Welcome to the third instalment of the serialisation of our deep dive on the questions lenders need to ask during covid-19.
From interviews with 16 market sources from the European real estate debt market, including bank lenders, debt fund managers, valuers, lawyers and borrowers, Real Estate Capital has identified five crucial questions debt providers are asking themselves to ensure solid underwriting in the face of the pandemic crisis.
The deep-dive analysis on these questions is being serialised over the course of this week. Today, we are revealing the third question:
Should I add protective mechanisms to the deal structure?
As lenders scrutinise their counterparties’ liquidity levels to assess their ability to service their debt, some are also considering the need for additional layers of protection in loan deals.
Sources report a greater focus on mechanisms such as interest reserve accounts or cash traps. Such facilities are often combined with lower initial loan-to-value ratios and higher pricing, to create more defensive loan deals. Sources say there is not a standardised approach though: it is considered and arranged on a deal-by-deal basis.
Andrew Petersen, finance partner at law firm Alston & Bird, believes lenders will focus on cash reserves going forward because “it is a good thing to build in good times, to be used in bad times. Cash reserves are more important than ever now, so there is a focus on them to support the asset”.
“One mechanism we have implemented is to ask a borrower to put a cash reserve in a locked pledged account, so then we know there is a 12-month interest reserve that they are free to use and dispose”
Brunswick Real Estate
Pontus Sundin, chief executive of the debt division at Nordic non-bank lender Brunswick Real Estate says they are adding protective measures to their debt deals: “Cash traps are an option, but there are others. One mechanism we have implemented is to ask a borrower to put a cash reserve in a locked pledged account, so then we know there is a 12-month interest reserve that they are free to use and dispose. I prefer this way because it exempts us from having to manage the cashflow.”
Interest reserve arrangements are a growing trend in the market, says Petersen. “At the end of the first full interest period in the UK, after lockdown, businesses were already running out of cash. We all need to think of ways in the future to build up that reserve.”
Paul Wilson, managing director at MetLife Investment Management, the investment management arm of US insurer Metlife, is responsible for the firm’s European real estate investment business. He says it would consider asking for cash reserves on loans financing assets such as offices.
“Office vacancy is modestly concerning in the short term, and we would generally seek a cash reserve for loans on assets with significant rollover or lease-up,” Wilson says.
Sources say covenant packages, which typically allow lenders to intervene if the LTV ratio rises above a certain level or if an income coverage ratio is breached, will not undergo changes in their structure. They will continue being key to monitor debt facilities during the tenor of the term. However, they are expected to be made tighter in future loan deals.
“Covenants will be tighter going forward. When lenders are looking at either refinancing a loan or granting a new facility, the quality of income will be more important than ever,” says Ian Malden, head of valuations at property consultancy Savills.