As Europe’s economies emerge from covid-19 lockdowns, property debt providers are increasingly keen to get back to writing loans. But amid an uncertain marketplace, real estate lenders are reconsidering their underwriting assumptions.
Lenders know the economic fallout of the pandemic could undermine the performance of tenants and, subsequently, their customers, the borrowers. On top of that, the crisis is accelerating structural changes already underway in the industry.
Surging demand for online retailing has provoked a growing appetite for logistics; for the same reason, there is dropping demand for physical retail property. Also, with so many people working from home, the future use of office space is the subject of debate likely to continue for months, if not longer. All this is putting into sharp focus the need for debt providers to question their assumptions of, and appetite for, the sector.
As Ian Malden, head of valuations at property consultancy Savills, puts it: “These changes have an impact on the relationship that developers, occupiers, and borrowers have with their lenders and on how lenders react. Occupiers are seeking shorter and more flexible operational-style leases which will have implications on borrowers’ ability to optimise loan-to-values, leading lenders to be more risk-averse and, perhaps, more conservative.”
Debt providers’ appetite to finance new projects or sponsors varies depending on the type of organisation and its source of capital. Some debt funds, for instance, are busier than ever, picking up the slack left by senior lenders that have decreased leverage, according to a July market report by property consultancy Knight Frank.
Overall, lending principles have not substantially changed. But the due diligence process to underwrite a loan has become more forensic and exhaustive. A renewed spotlight has been put on sponsors’ cashflows and liquidity, as well as on core lending principles.
“Critically, covid-19 has forced a return to fundamentals: the quality of the asset, the sponsor and the cashflow, as well as assessing and understanding the structural changes happening in the market,” says Malden.
From interviews with 16 market sources from the European real estate debt market, including bank lenders, debt fund managers, valuers, lawyers and borrowers, Real Estate Capital has identified the five key questions lenders are asking themselves to ensure solid underwriting in the face of covid-19.
How well do I know my sponsor?
A focus on the sponsor is not new. Ever since the global financial crisis, when an increasingly structured finance market became dislocated from the users of debt, finance professionals have emphasised this point. But debt specialists argue it is more important than ever now for lenders to ensure they know their borrowers. Their financial strength, expertise and track record are paramount, they agree, to determine the chances of the sponsor successfully managing a property through potential additional waves of the pandemic.
“Lenders are evaluating whether they have the sort of sponsor that will support the asset”
White & Case
Jeffrey Rubinoff, a real estate finance specialist at law firm White & Case, says: “Lenders are evaluating whether they have the sort of sponsor that will support the asset. Most real estate debt deals are limited recourse, so are ultimately dependent on the value of the asset. But people are now more concerned about who the sponsor is, and we might see less portability in loan deals.”
In real estate finance, the importance of the sponsor is sometimes clouded by the quality of the real estate, says Mohith Sondhi, senior director of debt finance at UK-based challenger bank OakNorth. However, he says, both will be equally important in a post-covid world.
Particularly relevant is the way a sponsor has operated during the lockdown period. “For a new deal, it is key to learn how sponsors are dealing with their existing portfolio; what actions they have taken? How proactive or reactive they have been?” says Sondhi.
In addition to understanding a sponsor’s track record, lenders want to know how well capitalised they are, should additional equity need to be injected into a deal.
Mark Bladon, head of corporate real estate lending in the structured property finance business of UK-headquartered bank Investec, says this is particularly important when financing development. “It is quite conceivable you are going to have cost overruns in this environment, so we need to know whether they have the ability to follow their equity.”
Borrowers canvassed for this article agreed on the importance of having an ongoing and open dialogue with lenders. John Dunkerley, chief executive of London-based private rented sector residential developer Apache Capital Partners, says: “Having regular contact and providing all the latest up-to-date information has been crucial to keeping a good working relationship during an incredibly challenging time for everybody.”
Karim Habra, head of Europe and Asia-Pacific at Ivanhoé Cambridge, the real estate arm of Canadian pension investor Caisse de dépôt et placement du Québec, says financing for value-add and development projects, on which the company focuses, is currently scarcer: “Covid-19 has reduced the availability of debt and fewer lenders are willing to take development risk due to the current market conditions. However, whenever deals are cashflow-secured, there is debt available for them.”
But mitigating covid-19 risk does not necessarily mean lending only to existing sponsors. Most lenders speaking to Real Estate Capital say they are open to new borrowers, provided they fulfil certain requirements.
Dennis Watson, head of real estate at UK bank Barclays, says: “We will be open to new sponsors. But if we take them, we will need to be very clear on their character, ability and management: they need to have a very demonstrable and identifiable track record to the business and the management team.”
Phil Hooper, head of real estate finance at UK bank NatWest, agrees. “It is typically more straightforward to work with a customer you have lent to before, as you have a shared experience. However, what is important for us is that a sponsor has a demonstrable track record for the kind of project they are asking us to support,” he says.
Will the borrower’s tenant keep paying its rent?
