Relationships are put to the test as banks toughen terms

Investors are finding bank lending terms more demanding in a range of areas, writes Lauren Parr

Savills’ head of UK valuation William Newsom declared this month that it is “a brilliant time for banks to be lending on property”. This may be true, but the fact is that forces other than high property yields and low interest rates are at play. Pricing is only one, and often not the top, priority for lenders and borrowers.

Debt capital is scarcer and real estate is competing against other business streams. Apart from German mortgage banks, most lenders (including some big players such as Barclays and Santander) are under pressure to lend to borrowers that might put other work their way.

The implications of Basel III regulations for banks’ balance sheets look likely to be harsher for commercial property than for other asset classes, so lending opportunities will have to stack up on a returns basis if banks are to deploy valuable capital to the sector ahead of retail and residential customers, for example.

All this means the balance of strength remains firmly with lenders. Borrowers face  challenges such as more thorough loan documentation, protracted negotiations and a degree of ‘back-scratching’.

Relationships are what count

“For banks in the market now it’s definitely more about relationships, in that if you’ve done things with them in the past and there have been problems you’ve helped sort out, they’ll be more willing to lend to you,” says Mike Pashley, AREA Property Partners’ finance director.

Steve Willingham, MGPA’s head of debt, says: “Every banker says the most important thing is the customer and who they’re lending to. They might have said that in 2006-09, but they really mean it now. They are looking at our track record over the past three to five years and how viable we are.”

Pashley adds: “They’re also looking for other business from property clients aside from real estate lending. They’re looking to see if you deal with foreign exchange through their bank, if you give them investment banking business or have all your corporate banking with them.

“It’s a relationship on two levels: have you played fair and are there other services  you can do with that bank? If you can do those things they’re more likely to give you an offer, assuming they’re in the market.”

Grappling with loan documents

Greater emphasis has been placed on the due diligence process, following a grappling with loan documents under circumstances that seemed far-fetched when loans were originated. The industry is trying to establish standards for future deals, through initiatives such as the Commercial Real Estate Finance Council’s (CREFC) CMBS 2.0 proposals.

CREFC has formed another working group, chaired by Peter Denton, which aims to produce best practice guidelines  for European real estate finance. Meanwhile, the Loan Market Association has set up a working group to produce a template property finance loan agreement. It has developed standard documents for the wider syndications market but, until now, real estate had been overlooked.

Both schemes aim to provide a reliable framework for lenders to follow in future. Some banks have paid the price for sloppy documentation, for example ancillary documents that may impair a lender’s contractual ability to foreclose – a clause potential debt buyers should beware of, says Wilson Lee, managing partner at First Growth Real Estate Capital.

Also, some CMBS issues have legal clauses that are irrelevant to the underlying properties, thanks to chunks of documentation being ‘cut and pasted’ at the time when banks were churning out loans. Fitch Ratings now takes a more stringent approach to assessing securitised deals, while there is also an attempt to either cap or reduce fees in a default situation, from the perspective of agents, security trustees and servicers.

These lessons in lending practice are not just a concern for banks. Borrowers are also mindful of the implications of what they sign up to. “The problem is, people didn’t focus on it quite so much until the market turned and suddenly they were scrambling for their documents to try to work out the meaning of their clauses,” says Pashley.

According to Willingham, responsible borrowers that value their reputation are equally selective about the banks they chose to do business with. “It comes down to one of the biggest lessons that’s been learned during the downturn: you have to know who your lender is; you have to understand their motivation; the relationship you have with them; and their own liability.

“We have had banks approach us that have previously dealt poorly with work-out situations or been obstructive, coming back and saying ‘we want to lend you money again – the issues/problems are in the bad bank’. Sorry, that doesn’t cut it” Willingham says MGPA needs a bank that is alongside it “so we’re interested in the viability and track record of the bank more now than we ever have been”.

MGPA chose HSBC as lender for its £134.6m purchase of Harbour Exchange in London Docklands last year, although the bank wasn’t the cheapest or offering the highest leverage. “In buying a multi-tenanted building that we wanted to asset manage, the most important thing was the flexibility that matched the business plan. We felt HSBC gave us that.”

