Real estate lenders are adapting office underwriting assumptions to account for sponsors’ plans to improve the quality of their assets, as well as growing occupier demand for flexible leases, according to panellists at industry body CREFC Europe’s 9 June virtual conference on the sector.
During a panel on financing conditions, moderator Zoe Maurer, partner with law firm Addleshaw Goddard, said: “For many years, the bread-and-butter of lending into the office sector was vanilla investment loans secured against fully tenanted office buildings let on long FRI [full repairing and insuring] leases.”
Such lending opportunities are now rare, Maurer added, with debt providers facing requests for a variety of financing structures. Here are some of the main points from the discussion.
Sponsors want to improve, rather than rebuild
According to Dan Riches, co-head of real estate finance at M&G Investments, demand for value-add loans for office assets has grown in the last year. “There is a shortfall of environmental, social and governance-compliant space, so value-add investors are looking to buy offices that are at the end of their economic life and convert them into something greener, which investors and occupiers want.”
Alexandra Lanni, head of investments for CBRE Global Investors’ EMEA credit strategies, noted an uptick in requests for finance for the comprehensive repositioning of schemes in the last three months. “People are looking at heavy capex, rather than knocking down and rebuilding assets. That is partly due to the environmental considerations of completely rebuilding, but also due to the good availability of debt for redeveloping buildings within an existing envelope.”
Future office standards are front-of-mind
Building owners recognise that offices need to meet the increasingly high expectations of investors and occupiers, panellists agreed.
“There may have been times previously where sponsors would have patched up an office building to make it good enough for a new occupier,” said Lanni. “Now, there is a real sense in offices that there is the best and there is the rest. As a lender, there is a lot to consider, including the delta between the traditional costs of reconfiguring an office building, and what is necessary now.”
Riches added: “We want to make sure these deals are fully funded to completion, with appropriate cost overrun, sponsor guarantees, and fundamentally, the metric we look at most is our exposure per square foot at exit. That’s what drives our pricing.”
Banks are no longer relying on the long-lease office
Representing the banking market on the panel, Sharon Quinlan, head of real estate finance in the UK for HSBC, explained that occupier demand for flexible leases has changed the way office property is underwritten by her organisation.
“Leases have been getting shorter for years, and covid has accelerated corporate occupiers’ thinking around how they want to occupy offices going forward,” Quinlan said. “That means landlords need to adjust how they invest in office property, which means, from a senior lender perspective, we consider those changes as part of our evaluation of proposals. Gone are the days of a 25-year FRI lease to a strong corporate covenant – they just don’t exist any longer.”
Cash is king
Lender panellists agreed that, in a world of shorter leases, ensuring a sponsor has sufficient cash within its capital structure to cover interest payments is essential.
“Heavier capex projects often don’t go to plan, so there is more scenario analysis than ever before,” explained Lanni. “If this crisis has taught us anything, it is that cash is king in such situations, so we are seeing our borrowers look for rent deposits from tenants, and we can use some of that as collateral. We are also looking at more interest deposits from sponsors in cases where the leasing model is more operational in nature.”
Borrowers want frank conversations with lenders
The borrower on the panel, Alison Lambert, head of finance for Europe at Canadian pension fund investor Oxford Properties Group, explained that dialogue with lenders is essential when adapting to the changing dynamics in the office space.
“When we have had issues with cashflow, we like the fact that we have been able to have open conversations with lenders,” she explained. “What we are really looking for from our lenders is that we can work in a partnership, and that they understand what we are doing – whether that is around new types of leases, or if we are trying to drive value by vacating part of a building to bring new tenants in. We want to share our strategy for the building with our lender at the beginning, to build a partnership.”
Lambert added that working with a lender to set appropriate loan covenants is important. “In the past, metrics were very focused on value, but it is important to have income covenants that we can work with. If we can understand what a lender’s requirements are, we can work with it in the term sheet.”
Clearers face challenges as office usage changes
HSBC’s Quinlan explained that the UK’s slotting regulation for banks can make it difficult to finance assets with potentially fluctuating cashflow. She said: “There is a discussion to be had around the role regulators need to play to ensure banks are not prohibited from continuing to fund sustainable real estate in the market, because there is arguably some catching up for regulators to do when thinking about the changes in market dynamics.”
ESG is crucial in office lending decisions
Panellists agreed that the topic of ESG factors highly during lender decisions around office assets. “You only need an understanding of where the office market is headed to know that ESG is of fundamental importance,” said Quinlan. “Occupiers want buildings that are fit for purpose from an ESG perspective, so that is at the forefront of landlords’ minds, and therefore lenders’ minds.”
Riches agreed, adding that M&G’s investors routinely scrutinise the firm’s approach to sustainability, including in its real estate debt strategies. “We are constantly asked how we are ensuring that we are lending to companies with the correct ESG credentials. It will become increasingly prevalent.”