Offices: Lenders consider the troubled sector’s future

Lenders are taking a cautious approach to European offices amid limited transactional activity in a sector still absorbing the impact of the covid-19 pandemic.

Signs of stress for debt providers are beginning to show. In March, London’s 20 Canada Square in the Canary Wharf business district came to the market for a sale price less than the value of the debt secured against it. As Bloomberg reported in March, the prime office building is on the market through consultant JLL for £250 million (€288 million). The £265 million loan held against it, provided by Lloyds Banking Group in 2017 when the building was bought for £410 million, matured in October without being repaid.

As values in the sector continue to decline, this situation underscores how very few assets are immune to the seismic changes that have impacted offices since covid.

Calm before the storm?

So far, there is limited evidence of distress. Despite European central business district office values continuing to fall, bank lenders have typically granted borrowers time to devise strategies to repay loans or refinance.

However, lenders are not likely to roll loans over indefinitely. “We are seeing some situations in which the lender has told the borrower it wants to be out of its position by the year end – that is starting to happen,” says Chris Gow, head of debt and structured finance at consultancy CBRE.

Gow has seen evidence of borrowers being granted short-term extensions of six months to a year, with lenders expecting the sponsor to find a way to reduce the bank’s loan-to-value position through the injection of equity, subordinated debt, or, in some cases, a sale of the asset: “We have seen senior LTVs for office assets reduce by between 5 and 10 percent, as lenders adjust for the substantial year-on-year increase in swap costs.”

Office values fell by 18 percent during 2022, according to property adviser Savills, which predicts they will decrease by up to 37 percent in total from Q1 2022.

Taking action

James Mathias, portfolio manager for European debt at investment manager PGIM Real Estate, says: “Lenders will undoubtedly be more active [with borrowers] than they were in the global financial crisis, whereby stronger debt service provided cover for poorer performance as interest rates fell.

“There’s a real change this time, including from Basel III and IFRS accounting standards, which will force bank lenders to mark-to-market their positions in loans.”

Gow believes borrowers that bought assets in 2019 will be among the most stressed cases on lenders’ books. “Owners that bought just before the pandemic wouldn’t have experienced much value uplift pre-covid and they are now impacted by weaker occupier sentiment.

“Yields have also changed. For example, an asset bought at a 4 percent yield, with an opening LTV of 60 percent, will now be at 75 percent LTV, assuming a 100 basis points movement in yields, and bank lenders in particular do not want to be in that position.”

Gow says most banks will support good borrowers “for a period of time, but if a borrower does not engage, show it has a plan and then a contingency plan on top, it can be difficult to secure a refinancing because bank lenders do not want to be highly leveraged. The worst thing a borrower can do is sit and wait without talking to a lender until it is too late.”

Double helping

For non-prime assets, borrowers face the prospect of providing two slugs of equity; to help reduce the lender’s LTV, and to enable a repositioning of the property to cater for post-covid occupier tastes, including sustainability enhancements.

But some believe sponsors will be reluctant to provide extra capital for poorly located assets that cannot be adapted into modern workspaces or converted into other uses. There is growing concern that secondary and out-of-town offices may become stranded assets, outside the purview of buyers and lenders.

Owners with the ability to upgrade the performance of troubled assets are most likely to rely on finance from alternative providers.

Gow says: “A significant number of loans are coming up to maturity and, in most asset classes, the funding gap isn’t a concept that applies – to logistics, to residential, even to retail. With offices, however, closing that gap is more of a challenge.”

Alternative debt capital comes at a price, however, and is currently between 7-10 percent for senior loans and in the double-digit margins for mezzanine. Gow says CBRE is advising investors that accepting this kind of debt for two to three years could bridge the current uncertainty until cheaper refinancing options become available.

In one notable recent non-bank office lending deal, manager Cheyne Capital provided £150 million to finance the acquisition in March by UK property investor Castleforge and Malaysia’s Gamuda Berhad of Deutsche Bank’s former offices at Winchester House in London, where the sponsors plan an extensive sustainability-focused refurbishment.

PGIM Real Estate is open to similar repositioning opportunities in the sector. Mathias says that, as banks seek to take “more realistic” positions in terms of office loans, there will be opportunities for alternative providers. “Banks are, due to regulation, capital constrained. This will be a catalyst for lenders to engage more proactively with borrowers on their plans for the asset and that is an interesting trend. Assuming the residual value is right, investing more capital will make sense to reposition assets for future tenant demand – and we expect opportunities to come from that.”

Location is critical, he says. “Local market supply and tenant demand are more relevant than ever and, although yields are under pressure right now, the right assets in key cities will perform from an occupier perspective in this new era.”

Taking a view

Banks can still be seen financing offices. In April, Bank of America issued £140 million of refinancing capital for Chinese investor Gingko Tree Investment’s Building 7 at Chiswick Park, west London. In April, German bank Berlin Hyp provided a €52.3 million loan to manager Tristan Capital Partners for an office portfolio in the centre of Brussels.

“We see US lenders willing to provide capital, at the right level,” says Gow. “These banks are trying to educate their US-based credit committees that the situation in Europe is better relative to that market – the return to office is more pronounced.

“In London, and a number of other gateway cities, we have worked on financings that are backed by Asian debt capital,” Gow says, explaining that they have a more positive viewpoint on the robustness of the office market and are less convinced in the long-term resiliency of hybrid working. “We think the recovery in the Europe office investment market, and especially in London, will be partly led by investors from this region.”