Mark Bampton, head of commercial property finance at Nationwide, says negotiations over loan terms are more lengthy and intense now because borrowers are looking to retain as much flexibility as possible, while lenders want to consult and review if borrowers’ business plans are not achieving results. “Increased pricing is less of a discussion point than financial covenants and amortisation,” he adds.

One of banks’ basic requirements is for loan-to-value covenants to be built into all deals. Although at lower levels of around 60-65%, compared with 80% or more in the past, LTV ratios now allow borrowers more headroom, so a covenant breach won’t be triggered by a small move in the market.

Borrowers inject more equity

Another difference is that borrowers are no longer seeking to push LTV ratios to the limit, aiming instead to raise more equity rather than risk losing control to the bank. Pashley says banks’ lawyers are being more pedantic about “dotting the ‘i’s and crossing the ‘t’s” at the loan document stage, making sure everything is in place in respect of the security, although initial term sheets have not always become longer.

In the past, a borrower such as AREA would have been able to pick the best term sheet that suited the deal from five or six; now it is down to one or two. For example, besides Lloyds, few other lenders stepped  up to offer finance for its 500,000 sq ft. shopping centre development in Wakefield.

The centre opened last month after AREA and its partners Sovereign Land and Shepherd Construction rescued the scheme from administration in December 2009. Lloyds lent £82m with a further £9m lent by local public-sector bodies. Despite potential high margins and low loan-to-cost ratios, development finance is off the table for many banks, including Nationwide. “Our preference is for prime, income-producing property or good secondary property with a spread of tenants,” Bampton says.

One option for investors is to refinance a development once it has been completed and largely let. Pashley says: “You start with a 50% LTC and once it has been de-risked you approach a new lender and say: ‘Will you give us an investment loan on this?’ Or you can go back to the bank that provided the development finance and say ‘can you raise that debt to 65% of either cost or value?’ You can use it to pay back either a portion of your original equity or mezzanine debt.”

In deals where mezzanine is involved, banks are looking hard at inter-creditor agreements. Above all, they are focused on the potential to service debt and therefore the income coming from properties, together with their longer-term income sustainability. The minimum interest cover ratio they  seek has risen from 1.15-1 in 2006 to 1.5-1, according to Newsom. This is partly a result of lower interest rates and property values.

Business plans must deliver

Where buyers may need leeway to let property as part of an asset management strategy, the difference between actual and covenanted levels would be a lot tighter than it was three years ago. “There’s less flexibility to allow the business plan to deviate too far away from what the borrower has agreed to deliver,” says Bampton.

For financing above five years, borrowers may turn to insurance companies, which are not subject to the Basel III rules. AXA and M&G, for example, will lend on 10-15-year terms, and Aviva and Canada Life have a strategy of lending over the long term to match their liabilities. But borrowers can find it costly to get out of longer-dated facilities, plus insurance companies tend to be less interested in value-added plays. For business plans that can be executed in five years, borrowers are still likely to seek traditional bank funding.

Mike Acratopulo, a managing director of Eurohypo’s UK origination team, says that banks are generally getting tougher in terms of what borrowers are allowed to do to fix a breach of covenant. “Banks are much more cautious on cure rights that only temporarily deal with a problem,” he says.

In the case of an interest cover ratio  breach, previously loan documents might have allowed the borrower to top up the difference with cash, but that doesn’t solve the fundamental interest cover deterioration, which can store up a bigger problem for later. Negotiation over cure rights would be very robust in MGPA’s dealings with a bank. Willingham says: “Covenant head-room is vital for us. We don’t want hair triggered default clauses and in the event of default, we want a range of cure options so we can work with the bank.

A limit to banks’ tolerance

“We don’t expect the bank to sit there seeing things getting worse quarter on quarter without any pay down of their loan; we understand that there is a limit to their tolerance. But having headroom and the ability to rework the situation, to release etc, is essential. Frankly we wouldn’t borrow from someone that didn’t give us that.”

