Do we need a rethink of loan covenants?

Questioning one of lending’s sacred tenets resulted in a thought-provoking debate at CREFC Europe’s most recent London conference, writes Jane Roberts.

Wells Fargo’s UK head of commercial real estate, Max Sinclair, has believed for many years that loan covenants focused on rental income levels rather than asset value would be better tests for UK REITs and property companies.

Max Sinclair
Max Sinclair

His view was forged in the firestorm that engulfed real estate after the global financial crisis. Many will remember how the crash in property values saw countless property owners breach loan-to-value covenants, or come perilously close, and forced a string of venerable UK names to carry out emergency rights issues to stay afloat. These deeply-discounted equity raisings were painful and highly dilutive for their shareholders.

Sinclair had the opportunity to discuss his point of view last November at the Commercial Real Estate Finance Council Europe’s Autumn Conference 2016 in London. Joined by finance directors from Capital & Counties, Derwent London, Secure Income REIT (SIR) and Oxford Properties, his panel all saw the sense in his proposition. More than ever, they said, they run their respective businesses with eyes fixed on their portfolios’ income generation rather than their fluctuating value.

Recalling the emergency rights issues in 2009, Sinclair said the listed sector then “had very few” covenants in their documentation, and most were structured around the value of their assets. Little has changed.

“Yet that’s one of the only things that is outside their control,” he said. “And so, what I’ve been grappling with over this time is whether or not that is the optimum structure for a REIT to have. Something that’s much more within its control is the level of rental income that it produces from its real estate ownership.”

Damian Wisniewski, Derwent’s finance director, and Soumen Das, then chief financial officer at Capital & Counties (who joined SEGRO in January), described how their company facilities contain both LTV and interest cover ratio covenants, but also emphasised how much more crucial income rather than value is to their business planning. Income was only likely to become more important in the wider market the longer the low interest rate environment persists and the further through the property cycle UK real estate moves, because the possibilities for making outsize returns from capital value rises are slipping away.

In common with most UK REITs, since the global financial crisis Derwent and Capital & Counties have not taken on a lot of financial risk and kept gearing low. In a business like Derwent, which redevelops and refurbishes office buildings in the capital, “there’s quite a lot of operational risk from our developments and managing our cashflow”, Wisniewski explained.

“Clearly you can manage the ‘L’ in LTV; the ‘V’ tends to go up and down a bit,” he continued. “With the interest cover covenant there is some risk that you can lose income but we have a very modest level of borrowing (sub 20 percent) so our interest cover is quite high. I think we could lose about 60 percent of our income before we breached any covenants.”

Das agreed. “Ultimately, what really drives the company and how it is run is the income that comes out of the portfolio. In our facility secured on London’s Covent Garden estate we have an ICR and LTV. There’s bags of room on the LTV, but the ICR is the one we think about in terms of interest rate sensitivity and how much risk we can take on.”

Oxford Properties, the subsidiary of Canadian pension fund OMERS, has a slightly different investment rationale, predicated on achieving 7-11 percent returns for its pensioners, explained European finance director, Alison Lambert.

“Traditionally we’re seeking slightly higher leverage, up to 50 percent LTV,” she said, “but I would agree with everybody that having an income test is far better, because as asset managers we are better able to control that, by getting good quality covenants, longer leases and therefore managing the cashflow. As we all know, valuation can be perceived as an art not a science.” Yet with LTV covenants so firmly entrenched, none of the four panellists thought banks were likely to relegate their importance.

“Credit committees are so used to having the LTV covenant that I’m not sure that borrowers are going to be very successful at removing them on a unilateral basis,” Das said.

Sandy Gumm, chief operating officer at Prestbury Investments, which manages SIR, was the only one of the four who had tried to remove LTV covenants from loans. The attempts hadn’t always been successful, although in pre-SIR times, operating in more highly-geared private structures, she said her management team had limited the frequency of LTV tests so that they did not have them every year, a strategy that helped them weather the financial crisis. “I can’t see credit committees suddenly becoming very relaxed about not having LTVs because they are there, and lenders like them,” Gumm admitted.

