A wake-up call from retail covenant breaches

For the first time since the global financial crisis, many commercial real estate lenders in Europe are facing the prospect of borrowers tripping their loan covenants.

Most property loans originated after the financial crisis continue to perform comfortably within their agreed terms. But the spate of retail closures in the last two years has led to a fall in shopping centre values, triggering alarm bells within loan structures. This has particularly been the case in the UK.

“If you lent against retail in the last five years, you will have had some breaches,” says one London-based banker, speaking anonymously. “Even if that only results in cash sweeping, it still requires investment into the shopping centre.”

The Cass Commercial Real Estate Lending Survey, published in October, shows defaults are still low in the UK: they peaked at 25 percent of all outstanding commercial property loans in 2011 and 2012, but have remained below 3 percent since 2016. However, in the first half of 2019 there was a 13 percent hike in covenant breaches that lenders expect to turn into defaults. Most were retail loans, and rising loan-to-value ratios are the most frequently cited reason for breaches.

“Plenty of retail landlords are in trouble from a financing perspective, not because they are losing tenants, but because widening yields across the market mean they have breached LTV covenants,” says Jeffrey Rubinoff, a real estate finance specialist with law firm White & Case. Research from broker Cushman & Wakefield shows UK shopping centre yields rose 125 basis points in the 12 months to the end of Q3. “Banks are requiring borrowers to deleverage their assets or conduct an orderly sale,” Rubinoff adds.

At the time of publication, listed UK property company RDI REIT was selling a portfolio of four shopping centres, following breaches of its debt terms this year. By the end of the first quarter, RDI owed £145 million (€165 million) to Aviva Investors. In RDI’s annual results, published on 24 October, it said the insurance group subsidiary  had called for an updated valuation of the portfolio in April because of concerns over the “structural challenges facing the retail sector and several retailer failures”.

“If you lent to retail in the last five years, you will have had some breaches.”

Anonymous banker

The borrower had already paid £9.7 million to cure an event of default following a valuation and had agreed to restrict all net operating cash flows. But the April valuation resulted in a further default.

RDI decided not to inject additional capital. “After considerable discussion with Aviva, both parties concluded that it was in their best interests to enter a consensual sale process to dispose of the four centres,” the company said in its results. A standstill agreement, under which Aviva will not accelerate the loan, is in place until the end of December, though Aviva can enforce at its discretion.

Neither firm would comment on the decision to sell rather than seek refinancing. However, sources point to the difficulty in sourcing retail finance, particularly in the UK. The retail investment market is also tough for anyone aiming to offload assets. Cushman & Wakefield research shows just 95 assets, totalling £1.1 billion, changed hands in the third quarter of 2019 – a 65 percent year-on-year drop. It means lenders are averse to taking back retail properties when defaults occur.

“Banks taking keys to shopping centres usually leads to bigger losses,” says the banker. “Banks are not asset managers.”

There is also little evidence of lenders putting non-performing retail loans on to the market. The wave of real estate NPL sales across Europe from around 2011 means there are plenty of opportunistic investors with experience of acquiring and working out defaulted loans. However, lenders remember the huge losses they took on legacy property loans.

One debt advisory source recalls a recent conversation with a hedge fund, which had looked at retail loans put up for sale by a bank. “The offers the vendor got back were very, very low,” the source says. “There is such a huge disconnect between where buyers and sellers think value is.”

Finding a cure

Although there is some evidence of consensual sales in the market, sources suggest many lenders and borrowers are looking for other solutions. Even with some vacancies, many shopping centres are still generating enough income to meet debt yield tests, and lenders are often prepared to be patient when breaches occur.

“There is a big difference between a breach due to the LTV and a breach because the borrower cannot service the interest,” says Luca Giangolini, partner and debt specialist at real estate capital advisory firm CAPRA. “In cases where the breach is the result of the LTV, we’ve seen lenders take a sensible approach and back the sponsor if they believe in their business plan.

“Clearly they will trap cash where appropriate but such trapping for the purpose of paydown often makes less sense than freeing up that capital for capex and tenant incentives. Ultimately, it’s about driving cashflow and footfall, which requires investment. We’ve worked with a number of lenders and borrowers and seen some pragmatic extensions going on.”

