The UK commercial real estate market is facing a sharp rise in loan defaults due to the economic fallout of the coronavirus, the latest Cass UK Commercial Real Estate Lending Report, published on 22 April, has warned.

The report – compiled by Cass Business School from City, University of London – showed that the absolute value of loans reported to be in default increased by 36 percent during 2019, concentrated in the retail and development parts of the market. It added that the increase started from a low weighted average default rate and ended the year at a relatively moderate 3.2 percent.

Cass anticipates further loan write-offs and debt losses in the retail sector of between £8-10 billion (€8.9-11.2 billion) as the economic impact of covid-19 exacerbates the crisis in the sector. The report added that £22 billion of outstanding commercial development loans face the risk of construction delays and defaults of construction contracts, with £15 billion of residential development loans facing losses due to lower unit sale prices.

Nicole Lux, senior research fellow at Cass Business School and author of the report, told Real Estate Capital that £25.5 billion of construction loans had already been left undrawn by the end of 2019. “This indicates to me that there was already a significant slowdown and delay in development projects in 2019,” she said.

Refinancing need

Cass said the coronavirus pandemic will “add to a range of challenges facing an already slowing market”.

The report revealed that loan origination decreased by 12 percent to £43.8 billion in 2019 – a decline many in the sector expected due to the impact of Brexit uncertainty on the market last year. Just 46 percent of last year’s new lending financed acquisitions, highlighting a debt market dominated by refinancing activity.

While property transactions are likely to be subdued this year, lenders must still refinance £43 billion worth of loans that are due to mature in 2020-21, the report showed.

For Peter Cosmetatos, chief executive of property lending industry body the Commercial Real Estate Finance Council Europe, the amount of debt that needs refinancing is a key issue for the market.

“The next few months will be extraordinarily difficult for managing existing loans that are reaching the end of their lives, for lenders that either need to get that capital back or even for lenders that are happy to stay there but might need to change terms,” Cosmetatos said.

The report showed that most categories of lenders were hit by the decline in lending activity during 2019. German banks had the second largest decrease in loan originations, down by 23 percent to £3.58 billion year-on-year. UK banks’ origination dropped by 2 percent, but they remained the most prolific lenders, accounting for £21.47 billion in total loan origination.

In the non-bank lending market, insurers’ origination dropped by 24 percent. ‘Other lenders’ – mainly comprising debt funds – were the only group that did not register a decline, recording a modest 4 percent rise in origination to £7.9 billion.

Non-bank lenders may face more challenging conditions this year, according to Lux. “Non-bank lenders were lucky in 2019 when attractive transactions were rare and banks did not find enough product to lend on,” she said.

“They will have more trouble to lend than banks in 2020 because they do not have the same government support as banks,” she added. “Debt funds have to satisfy investors with return and dividend payments. They are under more pressure and could be less flexible when working with borrowers.”

Lending costs

The report added that, towards the end of 2020 and into 2021, increased defaults and loan write-offs will push up banks’ capital costs and reduce liquidity. The underlying credit decline of loans could immediately trigger increased capital costs where a recovery of a loan over the long term is questionable, which could lead into higher lending margins, it said.

“While the change in capital treatment for interest on loans during coronavirus will offer short-term relief, some businesses will not recover in the long term and the losses of these loans will need to be reflected in banks’ balance sheets,” Lux said.

She added that continental European lenders are already adjusting to the requirements of Basel IV banking regulation, which will mean higher funding costs for lenders.

“My prediction is that we will see minimum margins of around 200 basis points,” said Lux. “Lenders which had been lending at 130 basis points in 2018 have already adjusted that up to 150 basis points now but I think it will go up at about 200 basis points even for very low loan-to-value loans.”

The report showed that prime London office loan margins increased across the sample from 199 to 205 basis points during the year. Margins on secondary property increased in the range of 40-70 basis points.

Although the report noted that market conditions are becoming more challenging, it highlighted that the UK commercial real estate lending market remained stable overall during 2019, in terms of the volume of outstanding debt and the loan-to-value profile of lenders’ books.

On average, 40 percent of outstanding loans reflect LTV of less than 50 percent.

Cosmetatos argued that the Cass report revealed a relatively healthy UK real estate lending industry in 2019. However, he added: “The problem is that we are facing what seems set to be an extraordinarily challenging period of unprecedented economic stress, and even a well-positioned industry is going to depend on how the underlying economy copes.”