This article is sponsored by First Growth Real Estate & Finance
In an ever-changing and unpredictable environment, First Growth Real Estate & Finance says technology and innovation are key to unlocking value in the real estate debt markets. The firm actively engages in financings, refinancings, loan amendments and syndicated loan terms while leveraging in-depth capital market knowledge, a unique loan valuation model and a network of financial institutions across Europe to keep up with this everchanging industry.
How will the refinancing gap and other challenges affect borrowers and lenders?
We are seeing increased refinancing problems arising from a combination of factors, including falling capital values, liquidity quickly fading away, especially for secondary and transitional assets, higher lender costs, a regulatory-induced capital requirement increase, lower LTVs for new financing as lenders take a more prudent approach, and hedge protection disappearing with the base-rate element of debt service steeply increasing automatically.
In most instances, a combination of reduced value and reduced LTV leads to a refinancing hole to be plugged, but in an increasing number of more distressed situations, no available liquidity, especially when no fresh equity injection is possible, means no refinancing is achievable.
We expect the refinancing gap to widen further over the next 12 months or so as more economic headwinds translate into more difficult performances and debt capital remains risk-off by staying away from potential ‘value trap’ assets.
Nevertheless, the refinancing gap we are witnessing remains, for now, less acute than the one experienced in the aftermath of the global financial crisis, which was characterised by a combination of banks adopting even more prudent lending policies post-GFC, like reducing LTVs drastically to less than 50 percent while there were virtually no non-bank lenders to bridge the gap.
How is the current economic situation different from the last downturn?
The market remains plagued by more macro uncertainty brought on by inflation, the Ukraine war, increasing geopolitical tensions, ESG considerations and falling property values, especially in the office and retail sectors. Office stock is impacted by work-from-home policies and retail by changes in consumer behaviour.
The reduced value/LTV problem is amplified by a much higher cost of debt today, which has increased by 400-500 basis points when accounting for, say, a 50 percent LTV cut, a 350bps base rate increase, and between a 50 and 150bps increase in margins, which all puts additional pressure on ICR/DSCR covenants.
Since the second half of 2022, we’ve seen many lenders assessing their loan portfolios. Banks are monitoring their balance-sheet risk closely but should be able to consider lending again on specific asset classes linked to the offloading process. We expect more distressed loans to come up through the end of this year and into 2024, which will likely require new capital injections and forced sales.
And refinancings are taking more time than before: committee approvals are more thoroughly prepared and lenders’ risk departments are adopting a more cautious stance. As a result, we are also seeing borrowers anticipating loan maturities further in advance, sometimes up to 12 months before coming due. In some cases of large refinancings with a big pool of lenders, we sometimes see one or more lenders not inclined to participate in the refinancing. This situation is leading advisers to find new lending partners at the loan terms negotiated with existing lenders, which creates complexity and takes extra time to align all parties’ interests.
We are increasingly seeing market-flex clauses in refinancing term sheets or reduced pricing for take and hold underwriting, as lenders who need to distribute are wary of market volatility, which could lead to quick repricing impacting syndication liquidity.
The refinancing process seems to be playing out in one of three ways: the ‘natural’ refinancing of maturing loans; the ‘forced’ refinancing of problematic loans, where no equity can be injected and hedge benefit expires upon maturity; and ‘opportunistic’ refinancings by sponsors wishing to show liquidity to investors or looking to boost returns through a dividend upstream.
On the upside, we do not anticipate a banking doom loop in the European lending sector, at least for now. The overall health of European large banks has significantly improved since the GFC, even if their profitability has not taken off significantly, and debt here is mostly held by large banks that are subject to cautious oversight. This contrasts with the US market, where the majority of commercial real estate debt is held in the public markets as CMBS securities or by smaller regional banks, some of which are experiencing substantial pressure from deposit flight, riskier investments and other issues.
