Oxford Economics has warned that refinancing shortfalls and declining interest coverage ratios are leading to an “increased risk” of forced sales as soaring debt costs threaten to push global real estate markets into distress.
In a research briefing, released on Tuesday, the consultancy placed offices and retail at “greatest risk” of forced sales owing to financing shortfalls and reported that interest coverage ratios were “dangerously low”.
ICRs for UK offices were most exposed as the recession starts to bite, the note said, estimating that the average UK office acquired in 2018 would be below 1.0 in 2023, posing a “huge risk to real estate stability”. However, ICRs in France, Germany and the US were also expected to be “very low” in 2023.
“Those with fixed-rate debt will be shielded, but with policy rates set to remain elevated next year; the situation at refinancing looks untenable without debt costs retracting,” it added.
Oxford Economics is also estimating that there could be a loan shortfall of up to 40 percent at refinancing for UK retail, where capital values have declined 30 percent since 2018. But it added that retail also “fairs poorly” in Australia, France, Germany and the US.
Meanwhile, there is lower risk of refinancing industrial assets, where the consultancy expects loan extensions, new junior debt and fresh equity to mitigate the risk of forced sales.
As financial dysfunction grows in the battle to control inflation, highly leveraged investors and private equity groups would be most at risk, said Oxford Economics: “One group that stands out… is private equity, where direct leverage has been consistently higher than the broader real estate industry since the GFC.”
The consultancy said that the median LTV for US private equity deals completed in 2022 was 69 percent, with an upper quartile at nearly 80 percent – significantly above the broader market average of 50 percent.
It also highlighted private equity investors’ exposure to indirect leverage, which it said was often used at fund level by funds, or through the use of special purpose vehicles. It added: “Private equity funds can also use leverage from subscription credit lines against committed but uncalled capital (dry powder) where no specific assets [are] designated as collateral.
“Given the significant increase in dry powder over recent years, if this practice were widespread, then subscription line debt could have also increased substantially, raising the risk of distress as interest rates rise,” it added, explaining: “Without clear data it is not possible to reach a conclusion, but we highlight this as an area where risk could be hidden.”