Typical real estate loans originated during this cycle feature several covenants. In addition to LTV covenants, by which lenders can act if leverage rises more than 10 percent during the loan term, they also feature interest cover or debt service cover ratio measures. These ensure that income covers finance costs. However, Dean Harris, managing director in credit and asset management at loan servicer Trimont Real Estate Advisors, says low interest rates mean these covenants are less relevant in today’s market: “Debt yield covenants, by which the property’s net operating income is divided by the loan amount, have become a more widespread measurement.”

“What is key to remember is that many of the retail assets are performing well, even if widening yields have affected valuations.”

Jirka Lhotak
CBRE Global Investors

Lenders are also likely to include cash trap mechanisms, by which surplus income is transferred to a blocked reserve account controlled by the lender. In some cases, lenders will also require cash sweep mechanisms, which use surplus income to pay down the loan. And timetabled milestones might be inserted into facilities underwritten against properties subject to value-add business plans. Covenant packages usually provide lenders with several measures of a loan’s health, as well as options to step in.

“Trapping cash is often a logical step to take,” says Emma Jack, European head of origination at investment manager PGIM Real Estate. “Lots of sponsors are cash-on-cash driven and need to distribute returns to investors. So, the threat of trapping cash is usually enough motivation for them to meet their obligations.”

A common sentiment heard during research for this article is that lenders are typically adopting a co-operative approach with borrowers when covenant breaches occur. Jirka Lhotak, EMEA chief financial officer of real estate investment management giant CBRE Global Investors, says his firm has proactively been at the negotiating table several times as weakening capital markets for retail assets cause breaches or the need for loan extensions. As a conservative, core borrower, its lenders were prepared to agree to its plans to remedy the situations, he says.

“It is important to find a long-term, mutually acceptable solution in such situations, so you don’t need to repeat the discussion with the lender every six months,” says Lhotak. “What is key to remember is that many of the retail assets are performing well, even if widening yields have affected valuations.”

When borrowers need to cure breaches, they have several options. They may be able to partially repay the loan, accept a cash trap with the goal of retaining cash in the borrowing system, or strengthen the security package. “You can redefine the loan terms, where appropriate, such as agreeing to an interest coverage ratio waiver or extending maturity,” he says. “But if we partially pre-pay, accept amortisation or provide more security, we need to get to a situation where we are not watching the covenant every quarter end.”

Stepping in

Although many lenders do not want the keys to assets they have financed, some debt providers have taken ownership of retail properties following breaches. In March, Austrian bank BAWAG took control of four UK shopping centres from Lone Star, a US private equity firm. In that case, BAWAG had been a mezzanine lender to Lone Star.

In May, London-based debt fund manager DRC Capital took over the equity in a portfolio of UK shopping centres. This followed an LTV breach by the owners, US private equity firm Oaktree Capital Management and listed property firm London & Associated Properties, which declined to inject further capital.

The resolution to a retail loan covenant breach depends to a large extent on the strategies of the lenders and borrowers. Many European retail assets were bought by private equity funds around 2014-15 at what, in retrospect, was the peak of values in the market. Unlike property companies, which are eager to hold on to property assets, sources say private equity sponsors are unlikely to inject fresh equity into a deal if they are coming towards the end of an investment period.

Similarly, some argue institutional debt fund managers will take a more pragmatic view on default situations to banks. One manager notes that having capital locked up for an investment period, with high yield return targets, means stepping into the equity of a defaulted asset and managing it over time can make more sense than seeking a fire sale. Non-bank lenders have a more equity-focused mindset, some believe, meaning default situations can create an opportunity.

“Regulations around non-performing loans have since made it very expensive for banks to hold non-performing assets.”

Emma Jack
PGIM Real Estate

The problems befalling many retail assets across Europe ultimately require well-considered business plans, as well as fresh investment. PGIM’s Jack says senior lenders’ choice of sponsors during this cycle will determine how they react to senior loan breaches: “We have a lot of sponsors with whom we do a lot of repeat business. Selecting the best-quality sponsors in the first place is important, because even when covenants are tripped, you still have borrowers who are best-placed to carry out a business plan.

“This business is about capital recovery, so in the event a sponsor was not able to fulfil its business plan, we have an in-house equity team that could take on asset management of the collateral, but that is very much a last resort.”

