Until recently, the idea of underwriting a pandemic would have seemed outlandish. Yet here we are, more than two months into a lockdown, with debt and equity investors alike trying to do exactly that.
In times like these, the instinct of many in the market – particularly the traditional lenders – is to press pause and take stock, meaning liquidity dries up. Lenders are trying to support their clients on existing positions, but many will inevitably shy away from new loans that do not have grade A credit.
Yet every crisis also presents opportunities. Alternative lenders, with their ability to take a creative approach, are well placed to provide real estate finance amid the dislocation caused by current conditions. It is inevitable that alternative funders will move further into traditional bank lending territory. They will fill the gaps others cannot, due to the crisis.
The market drives the pricing of risk, but the market is not currently functioning particularly well. Most likely, a global recession is on the way and consequently risk is, and will continue to be, priced higher.
With this recession will come distressed opportunities, but most will not appear until the end of the year when the full effects of the crisis are visible. Those that aim to take these opportunities need to be sure a prospective deal has strong fundamentals, no matter what distress has befallen it. That means a strong sponsor, location and the prospect of strong returns.
As risk across the sector increases, loan-to-value ratios will be lower, but there will be higher margins as the market recovers. The difficulty is predicting when the recovery will come – but if you have the fundamentals right and the capital to weather the storm, you can come out of this in a solid position.
Lending successfully throughout a crisis like this requires a disciplined back-to-basics approach – maintaining a strong relationship with the sponsor, understanding its underlying business and the real estate itself, and having a realistic delivery plan.
It also requires a focus on long-term, sustainable cashflow to mitigate refinancing and repayment risk. Although the covid-19 crisis has felt interminable at times, real estate will come out of it and find a way to thrive. Some sectors, such as life sciences, logistics and data centres, have already become more attractive due to the pandemic. Other sectors will need a refresh, be that through the evolution and development of more diverse urban mixed-use, more creative office design, or the emergence of tech-assisted healthy buildings that cater to denser environments, such as co-living or student accommodation.
Debt providers will play a significant role in facilitating this change. But we will need to be creative and flexible in our approach.
Many claim the crisis is at least as detrimental to the market as that of 2008. However, the banks are in a stronger position than they were 12 years ago. The reforms post-2008 have resulted in greater cash reserves on their balance sheets, so the risk of default is diminished. Decisive economic intervention by governments around the globe is also helping soften the blow of virtually complete economic shutdown.
We are undoubtedly in thin times, and lenders will need to work in partnership with their borrowers to get through it. Although the short term is uncertain, I believe the medium term will bring more normality. People’s desire to connect, collaborate, travel and explore is undeniable. Even this virus cannot quash it. We will come through this using the flexibility we build into our deals and confidence in our partners’ businesses. Because, ultimately, real estate is a long-term game.
John Cole is senior managing director, head of real estate debt at Cain International