Debt reduction over the life of the loan is another necessity for banks. Generally, this goes for anything above a 60% LTV and can be achieved by scheduled amortisation and/or repayment milestones, met through sales of assets or additional equity being injected. Deutsche Pfandbriefbank, for example, would need some amortisation at the top end of its 60-65% LTV ratio range, says Harin Thaker, head of real estate finance.

In today’s environment, lenders are seeking more control through tighter financial covenants and improved security packages. The terms may be unpalatable for investors, but they are hardly in a position to shop around. “You’ve just got to make the calls; work your relationships,” says Pashley. “If you’ve kept it alive, rather than playing hardball and causing a problem, hopefully they’ll still be there when you ask for new debt.”

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Hedging remains part of the property debt landscape

Many lenders still demand that borrowers hedge their debt, even though interest rates are at historic lows and medium-term swap rates have fallen to reflect forecasts that interest rates will rise less aggressively than expected, due to a depressed outlook for UK growth. The rationale is that rates will inevitably go up at some point.

Most hedging has been on the basis of fixing for five years using an interest rate derivative. Long-dated swaps, like those some banks and borrowers put on deals at the top of the market, are now out of favour. Their legacy is clear; in the low interest rate environment, swap breakage costs are large; sometimes up to 20% of the value of the loan. This has stalled many proposed restructurings or potential asset sales.

However, Savills’ head of UK valuation William Newsom says the pendulum is starting to swing the other way, “with some banks prepared to lend at floating rates, regardless of an inherent interest rate risk, and they are not insisting on hedging”. AREA Property Partners’ Mike Pashley says that in his experience, the interest rate is usually required to be hedged. “The only time it wouldn’t be is if some of the portfolio is expected to be sold quite quickly; then the bank might say ‘you can hedge 80% and the other 20% can be left floating, because that’s what you’re going to sell’.

“If you don’t sell it, the bank will want you to put a hedge on the other 20% as well.” Alternatively, banks can allow borrowers to buy a cap or use a combination: “You might swap 80% and cap 20%, then you can still sell the property and all you’ve done is pay the premium for the cap,” says Pashley. For borrowers, the downside to a cap is that it is an up-front premium payment – effectively extra equity to put into the deal.

“You’ve got to look at the deal itself,” adds Pashley. “If you buy 10 assets, two of which you plan to sell very quickly, and the bank says you’ve got to be 100% hedged from day one, you’d probably be wise to consider capping on those two deals. If the cap is in the money and it runs for three years you’ll probably get your cap premium back, but then I’d still fix or swap the other 80%.”

AREA tends to hedge all its debt because it is in the deal to make money on the underlying real estate, not by speculating on interest rate or currency movements. “You want to take that risk off the table and concentrate on the property,” Pashley says. But in future more borrowers may opt for caps or fixed-rate loans than swapping out floating-rate loans, because of changes to European regulations governing derivatives Under the European Markets Infrastructure Regulation, in less than two years’ time property companies taking out interest rate swaps will have to clear them through central exchanges and post collateral.

Debt transfer issue can be a tricky clause in negotiations

One contentious property lending area is that banks are pushing for transferability clauses that would allow them to pass on loans without borrowers’ consent, reflecting an increasing need to retain flexibility to manage their balance sheets. “As freely transferrable as possible is the language we would always aim to get, and that’s very much in line with the Loan Market Association standard,” says Margot Waddup, head of syndicated debt at Eurohypo. “Some clients resist, but it’s very rare that we would concede that point.”

Borrowers are familiar with transferability clauses, but they were less relevant before. “We’ve always said we want [the bank] to maintain a piece and be the person we talk to about an extension or minor covenant breach,” says Mike Pashley, AREA Property Partners’ finance director. “I don’t want to call someone they sold it down to.” It is the borrower’s responsibility to agree terms they are comfortable with, “but you don’t want to leave it vague; if something happens, you want a period to resolve it; and you want that documented”, he adds. After all, the ‘relationship guy’ a borrower first dealt might not be the ‘go-to’ person to re-work the debt later. “If things are slightly different to how they used to be, you look at the various scenarios and work out what your position would be.”