But if the high levels of gearing prevalent before the crisis have been banished, why worry at all about LTV covenants? Why not just live with the status quo? As Wisniewski put it: “We all learned a lot from the last crisis and so the level of leverage is just that much lower today.”

The reason is an issue linked to LTVs that clearly concerned the panellists; specifically, the trend towards tighter headroom in LTV covenants. Lenders and borrowers might sing from the same hymn sheet regarding the desirability of a lower starting point for leverage since the financial crash, but an issue for borrowers is that UK banks in particular want to ensure that the leverage stays low.

“My experience, of UK clearers in particular, is that, yes, leverage is lower, the starting point is lower. But the headroom that is being asked for is skinny, very skinny and has become even more so,” Gumm said.

What borrowers are interested in, she continued, is “how much headroom have I got and how can I fix a problem? While you have more control over income than how much the valuer sharpens his pencil, you don’t have total control. If your tenant goes bust, your tenant goes bust. What can you do, how can you fix it, is there a cash cure? Those questions don’t tend to be asked so much. Analysts say, ‘35 percent (LTV) is better than 50 percent.’

“Well, it’s not always; it depends where the headroom is,” she added.

“I completely agree that you need a good level of headroom,” Wisniewski said. “And I don’t think it’s a bad thing for the lenders either. Also, we have to issue viability statements. If you’ve got covenants that are too tight, and a market that could go down, it’s quite a difficult thing to sign off, and that’s a big issue.”

Gumm added that Prestbury has “walked away from debt offers that would otherwise have been very attractive because the LTV headroom is just too skinny”.

Sinclair rounded off the discussion by urging borrowers to continue talking to their lenders. While he formed his views on LTV covenants during a period when he worked for a German real estate bank, Eurohypo, he now has additional perspective from working at Wells Fargo, which is a US bank.

As he said, in the US they do things differently, with more emphasis on income cover or debt yield: “The LTV is not considered to be anything like as powerful as it is in the UK.

“I would encourage you to continue to have that debate with your bankers.”

Defining the ‘new normal’ and using alternative lenders

The very low or even negative interest and inflation rates witnessed since the financial crisis are unprecedented, but the panel at CREFC Europe’s Autumn Conference 2016 wondered what exactly is a ‘normal’ level, and was it any closer?

The CREFC debate took place shortly after Donald Trump won the US presidential election precipitating a rise in US forward rates and bond yields which was duly followed in December by the Federal Reserve’s first interest rate rise for 12 months.

Derwent London’s Damian Wisniewski sensed a change. “I’ve been expecting rates to go up for about 10 years, and I’ve been wrong almost every year.

“I think we are now beginning to see a change of mood in capital markets … This doesn’t feel like a blip to me; it feels like the start of a slight and gradual change.”

The four borrowers also expected to diversify their sources of finance further away from banks, although only one, Sandy Gumm of Prestbury, has experience borrowing from a debt fund and that was not for Secure Income REIT but for Max Property, the public company invested in and managed by Prestbury until its sale to Blackstone in 2014.

In recent years both Capital & Counties and Derwent London have issued convertible bonds and US private placements. Oxford Properties has borrowed from insurance lenders in Europe and parent OMERS has issued debentures in its home base in Canada.

Gumm noted that the regulatory cost for banks, especially UK clearing banks, is rising and suggested that this is starting to affect their flexibility and competitiveness as lenders.

“The regulatory cost for the clearers now seems to me to be disproportionate… perfectly safe, vanilla lending is becoming more and more difficult and shorter and shorter term. I’m not sure that’s good for the health of the sector or the banks.”

Soumen Das, at the time CFO of Capital & Counties and now at SEGRO, said it “just happens” that the type of debt Capital & Counties had wanted had been best served by banks: “But never say never. Clearers may become a smaller proportion of the market.”

Das observed that an £800 million loan to Quintain secured on Wembley Park in north London, signed off the week of the conference, had been written by Wells Fargo, AIG and CPP Investment Board.

“That’s an extraordinary collection there: you’ve got a traditional lender if you like; a newer, insurer co-lender; and pension fund CPPIB — I’m not sure people even knew they are lenders.”