AEW: Falling values and lower ICRs bring debt funding gap to €51bn

The shortfall between the original principal volume of real estate loans due to mature in the UK, France and Germany during 2023-25, and the amount of new financing available to repay it, could be more than double initial estimates, AEW has warned.

In September 2022, the Paris-based manager forecast a €24 billion debt funding gap for the three markets, due to declines in collateral values and the amount of leverage lenders are willing to provide in new transactions.

However, in follow-on research to be published this week, it said the gap could be as much as €51 billion during the period, due to faster than anticipated declines in collateral values resulting in lenders making even less capital available to borrowers at refinancing.

In a significant expansion to its analysis, AEW also factored in the likely impact of lower interest coverage ratios on the amount of capital lenders are willing to provide, following a sustained period of higher debt costs since mid-2022.

“The refinancing challenge facing these markets is not quite as significant as after the global financial crisis. The markets faced a €63 billion shortfall for 2010-11, which puts the current challenge at near 60 percent of the GFC on a like-for-like basis,” Hans Vrensen, head of research and strategy at AEW, told Real Estate Capital Europe.

Falling values

AEW’s research team took investment volumes data from 2018-20 for four property types across the three countries and adjusted it for leveraged-only deals. It then applied a market average 60 percent loan-to-value at origination, to estimate how much debt was taken on by borrowers during each year, secured by each property type.

Assuming an average five-year loan term, it estimated the volume of debt coming due in 2023-25. Using in-house capital value projections, it forecast the aggregate value of loan collateral at maturity across the 12 markets, and applied a 50 percent LTV ratio, to estimate lender appetite to refinance the debt.

Looking only at LTV, AEW found the upcoming debt funding gap to be €46 billion – almost double the €24 billion forecast from September.

However, the manager also factored in the impact of rising rates on lenders’ willingness to refinance debt. Using rental and loan pricing data, it forecast how ICRs will change between loan origination and maturity. “As rates have now been elevated for some time, it seems appropriate to quantify this ICR impact,” explained Alexey Zhukovskiy, associate in AEW’s research division.

Most restrictive

“Interest coverage ratios were typically 4.0x in 2018. Despite increasing rents, higher all-in borrowing costs pushed these below 1.6x for loans due to be refinanced in 2023,” said Zhukovskiy. “This is unlikely to be either commercially appealing or acceptable from a regulatory and capital reserve perspective, especially for bank lenders,” he added.

Based on input from debt specialists, the team determined 2.0x to be the average ICR lenders will consider acceptable to refinance a loan in current market circumstances. “In most cases, the available ICR-restricted refinancing debt is less than the original debt, triggering an ICR-driven debt funding gap,” Zhukovskiy said.

AEW’s final and combined debt funding gap estimate of €51 billion was calculated by taking the most restrictive measure for each of the 12 segments – LTV or ICR – and working out how much new financing lenders would be willing to provide. ICR was the most restrictive factor in the German and French markets, with LTV considered most likely to influence lenders in the UK, AEW found. By country, Germany accounts for 45 percent of the total combined debt funding gap estimate, with the UK accounting for 33 percent and France for 22 percent.

Faster resolution

Vrensen believes the debt funding gap will be bridged in part by asset owners injecting additional equity into transactions. He also expects to see alternative lenders play a bigger role in the market, providing whole loan and mezzanine finance to borrowers unable to source the volume of new debt they require.

However, in cases where borrowers struggle to refinance existing loans, Vrensen expects incumbent lenders to seek a faster resolution than was often the case following the 2007-8 crisis, when many lenders repeatedly extended loans.

An incentive to resolve situations of default rather than extend problem loans, he said, is the fact hedging instruments will expire when loans mature, potentially making borrowers liable to untenable interest payments in a higher interest rate environment. Regulated banks are also unlikely to be allowed to leave loans unhedged for extended periods of time, he added.

“Lenders and borrowers will have to be creative to restructure the capital stack to reach sustainable LTV and ICR levels as refinancings come through over the next few years. This will require more than the usual maturity extensions, covenant waivers, cash-traps and/or partial restructuring of existing loans before they can be refinanced, especially with hedging requirements,” said Vrensen.

“These required loan restructurings are likely to be immediate enough to trigger a potentially faster downturn than the delayed and prolonged retrenchment after the GFC, amplifying the current market cycle,” he added.