverage for significant European real estate projects. In one instance, Goldman Sachs partnered with PGIM to provide approximately £110 million for the construction of The Other House, a luxury apartment hotel in London's Covent Garden.
"It’s a massive trend that we expect will continue to grow," said Jacky Kelly, who leads the London structured finance practice at law firm Weil Gotshal & Manges LLP. "It’s really taken off in the last two or three years."
This surge in popularity has intensified competition. According to AJ Storton, a partner at real estate debt advisory firm Art Capital, "The back leverage space in Europe has become a lot more competitive."
Growing Pains and Hidden Risks
The intense competition is beginning to show signs of strain. Insiders report that some banks are lowering their margins significantly to win deals. Margins that were once healthier are now sometimes between 100 and 150 basis points over benchmark rates, compressing profitability.
More alarmingly, some lenders are reportedly dropping key creditor protections, such as margin calls or the right to pursue a borrower's other assets in the event of a default. This erosion of safeguards could introduce instability into the market, particularly if economic conditions worsen.
Untested Waters
A primary concern among market observers is that many of the private credit funds now heavily involved in back leverage have not operated through a severe economic downturn. Their ability to navigate a wave of defaults or a sharp drop in property values remains unproven. In a crisis, these funds would face the complex task of negotiating with both the developer and the senior bank lender simultaneously.
Another potential vulnerability lies with the investors who back these private credit funds, known as Limited Partners (LPs). These LPs, which often include pension funds, insurance companies, and sovereign wealth funds, have exposure across numerous funds and assets.
Ben Barbanel, head of debt finance at Oaknorth Bank Plc, which has engaged in back leverage lending, voiced this concern. In a major downturn, LPs could receive simultaneous capital calls from multiple funds, creating a correlated risk that could lead to a widespread liquidity squeeze.
"In the back of my mind, I’m always a bit nervous that risk potential is not necessarily well enough tracked," Barbanel noted.
Regulatory Blind Spots
Despite the rapid growth and emerging risks, the back leverage market appears to be operating with limited regulatory oversight. According to Peter Cosmetatos, CEO of CREFC Europe, the prevailing view among UK and European regulators is that the sector is currently too small to pose a systemic threat.
However, he also pointed out that regulators are not yet collecting comprehensive data on this specific financing area. Both the European Central Bank and the Bank of England declined to comment on their stance. This lack of broad-based data collection means that the true scale of the market and its interconnected risks may not be fully understood until a crisis hits.
As more capital flows into these complex structures, the balance between innovation in financing and maintaining market stability will become an increasingly critical issue for developers, lenders, and regulators across Europe.