To put it in a nutshell, we expect borrowers across Europe to feel the squeeze as liquidity tightens for some asset classes and sponsors. A debt adviser with a strong expertise in both capital sourcing and restructuring is key. Our firm is pretty unique from that standpoint. We are receiving an increasing number of incoming calls from borrowers to assist them with their loan extension or restructuring discussions with in-place lenders, not only on the continent but also in the UK, where we are beefing up our capabilities to address clients’ demand and in anticipation of further distress over the next 18 months.
What issues are borrowers seeing as they seek refinancing?
The combination of a decline in value and a reduction in LTVs creates a gap to be filled. Most of the loan restructuring situations require new capital injections as borrowers are not able to replace existing loans with like-for-like debt quantum.
In some situations, high-yield debt funds can plough money subordinated to incumbent lenders to fund capex needs, handle transitional cashflow shortfalls or offer a partial paydown of a senior lender, but in other cases, no new capital is available from a third party. These senior deleveraging financing opportunities represent a significant source of dealflow for high-yield debt funds when more traditional acquisition financing opportunities are scarce. However, intercreditor and security issues come up and can lead to long negotiations.
We also observe situations involving equity top-ups with related negotiations over the extent and conditionality of new money.
Lastly, we are seeing more and more situations where sponsors cannot inject new money. Sponsors unwilling to throw good money after bad prefer to engage in harsher negotiations, which can result in asset liquidations or foreclosure. We are also seeing an increasing number of situations where no agreement between lenders and borrowers on the terms of an extension can be reached for a number of reasons, which can lead to asset liquidation.
We expect more of these cases to materialise over time as heavily distressed assets cannot be rescued by new money and eventually require lenders to take over the property. Similarly, the number of loan restructurings is likely to increase in the second half of the year due to persistent rental difficulties, most notably in the office and retail sectors.
What about the lenders you work with, how are they impacted?
We see lenders being much more proactive and much quicker than during the GFC of 2008-09, when extend and pretend strategies were extensively followed.
A lot of this is due to increased regulatory scrutiny on treatment of impaired situations. Regulatory scrutiny is particularly strong in Germany, with Bafin closely monitoring German lenders’ balance sheets. But we expect that pressure will progressively increase in southern markets such as Spain, Italy and Greece.
An adviser can assist in assessing and working out difficult situations, even working out loan books in close co-operation with lenders – from purely strategic advice to taking a more active role in negotiations – while working towards realigning various stakeholders’ interests with a view towards maximising value over a reasonable timeframe.
You mentioned the use of technology in loan valuation activity, why is that important?
Change is an unwavering constant across industries, and real estate financing markets are no exception. Two significant factors contribute to this. First, continuously evolving technology like artificial intelligence is serving as a catalyst in propelling the industry into uncharted territories of possibility. And second, the stringent regulations that shape the industry’s conduct is compelling professionals to embrace new and better approaches in conducting business.
Real estate fund and asset managers alike are facing major hurdles in reporting due to heightened investors’ requests and challenges in extracting and monitoring data from various sources. As a result, there is a growing push to standardise reporting and performance measurements, and technology can help with that.
INREV guidelines have become the most recognised and widely used best practices in the industry across Europe. These guidelines outline net asset value calculation principles, which involve fair valuations. It is crucial that these guidelines are also applied to liabilities, especially in the current volatile rate environment.
Senior lenders and real estate debt funds are struggling to face rigorous directives framing loan portfolio management. More and more lenders are instructing independent assessments of their loan books to ensure internal valuations reflect actual market conditions. We have developed a complex loan valuation model which is currently gaining industry-wide approval. This model helps address the pressing need for loan fair valuations for both borrowers and lenders.
Are you seeing lenders shying away from construction loans, due to the inherent risk?
Yes, and the deals that do get done are sometimes leading to even more distressed situations.
We are seeing distressed situations involving construction delays, significant cost overruns resulting from the covid period, current high inflation and issues with availability of labour and raw materials, which can all materially impact a sponsor’s initial business and development plans and impact the entire capital stack of the project.