On paper, the commercial property debt market today is far better able to withstand shocks than it was when the financial crisis hit. Banks are better capitalised, there are many more lenders out there with different funding sources and leverage is typically lower than in the 2000s.
However, this is not a re-run of the financial crisis. Thankfully, there is no credit crunch, but the market is facing new challenges. Whereas in 2008, the Bank of England responded to the crash by slashing interest rates, now high inflation is forcing it to hike rates at a speed not seen for generations.
The problems and stresses this will create in commercial property are likely to be quite different. Here we take a look at some of the key things to watch out for in the coming months.
As valuations fall, some borrowers will fall foul of loan-to-value (LTV) covenants, but an equally, if not more pressing issue is likely to be interest cover. Many will have hedging in place, but many will not, and as rates rise income left after interest expenses will be squeezed. Interest cover covenant breaches will inevitably become more commonplace. Lenders are expected to be accommodating when it comes to existing loans but refinancing deals will be a different story.
“Lenders will be looking at their books very closely,” says Neil Odom-Haslett, head of commercial real estate lending at Abrdn and president of the Association of Property Lenders.
“I don’t see evidence of distress yet but it has to happen at some point. The issues will come at refinance, mainly as a result of challenges around interest cover.”
At refinancing, the problem for borrowers is that in order to comply with interest cover requirements, they may not be able to borrow as much as they did before.
“I don’t see evidence of distress yet but it has to happen at some point”
NEIL ODOM-HASLETT, ABRDN
There will be different options to explore to manage this. Adam Buchler, co-founder of debt adviser BBS Capital, says there may be “more creative ways” of structuring deals using different hedging products.
But in many cases the only solution will be to put more equity in or seek out more expensive mezzanine debt. Some more highly geared borrowers may even find they have nowhere to go.
New sectors in focus
In recent years, it has only really been owners of retail properties who have faced financing challenges, but that is now set to change. Increasingly office landlords will struggle, and some logistics owners will also be feeling the heat, something that would have been unthinkable at the start of the year.
The sector has seen such strong rental growth and valuation gains in recent years that owners are unlikely to run into trouble with assets bought early enough in the cycle even if they did gear them highly at the time. But with logistics pricing down significantly from peak levels, increasing numbers of assets will be in the danger zone.
Borrowers that bought properties off low yields and haven’t yet had the chance to push up rents in line with the market may be in for a shock when they see how far available LTVs have fallen as a result of interest cover requirements.
This could be a common occurrence if debt costs continue to rise. A popular private equity strategy in recent years has been to rapidly buy up lower yielding warehouses and still achieve high returns thanks to a combination of yield compression, rental growth and gearing.
“Everyone would say we don’t go above 60-65% LTV, but then would make an exception for logistics,” says one leading private equity investor. “Some of those logistics aggregators will be facing some tough decisions.”
The get-out-of-jail card is strong operational performance. The exceptionally high levels of rental growth in logistics will offer a route out of trouble so long as lenders are willing to be patient.
And providing that the operational outlook remains positive, even at refinancing, many borrowers should still be able to find sources of additional debt or equity capital to step in, although the terms may not always be appealing.
Build-to-rent is another sector with low yields that faces potential interest cover headaches, but like logistics, it is benefiting from rental growth, which has accelerated in recent months. Crucially for borrowers, higher market rents are passed on much more quickly, easing interest cover challenges.
Just how tough could things get? AEW published research last month estimating that commercial real estate debt markets in the UK, France and Germany face a cumulative €24bn debt funding gap for the next three years. This is the gap to be bridged between the original debt amount due at loan maturity and the new debt available to repay it. It is significant but well below the levels seen in the aftermath of the financial crisis. There is an important caveat, however.
The estimate is built by considering valuation changes since 2018 and assuming lower available senior LTVs, but Hans Vrensen, head of research and strategy at AEW, says it does not explicitly factor in interest cover which is harder to model. As debt costs rise, accounting for interest cover could reduce available LTVs further even than the AEW model assumes and push up the funding gap.
Ultimately, much will depend on how far values fall. Values largely held steady at the end of the second quarter but the third quarter will be a different story as evidence of weaker pricing in the investment market has built up. The first sign of the size of reductions to expect from September valuations came last week from Abrdn Property Income Trust, which reported today that the value of its portfolio had decreased by 4.2% on a like-for-like basis compared to the end of June. The £540m trust said it believed the decline would be similar to the MSCI index.
Evidence from the investment market would suggest that more write-downs are likely to follow. The Green Street Commercial Property Price Index, which measures the pricing of a broad swathe of commercial properties, is about 15% below its recent peak, having fallen by 4.4% in the third quarter.
It is not just in the investment market where signs of debt-driven stress are likely to emerge. Developers will be feeling the heat too. As well as rapidly rising debt costs, they are having to contend with high construction cost inflation and the likelihood that the end value of their schemes will be lower than previously hoped.
Highly geared developers who bought land at the top of the market and face the prospect of selling into rapidly cooling markets like residential for-sale or logistics will be particularly vulnerable.
Lenders are understandably more cautious than ever about development lending. Debt is still available but developers will have to be at the top of their game to secure funding for new schemes.
“We’ve gone from being thorough in our underwriting to forensic,” says Mark Quigley, managing director at Beaufort Capital, a development lending specialist. “We’ve kept our margins and leverage unchanged for the present time, but whether we can stick to the same leverage and pricing depends on just how challenging things become over the coming months.”
Could lenders themselves run into trouble? Higher octane lenders are most likely to face challenges. Inevitably as values fall and debt costs rise, mezzanine lenders will increasingly find they have problem loans on their books but are unlikely to rock the boat while borrowers are still working through business plans that could add value to properties.
There is no evidence of this happening yet but an early sign of trouble will be when they start looking to sell on loans at a discount.
How well lenders are able to cope will depend to a large extent on their own funding. Some may even do better than they would otherwise have done had rates remained at rock bottom levels, as BBS Capital’s Buchler explains.
“There are those that raised capital before all this happened. They’re unlevered and have promised a certain return to their investors predicated on interest rates being close to zero. Suddenly, they’re able to achieve materially higher returns thanks to higher rates.”
Such lenders will be in a good position to be accommodating to their borrowers.
By contrast, those that rely on loan-on-loan financing are most likely to struggle as their costs will be increasing rapidly. These lenders will therefore find it harder to be as flexible with their borrowers as others.
Bridging lending, which is a part of the market that has grown rapidly in recent years, is expected to face problems. Not only are bridging lenders often reliant on loan-on-on financing, but the short-term and higher leverage nature of their loans means many of their borrowers will be facing more problematic refinancing events.
The debt market as a whole may be a lot more robust than it was going into the financial crisis but there are still areas of weakness that look like they will be tested in the coming months. It is just a question of how much damage will be done and what the fallout will be.