Welcome to the second part 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 the five key questions lenders are asking themselves to ensure solid underwriting in the face of the pandemic crisis.
The deep-dive analysis on these questions will be serialised over the course of this week. Today, we are revealing the second question:
Question 2: Will the borrower’s tenant keep paying its rent?
In most instances, when a landlord faces rent shortfalls and renegotiations because of the pandemic, a lender is also exposed.
In the UK, however, tenants met their rental obligations better than expected on the latest quarter payment date, per data from real estate services company Cushman & Wakefield. The firm had collected 69.1 percent of rent for clients within 21 days of the June collection date, compared with 69.5 percent in March.
But collection numbers still show a significant impact from the covid-19 pandemic, particularly on the retail sector, which has led lenders to put a greater focus on the underlying tenant. Pontus Sundin, chief executive of the debt division at Nordic non-bank lender Brunswick Real Estate, says: “We have no new questions. But we ask more explicitly now if the tenants are paying.”
“Conversations are moving beyond whether the sponsor has leases in place, to who exactly is the tenant.”
Rental income from the property ultimately pays the mortgage, so lenders are working hard to understand the profile of the tenant, or tenants, within the asset, as well as the structure of leases. Jeffrey Rubinoff, a real estate finance specialist at law firm White & Case, says: “Conversations are moving beyond whether the sponsor has leases in place, to who exactly is the tenant. Lenders are interested in the creditworthiness of the tenant and what the population of potential replacement tenants looks like.”
Lenders are, thus, taking time to assess how occupiers perform in a variety of circumstances and their financial health. Market sources agree this is leading to more work than before, especially where there is large exposure to a non-public company. One non-bank lender, speaking in private, says it recently went as far as requesting a call with the financial director of a tenant to find out directly how well-positioned the company was to cope with covid-19.
A restriction on the number of tenants, or a focus on financing assets containing a mix of leases are, according to Andrew Petersen, finance partner at law firm Alston & Bird, among measures lenders are looking at to mitigate risk. He adds: “Previously, it used to be the landlord’s job to do the due diligence with the underlying tenant. But now lenders are also testing the cash behind the leases.”
Petersen believes lenders should go one step further and blacklist tenants that, during the lockdown period, stopped paying rents, despite having the cash – particularly in the retail sector. “A lot of lenders are focusing now on that robust due diligence through the tenant. We all know where occupational leases went, so lenders now possibly do not want to have too many tenants, for example on turnover rents.”
“Previously, it used to be the landlord’s job to do the due diligence with the underlying tenant. But now lenders are also testing the cash behind the leases.”
Occupiers are demanding more flexible leases, which provokes a range of responses from lenders. John Cole, head of debt at London-based real estate equity and debt investor Cain International, says flexibility on tenant agreements is not an issue for them. For other lenders, he argues, it will depend on their risk appetite.
“For example, single-tenant or few tenant buildings, unlike multi-let, will be harder to finance on a plain, vanilla basis, due to an impact on rating and refinance risk. Shorter leases are common across Europe so lenders can apply a similar assessment on underwriting – three-year rolling for example. Another option is that real estate income turns more operational, as is happening with flexible office space,” Cole says.