Covid-19 crisis expected to expose overleveraged sponsors

Borrowers with financially engineered performances face covenant breaches amid a market correction, warns AXA IM – Real Assets’ head of research and strategy.


Real estate investors that have taken on high leverage in recent year to ‘juice’ returns risk being exposed to technical defaults and breaching loan covenants as the property market experiences a correction, said Justin Curlow, global head of research and strategy at insurance company investor AXA Investment Managers – Real Assets.

“Over the last couple of years, more and more aggressive equity sponsors have been utilising higher levels of leverage and/or pro-forma underwritings to financially engineer stronger performance to the underlying real estate,” Curlow told Real Estate Capital, commenting on his latest report on the impact of covid-19 on the real assets sector.

The limited availability of prime property across European markets has placed pressure on managers to deploy capital over the past 18 to 36 months, resulting in equity investors either bidding up asset prices by accepting a lower return on their equity or taking on more leverage, said Curlow.

“As we got into this lower-for-longer environment, we saw property yields compress year in and year out, with borrowers basically pulling out all the stops, including financial leverage, they could try to hit their target return level,” he said.

Now that the markets are likely to experience a correction, trouble may lie in store for those with “financially geared performance” in the form of covenant breaches, Curlow warned.

However, others in the market believe the risk of overleveraged borrowers facing trouble lies more in the subordinated loans part of the market.

“Senior financing might face some short-term liquidity issues from the deferral of interest payments, but should benefit in the medium-term from the protective equity cushion, helping to absorb potential pressure on values post-crisis,” said Bertrand Carrez, head of real estate debt at asset manager Amundi.

Brad Greenway, senior director in consultancy JLL’s debt and structured finance advisory team, does not expect a large amount of foreclosures due to lower leverage levels across the market, compared with the previous financial crash of 2007-08. “The focus needs to be on operating assets and how long it takes for income to recover, as we have never seen the global economy be forced to shut down for a period of time,” he added.

AXA’s Curlow agreed that, while covenant breaches loom in the near-term, they are not expected to be anywhere near as widespread as they were in the last crash. He added that comfort can be taken from the fact that although this downtown will be severe, the property industry is not going into it with the high volumes of supply or aggressive levels of debt that traditionally exaggerate periods of adjustment for real estate markets, as seen in 2007-08.

Debt pricing

In order to assess the impact of the covid-19 crisis on real estate valuation and equity pricing, Curlow stressed it is “critical” to monitor whether the debt market remains functional, how loan pricing changes and for what quality of underlying assets and borrowers are lenders prepared to write loans.

Now that the cost of capital for banks is up by about 50-100 basis points, there will be heavy scrutiny on what extent that will be passed onto real estate borrowers, he added.

The US, which has a more diversified, competing lender base, is experiencing slightly more price discovery than banking-dominated Europe, according to Curlow, although he maintained that it was still too early to pinpoint exactly what that pricing will be. “We will need to monitor this before we have any real clarity on where the equity piece will land,” he added.

According to JLL’s Greenway, evidence of increased margins in deals varies by capital source and asset class, with some lenders holding margins and pricing for loans that have reached the legal documentation stage or that were agreed prior to the covid-19 crisis escalating.

He added that balance sheet lenders have hiked margins by 25-75bps for new transactions while some lenders distributing or using loan-on-loan have increased margins by more than 150bps in cases.

The market overall is adopting a very “commercial” approach, with most lenders allowing for margin flex to account for volatility and assessing the cost of capital at closing of the loan, he continued.

“If the underlying cost of capital and alternative investment yields return back to where they were pre-covid-19, then there is no tolerance for an increase in margins,” said Greenway. “But if they settle somewhere wider, then the market will need to accept this and adjust their tolerance for cost of debt.”

Looking ahead, Curlow does not expect the debt capital markets to dry up and is confident there is still appetite for lending.

“But the question is,” he said, “to what extent will they remain open and, most importantly, at what price?”