Lenders and borrowers in the European real estate market are increasingly having difficult conversations about how to resolve stress in outstanding loans, according to panellists at industry body CREFC Europe’s Autumn Conference.
Debt specialists at the London event on 8 November said the sharp rise in interest rates in the past 18 months is impacting loan-to-value ratios, interest coverage ratios and sponsors’ ability to service their debt.
Alison Lambert, head of finance, listed markets, at manager M7 Real Estate, which lends predominantly in UK regions, described a challenging debt environment. “We’re in a cycle where values are going down, so LTVs are going up. Our sponsors are struggling, and we want to work with them to make sure they can get through this. But let’s be realistic, this is a hard market.”
Lambert said M7 is working with sponsors to find refinancing options. “We are being very clear with them that they are going to have to support a significant hike in their rate and their cashflow may or may not support that. Or we are sometimes suggesting they need to sell their asset. That is a difficult conversation to have. It will be tough for the next six to 12 months, but we are going into it with our eyes wide open.”
In October, Bayes Business School’s H1 lending market report, which focuses on the UK market, reported an increase in the default rate, from 3 percent to 3.9 percent in the first six months of the year. Bank default rates were typically within 2-5 percent, although debt funds reported up to 11.2 percent.
However, amid ongoing discussions between lenders and borrowers, some see successful refinancing transactions completing. “We’ve just been refinanced on a loan in the Netherlands by a new-to-country lender which took us out of a deal, and it went very smoothly,” said Gareth Williams, head of real estate finance at alternative lender QSix.
“But the nature of the assets is very high yielding. Cashflow is key for a lot of new lenders coming in. If you have low-yielding assets, if you just lent at the wrong basis, discussions are very tough, whether at the smaller or bigger end of the market.”
Williams has seen situations where sponsors have opted to not continue to financially support assets, leading lenders to consider options including taking ownership or a discounted payoff. However, he believes such situations are not widespread. “I get the sense [the market] hasn’t quite got to those really tough discussions yet and is still churning through the low-hanging fruit.”
Asked by panel moderator Dean Harris, executive managing director at loan servicer Trimont, if sponsors are putting fresh equity into deals, Williams said there is a mix of scenarios.
“I’m sure there are instances where people are. But there are also instances where people are not. If lenders are not getting debt service, they are quite rightly taking action. But if you have 12-13 percent debt yield, the tenant base looks strong, why would you do anything else as a lender other than work with your sponsor to try and ultimately get to a better position?
“Ego gets in the way – I see that a lot on both sides. But you need to cut ego out, be very logical, be very disciplined, and try to avoid enforcing at all costs, because it’s going to destroy value.”
The borrower on the panel, Gwendal Kalkofen, head of real estate finance at manager Europa Capital, expects lenders and borrowers to resolve stressed situations together where possible.
“The past decade has been a borrowers’ market followed by the last six months, and the next three to six months, having become a lenders’ market. Both sides – borrowers and lenders – will come to terms and accept that they need to work together, to prevent loan accelerations and lengthy insolvencies. At present, situations are largely consensual across Europe.”
A constraining factor across the market, panellists agreed, is continued uncertainty around property values. Nick Knight, head of valuation at consultant CBRE, said the lack of investment transactions is resulting in fewer benchmarks and therefore a requirement for valuers like him to use more judgement.
However, Knight described positives in the market. “One of the features of the last six months, particularly at the prime end, is the operational side of the assets has been performing well. Income has held up, there is rental growth evidenced in certain sectors.”
As stressed loan situations persist, Harris said Trimont has seen lenders position themselves for “deeper restructuring conversations”. One challenge they are facing, he said, is how to satisfy hedging requirements as loans are extended in a higher interest rate environment.
Kalkofen agreed implementing well-structured hedging strategies is becoming increasingly challenging, especially in a ‘normalising’ rates environment.
“We still see a continued risk that if you chose to put in place an interest rate swap-backed hedge strategy, the investment performance is at risk of further downward pressure due to a negative mark-to-market position caused by an unexpected, sudden shift in rates. The risk increases in particular for transactions which require short- to medium-term extensions and co-terminating hedge protection.”
Panellists agreed that lenders are applying greater scrutiny to existing loans. Knight reported a recent spike in valuation requests. “We have had the odd conversation about what happens to the value in the case of enforcement, the concern being enforcement itself can impact value. That’s quite a tricky one to answer.
“Enforcement provides certainty to the market that there’s a deal to be done. And from a valuation perspective, as long as you are exposing an asset to the market without a short timescale, that probably will result in market value.”
Williams said QSix is speaking more regularly to its sponsors than ever before. “There are a lot more discussions, a lot more vigilance. But we take valuations with a pinch of salt and value is not really the driver of our actions. You can only really tell when you put something on the market and get bids. Income is key. Even if it is not paying you down, it services the debt, and you can continue to work on the business plan.”
Speaking about investment market conditions, Emma Winning, head of equity advisory at consultant Knight Frank, described strong interest for “high-returning transactions where there is a good business case”.
She added: “We are quite positive about the rental growth story in particular. Across multifamily, it is that rental growth that has kept many transactions on track. There is money for the right transactions, although everything is taking longer in the current market conditions.
“We have also seen that certain investors are out of the market, including some of the core pension funds that were previously active. Many of those that do not need to deploy are sitting on their hands. Until pricing certainty is there, reduced investor appetite is to be expected.”
As lenders and borrowers work to replace outstanding debt with fresh financing, panellists said they had not seen a return to the complex capital structures prevalent in the run-up to the global financial crisis of 2007-08.
“At present, the challenge is to convince a senior lender, primarily a traditional bank, to provide financing in excess of 50 percent at accretive terms,” said Kalkofen. “You will find occasional new entrants willing to go a little higher, albeit on terms which may not necessarily be accretive. To prevent potential refinance shortfalls, borrowers increasingly revert to whole loan or senior/mezzanine solutions which are somewhat constrained due to the shift in yield environment.
“Senior ‘A/B’ loan structures, as they were commonly used in pre-GFC financings, haven’t necessarily found their way back – yet. However, from discussions with lenders, we’re aware of their ongoing efforts to improve their current use of risk-weighted assets including the sell-off B-note loan tranches.”
Although the financing market remains constrained, Kalkofen argued there remains available debt liquidity for real estate financings. However, he said the execution of deals is more challenging due to increased market volatility and lenders not always securing committee approvals.
“The availability of traditional bank liquidity has certainly suffered the most. Alternative lenders are having to assess the higher LTVs at which they have lent in the last two and a half years, in particular the ones which have taken on bank leverage. Consequently, the market will most certainly face digestion problems over the next 12-18 months.”
Lambert agreed: “I think there is opportunity, but I don’t think people are taking that opportunity at the moment. I think everyone will hold out to the end of the year and see what happens next year. There will be opportunity if you’re willing to take the risk.”