In most instances, when a landlord faces rent shortfalls and renegotiations because of the pandemic, a lender is also exposed.
In the UK, however, tenants met their rental obligations better than expected on the latest quarter payment date, per data from real estate services company Cushman & Wakefield. The firm had collected 69.1 percent of rent for clients within 21 days of the June collection date, compared with 69.5 percent in March.
But collection numbers still show a significant impact from the covid-19 pandemic, particularly on the retail sector, which has led lenders to put a greater focus on the underlying tenant. Pontus Sundin, chief executive of the debt division at Nordic non-bank lender Brunswick Real Estate, says: “We have no new questions. But we ask more explicitly now if the tenants are paying.”
“We have no new questions. But we ask more explicitly now if the tenants are paying”
Brunswick Real Estate
Rental income from the property ultimately pays the mortgage, so lenders are working hard to understand the profile of the tenant, or tenants, within the asset, as well as the structure of leases. “Conversations are moving beyond whether the sponsor has leases in place, to who exactly is the tenant. Lenders are interested in the creditworthiness of the tenant and what the population of potential replacement tenants looks like,” says Rubinoff.
Lenders are, thus, taking time to assess how occupiers perform in a variety of circumstances and their financial health. Market sources agree this is leading to more work than before, especially where there is large exposure to a non-public company. One non-bank lender, speaking in private, says it recently went as far as requesting a call with the financial director of a tenant to find out directly how well-positioned the company was to cope with covid-19.
A restriction on the number of tenants, or a focus on financing assets containing a mix of leases are, according to Andrew Petersen, finance partner at law firm Alston & Bird, among measures lenders are looking at to mitigate risk. He adds: “Previously, it used to be the landlord’s job to do the due diligence with the underlying tenant. But now lenders are also testing the cash behind the leases.”
Petersen believes lenders should go one step further and blacklist tenants that, during the lockdown period, stopped paying rents, despite having the cash – particularly in the retail sector. “A lot of lenders are focusing now on that robust due diligence through the tenant. We all know where occupational leases went, so lenders now possibly do not want to have too many tenants, for example on turnover rents.”
Occupiers are demanding more flexible leases, which provokes a range of responses from lenders. John Cole, head of debt at London-based real estate equity and debt investor Cain International, says flexibility on tenant agreements is not an issue for them. For other lenders, he argues, it will depend on their risk appetite.
“For example, single-tenant or few tenant buildings, unlike multi-let, will be harder to finance on a plain, vanilla basis, due to an impact on rating and refinance risk. Shorter leases are common across Europe so lenders can apply a similar assessment on underwriting – three-year rolling for example. Another option is that real estate income turns more operational, as is happening with flexible office space,” Cole says.
Should I add protective mechanisms to the deal structure?
As lenders scrutinise their counterparties’ liquidity levels to assess their ability to service their debt, some are also considering the need for additional layers of protection in loan deals.
Sources report a greater focus on mechanisms such as interest reserve accounts or cash traps. Such facilities are often combined with lower initial loan-to-value ratios and higher pricing, to create more defensive loan deals. Sources say there is not a standardised approach though: it is considered and arranged on a deal-by-deal basis.
Petersen believes lenders will focus on cash reserves going forward because “it is a good thing to build in good times, to be used in bad times. Cash reserves are more important than ever now, so there is a focus on them to support the asset”.
Sundin says Brunswick is adding protective measures to their debt deals: “Cash traps are an option, but there are others. One mechanism we have implemented is to ask a borrower to put a cash reserve in a locked pledged account, so then we know there is a 12-month interest reserve that they are free to use and dispose. I prefer this way because it exempts us from having to manage the cashflow.”
Interest reserve arrangements are a growing trend in the market, says Petersen. “At the end of the first full interest period in the UK, after lockdown, businesses were already running out of cash. We all need to think of ways in the future to build up that reserve.”
Paul Wilson, managing director at MetLife Investment Management, the investment management arm of US insurer Metlife, is responsible for the firm’s European real estate investment business. He says it would consider asking for cash reserves on loans financing assets such as offices.
“Office vacancy is modestly concerning in the short term, and we would generally seek a cash reserve for loans on assets with significant rollover or lease-up,” Wilson says.
Sources say covenant packages, which typically allow lenders to intervene if the LTV ratio rises above a certain level or if an income coverage ratio is breached, will not undergo changes in their structure. They will continue being key to monitor debt facilities during the tenor of the term. However, they are expected to be made tighter in future loan deals.
“Covenants will be tighter going forward. When lenders are looking at either refinancing a loan or granting a new facility, the quality of income will be more important than ever,” says Malden.
What do I believe the underlying real estate is worth?
In the current market, faith in the ‘V’ of the LTV is critical, but difficult to assess given a lack of transactions to benchmark pricing against and economic uncertainty. Lenders are spending more time interrogating valuations, including assumptions on an asset’s future use.
But, according to Malden, confidence in market valuations, at least in the UK, is coming back thanks to the return of liquidity, although just to some sectors. “Generally, there is more evidence in the market now for valuers to make informed judgements.”