Jack adds that the experience of the last real estate downturn will encourage lenders to deal with senior loan breaches effectively: “After the crisis, there was a lot of extend-and-pretend. But regulations around non-performing loans have since made it very expensive for banks to hold non-performing assets, so they are more likely to take action.”

The 13 percent rise in potential default situations reported to City University’s Cass Business School in its UK lending survey is a worrying sign for any lender with exposure to retail. However, the Cass figures also suggest there has been no significant change in reported defaults, in the UK at least, with the total weighted average default rate stable at 2.5 percent. Enforcement, the figures suggest, is not – currently – a regular course of action.

But as the ability of both lenders and borrowers to find solutions to loan breaches is sorely tested by the crisis in the retail sector, it is unclear how long this restraint can continue.

Are lenders maintaining loan covenant standards?

Real estate debt professionals argue protective covenants have enabled lenders to act in cases of rising loan-to-value ratios in retail loans.

They deny the European lending market is sliding towards ‘covenant-lite’, as is the case in the corporate private credit industry. However, there is talk of the largest US private equity firms requesting lighter covenants. One banker, in private, refers to “big US private equity investors” trying to do “US-style covenant-lite deals in Europe”. US real estate lending deals typically contain more flexible covenant packages than those in Europe, and some suggest US investment banks are willing to apply such standards across the Atlantic.

However, most sources report that such practices are limited. Blackstone – Europe’s largest borrower – is frequently cited as a sponsor that receives unique treatment, with default covenants absent from its loans.

Gadi Jay, managing director in its real estate group, suggests the firm’s large-scale, value-add investments and longstanding reputation allow it to borrow in a way that means lenders should not be in a position to disrupt its business plans. “We look to work with lenders who appreciate we are buying quality real estate which we can manage, even through a downturn,” he says. “We seek a minimum five-year certain term to execute a business plan, so our financing packages must be robust enough that we are able to achieve what we set out to do.”

Jay denies Blackstone is encouraging a covenant-lite culture in Europe: “We’re not loosening covenants for the wider market. We are borrowing in a very specific way. Our deals do include lender protections and covenants, but ultimately, we look to ensure the loan is structured to ensure that it can go through to full term.”

Although other large US investors might be requesting similar treatment, they may not be receiving it. “I’m surprised how little it has spread in the market,” says one debt fund manager. “Beyond three or four private equity firms, no-one’s even asking.”

“Blackstone has been successful in its approach, largely due to its scale,” says Jeffrey Rubinoff of law firm White & Case. “But it remains an outlier. I’ve seen some of the other private equity firms try to get the same treatment, but not successfully.”

Sources say real estate lenders are generally unwilling to compromise covenant terms, and few borrowers attempt to push the issue. Some say lenders are offering flexibility when it comes to additional headroom in LTV covenants. “I’ve seen deals with a 60 percent LTV which will not default until the LTV gets to 75 percent,” says Rubinoff. “But wherever the starting LTV is, lenders are unlikely to set the default covenant much higher than 75 percent, or 80 percent in rare cases. Two years ago, headroom might have been closer to 70 percent.”

Covenant standards have become a talking point in Germany’s ultra-competitive lending market. “Most banks say they remain very strict on covenants, but say they are losing transactions to others who are competing on covenants,” says Tobias Just, an author of the University of Regensburg’s German Debt Project survey. “If investors are beginning to argue about covenants, rather than the last few basis points of a loan, it hints they are worried there will be a turn in the market.”

Berlin Hyp’s head of real estate finance, Assem El Alami, says there is always pressure on covenants, but the bank stands its ground: “We’ve lost deals because we weren’t prepared to work without covenants. In cases of very conservative risk profiles, borrowers may ask to do away with the debt service coverage ratio or covenants all together. We wouldn’t, but apparently other banks will.”

One London-based debt fund manager dismisses fears that German banks compromising on the terms of loans written to conservative LTVs on prime properties represent a slide to covenant-lite. For the most part, he maintains, there is no cause for concern for European covenants.

In contrast, covenant-lite has become routine in private corporate credit. Although default rates remain low, there is concern about sliding lending standards as leveraged loans have shifted from being bank-dominated to having a thriving institutional lending community. One debt specialist with a background in leveraged loans says this has led to lenders doing away with covenants. He warns that as non-bank lenders take a larger share of Europe’s market, they will face pressure to compete on covenants: “The make-up of the market could be very different 10 years from now.”