Borrowers prize flexibility most highly

Pricing is not necessarily the deal-breaker in real estate loan deals, with sponsors increasingly focused on ensuring adequate breathing space in covenants.

An often-repeated sentiment from the borrower side of the European real estate debt market is that loan covenants should allow sponsors the flexibility to effectively execute their business plans. Loan margins, many insist, are not the main consideration when choosing where to source debt.

The point was reiterated in recent weeks by borrower panellists at the CREFC Europe and Loan Market Association real estate finance conferences in London. “Ultimately, we’re looking for a package with maximum flexibility to manage an asset,” said one finance director from a property company. “We’re negotiating for that rainy day.”

The fact is that property debt, especially in the senior market, remains inexpensive for borrowers. It is difficult to imagine that pricing doesn’t go a long way to informing a sponsor’s credit decisions, but the point increasingly being made is that a cheap loan is not necessarily the best loan. If covenants are too rigid, and if there is a market event during the life of the loan that affects an asset’s value or its income stream, a default can occur despite the borrower remaining in a strong position to manage the situation.

Especially in the opportunistic and value-add segments of the market, borrowers are demanding debt terms which allow them to fix-up properties through asset management strategies, with in-built sensitivities to situations such as the property suffering a temporary lack of income. Borrowers argue that it is essential that lenders genuinely understand their business plans and the underlying properties so that enough trust is established leading to a loan structure which works for both sides of the deal.

Among the larger owners of core property portfolios, there is also a desire to see covenants focus less on loan-to-value than the income performance of assets, more in line with the US way of doing things. Finance directors from large REITs have recently argued that the value of their prime property holdings is somewhat at the mercy of market conditions, while income cover ratios are covenants that can be more actively managed.

From the lender side of this debate there is a willingness to accommodate borrowers’ needs, even though many remain wedded to LTV measurements in order to control leverage across their loan books. However, there is a growing awareness that choosing the most appropriate covenants in the first place is important, with measurements like interest cover ratio and debt yield ratio increasingly common.

There are, however, some concerns among lenders that there could be a slide towards a ‘covenant-lite’ culture in parts of the market, something that lenders say they are determined to withstand.

There will always be some give-and-take between borrowers and lenders when it comes to determining the small-print on lending deals, and in a market where lenders as well as investors are following more distinct business strategies, there is a growing need for debt deals to be tailored towards a situation.

However, lenders also have a responsibility to ensure that their loan books remain robust and that loan terms remain defensive enough to avoid a repeat of last cycle’s reckless lending. Striking the balance between lenders’ need for caution and borrowers’ desire for wriggle-room is no easy task.