One difficulty is in visiting sites due to covid-19 restrictions, and much depends on how long these will last.
Malden adds that while covid-19 will reduce LTVs from 60-65 percent to 50-55 percent in senior financing deals, stronger cashflows will warrant higher LTVs and more competitive pricing.
In lieu of transactional evidence of property values, some lenders are looking for comparable metrics. “We are more actively looking at the public markets and the REITs to get a sense of real estate value. We’ve been using all sources of information, as well as our instinct, to assess value,” says Jim Blakemore, global head of credit investing at manager BentallGreenOak.
“The LTV covenant is a great thing about being a lender in Europe,” adds Blakemore, “it is a pretty powerful covenant. But if values move by 3 percent, or even 10 percent, no one wants to see a deal default. The idea of enforcing and selling into a covid market is not good.”
Petersen admits he does not get why lenders are currently placing any importance on valuations. “[They] are based on an assumption of the consequences of covid-19 which, in my view, questions their accuracy and reliability.”
Assem El Alami, head of real estate finance at German bank Berlin Hyp, agrees it is extremely difficult to come to a precise idea of what the market value of a property is today. Therefore, the bank has focused, even before the pandemic outbreak, on cashflow, which he says is a more stable indicator: “The values can at times be relatively volatile, whereas cashflows are our reality.”
He adds: “I think cashflows are an even more important factor than values. Rather than discussing whether 50 or 60 percent LTV is the right level, we prefer to engage in discussions on whether the debt yield should be, for instance, at 6 or 8 percent.”
Given the difficulties around market valuations, lenders are entering deals at reduced LTVs, aiming to protect themselves if the ‘V’ falls.
Do I want to make this loan now?
Most fundamentally, lenders are reassessing their appetite for lending in the current market. Different lenders have different pressures and risk parameters: bank lenders have targets as they need to replace loans that are reaching maturity to keep their books at the optimum levels, while some debt funds need to lend to deploy investor capital in a proposed timeframe.
Others are lending more selectively while considering if a loan deal is worth the risk at all. Then there are lenders with higher risk and return targets, which see the current market as an opportunity to take advantage of increased loan pricing. “It’s quite binary – do you want to be in the market at all right now? Do you have existing problems within your loan book, which senior management might rather you focused on?” says Blakemore.
Christian Janssen, head of the European real estate debt division at investment manager Nuveen Real Estate, says there is a good refinancing opportunity due to the funding gap left by those lenders hitting pause: “It is a great opportunity to capitalise now on the fact many traditional lenders face challenges to make new loans. While new purchases of assets might slow down in the current environment, the outstanding loan universe will need refinancing.”
If lenders decide they want to be in the market, they need to consider which real estate sectors they see as most reliable in this crisis and on what terms they want to lend against. Most debt providers are reluctant to back retail, while offices, hospitality and student accommodation are a tricky call at present.
Jan Peter Annecke, head of real estate lending at the German bank Helaba, is confident about the longer-term appeal for the office sector: “Office properties in good locations in top cities will continue to function, even if the number of office tenant insolvencies increases. Office properties in peripheral locations or smaller cities, however, will be hit harder.”
Apache’s Dunkerley says the BTR residential sector, in which his firm specialises, has proved to be resilient during the covid-19 crisis. “As lenders consider their real estate exposure, post-pandemic, I expect BTR and other alternative residential asset classes like senior living, supported by long-term demographic growth drivers, to be seen as increasingly attractive investments.”
Sector choice may prove to be as crucial as the decision whether to provide finance at all. Many debt providers will not have the option to turn off the lending tap. But careful sector and location choices, alongside scrutiny of sponsors, tenants and loan structures, may be the best way to mitigate risk.
COVID-19: A DIFFICULT THREAT TO DOCUMENT
Despite the huge impact another round of lockdowns could have on the European real estate sector, in the event of a second wave of coronavirus, lenders are not understood to be writing specific covid-19 clauses into new deals.
Structuring them, says Cain International’s John Cole, would create more problems than solutions from a risk perspective, “because we do not even know what a second wave would mean”.
The difficulty of defining and invoking such clauses from a legal perspective is another factor preventing their implementation, says Barclays’ Dennis Watson. Rather, he says, covid-related considerations are being discussed during loan structuring talks: “We are asking our sponsors the ‘what if’ questions. But that is not a clause we are inserting into documents. That is just a sensible dialogue about a sensitive analysis on our clients and their portfolios, their acquisitions and development programmes that may have to stop or be subject to time and cost overruns.”
However, specific covid-19 clauses are being included in some development loans, according to Nuveen’s Christian Janssen. “If there is a closure of a construction site, that is now being included in the development contract, which may or may not trigger an event of default.”
Janssen adds lenders should be alive to the existence of covid-19 clauses in tenant agreements. “What lenders will have to consider is if, for some reason, a large percentage of their tenants have pandemic clauses that allow them to not pay or defer rental payments, whether that transaction has enough protections to be able to survive for the period of time the asset is going to generate less rental income.”