These are difficult times for lenders with real estate exposure. They are faced with clients under pressure, an uncertain economic environment and the potential for further interest rate rises in months to come.
Our advice to lenders is to focus on the following key areas as you seek to work your way through complex situations.
Keep an eye out for early warning signs: Sponsors breaching financial covenants is not the only issue – lenders also need to understand the operational issues at the asset. Key areas to focus on include how up to date the borrower is on planned preventative maintenance; whether any landlord service charge arrears are up to date; whether service charge accounts have been reconciled for prior years; and the quantum of any arrears.
This is all highly relevant, with 74 percent of FTI Consulting’s 2022 Resilience Barometer respondents in the real estate and housebuilding sectors anticipating they will require financial restructuring in the next 12 months.
Cashflow forecasting is also crucial: Lenders should ask: has a liquidity forecast been produced and stress-tested? Are interest rate hedged positions expiring, leaving borrowers exposed to SONIA rises?
Consider capex-hungry assets: One of a lender’s most difficult dilemmas is whether to provide additional support for capital expenditure and what level of equity is also being contributed. Should funds be made available to maintain the appeal of a property, and do valuations support the capex plans? Our advice is that the need for capex will not go away, especially with environmental demands growing. A clear understanding of the pathway of costs in achieving Energy Performance Certificate compliance is critical to securing best value on a sale.
Preparation of a detailed cost plan, including risk-based cost contingencies, should include live market testing and be reviewed frequently, accounting for the current high inflation environment, supply chain issues and contractors, which are always looking for any reason to renegotiate terms.
Where a development is involved, step-in rights and collateral warranties are increasingly important. These are often given little attention at the outset but are essential as part of any contingency plan and for stability after any potential enforcement.
Timing is Critical: Early engagement is key. Even without a potential covenant breach looming, it is important to try to engage a customer who might be in a difficult situation quickly and ask questions early.
Post-enforcement, it may not be best to run an accelerated sales process if the market remains challenging with a lack of recent transactions and therefore momentum to ensure a competitive bidding process.
It may be better to wait, stabilise the asset, improve it – potentially by securing planning consents or improving an EPC rating – and then go to market. Timing is key in respect of both approaching the market at the right time and avoiding perception of a ‘distressed’ sale.
Know your structure: From a legal perspective, are you dealing with a special purpose vehicle, or are employees involved? Is it a joint venture and what impact will any action you take have on the JV partner?
Jurisdictions will clearly impact on any contingency plan too, and the interests of mezzanine lenders, if applicable, may need to be taken into account, especially where there are question marks around any valuation.
How easy it is to take enforcement action is another issue. Lenders may well be reliant on management teams, highlighting the importance of finding experienced candidates to take on challenging roles quickly and the importance of quickly obtaining directors and officers liability insurance for incoming directors. The D&O market has tightened significantly post-covid, and while more providers are coming to market, cover is expensive and can take time to secure.
Consider tax: This must not be an afterthought in real estate transactions, especially given jurisdictional issues. The tax landscape has changed materially since the 2008 global financial crisis, and non-resident companies are now subject to UK corporation tax, with consideration needing to be given to deductibility of finance costs, restrictions on brought forward losses and anti-hybrid rules.
Taking these tips on board is crucial right now. My final tip to lenders is to ensure the early appointment of the right advisers to work alongside them.
Ali Khaki is a licensed insolvency practitioner in FTI Consulting’s corporate finance team. In May, he was appointed joint administrator of 5 Churchill Place Management Company and fixed charge receiver over the shares of the owner of the long leasehold interest in the 313,000 square feet 5 Churchill Place office building in London’s Canary Wharf, on behalf of a syndicate of senior lenders.