Borrowers make the case for flexible covenants

Loan terms should give sponsors the freedom to execute business plans, argued borrower panellists at the recent CREFC Europe Spring Conference. Daniel Cunningham reports.

Pricing is not necessarily a borrower’s main consideration when agreeing a real estate loan, delegates at the Commercial Real Estate Finance Council Europe’s spring conference in London heard last month. Rather, having a lender that is prepared to structure a deal with flexible covenants is most highly prized, said those on the borrower side of the stage during a lender/borrower debate.

Margin, explained Lars Kreutzmann, senior vice-president with Swiss private markets investment manager Partners Group, is just one element to consider:

“Pricing does matter, but pricing overall for real estate investors is quite favourable. We are active in the value-add space, so covenants are the most important thing, as well as a reliable banking relationship. If you have a lender who understands your business model and trusts what you’re doing, they will be more willing to provide flexible covenants which help you execute your business plan.”

An understanding of the collateral is crucial, agreed Morgan Garfield, managing director of UK shopping centre investor Ellandi. “Shopping centres are probably one of the tougher asset classes to underwrite, so pricing is pretty insignificant. What’s important is actually having lenders who roll their sleeves up and visit the asset; someone who is willing to understand the story and think through the loan structure.”

There is far more differentiation between lenders today than during the last cycle, when loans were designed by many banks to be put into “CMBS-land”, Garfield continued. “It used to be the same set of packages with the same documents. Now, there are different banks and lenders with different strategies.

“Even within banks that you might expect to look the same, different loan terms are offered; UK clearers all talk about slotting, yet can come up with different terms for the same type of loan, despite putting it through the same regulatory calculator,” he added.

Lesley Chen Davison

“Covenants and the flexibility to manage an asset are so important,” said another of the panel’s borrowers, Delancey’s portfolio and corporate finance executive, Lesley Chen Davison. “What we never hear is a lender say, ‘We will give you flexibility but we’ll charge you more.’ I think that would be a rational commercial argument. Ultimately, we’re looking for a package with maximum flexibility to manage an asset. We’re negotiating for that rainy day.”

‘Relationship’ can be an argument used in negotiations rather than something more fundamental, argued DRC Capital principal John Bigley, from the lender side of the debate: “At the core end of the market, for larger transactions, we do hear that there is more pressure on covenants, but it’s more of an issue at that end of the market.”

TH Real Estate’s Shawn Kaufman emphasised that building a relationship with borrowers is important: “When you think about buying a car you don’t buy the cheapest car in the market. Since the financial crisis the diversity of lenders has changed, a lot of us here worked in banks and the banks, for better or for worse, have become pretty regulated and bureaucratic. It’s a tough situation for borrowers to deal with. We have a client looking to buy an asset and debt was needed in 45 days. The relationship bank said three to four months.”

Asked whether there is a movement in the market towards softer covenants with features such as cash sweeps and cash traps, and less focus on defaults, the lender panellists agreed, with one making the point that choosing the most appropriate covenants is the main issue, with cashflow increasingly prioritised over loan-to-value as a more manageable variable.

Although there is some pressure on lenders to relax covenants, DRC has largely withstood it, said Bigley. “It is about the package; having a sponsor who knows what they’re doing. But no-one’s ever going to trade 50 extra basis points for no LTV covenant.”

“But we will get to that point,” Kaufman interjected, “it’s what always happens. In the UK, we feel strongly about our covenants – in the US they don’t have performance covenants. Instead there’s more of a focus on things like amortisation and a lower initial advance rate.”

Kreutzmann added: “If the market follows the corporate debt markets, we will see covenant-lite. Under competitive pressure, lenders might give in.”

Chen Davison argued that while it is a sponsors’ market in terms of pricing for prime cash-yielding assets, higher-risk deals still command a premium: “Pricing for plain vanilla cash-yielding assets is extremely attractive from a borrower’s perspective. Unfortunately for me, it’s not where we usually play. We play at the higher-risk end of the spectrum, so we are content to pay more for the right lender, the right package. Relationships absolutely matter. But you want your lender relationships diversified just as you want your portfolio diversified.”

Chen Davison would like to see lenders fill in the gaps in the market between low-priced senior debt and expensive high-yield lending: “I understand debt fund structures promise investors a minimum return so their hands are tied, but debt funds should make their investors understand where pricing is and that there is a need in the middle.”

Garfield argued that debt funds are raising money from the same LPs that are often also investing in direct real estate vehicles. The LPs are told they can get similar returns from a lower risk point in the capital structure, although Garfield said it is questionable that this is achievable. “Will debt funds be lead into higher risk loans to try and deliver returns that they may have exaggerated in fund raising?” he asked.

“In high-yield capital, the market is generally broadening out, but we see the same names,” added DRC’s Bigley. “However, there are people slowly filling in the blind spots in the market. There are definitely parts of the market that are not served and others that are well bid.”

Partners’ Kreutzmann added that there are an increasing number of alternative debt providers prepared to underwrite larger loans: “Larger funds can do large tickets. It was a only few selective players in the last couple of years but now more and more debt funds can underwrite larger loan amounts.”

Talk turned to the refinancing market. “Commercially, it doesn’t make sense for the borrower not to take some of the equity out if they have done something to the property that is value-enhancing,” commented Kaufman, to which Bigley agreed: “It’s important to draw a distinction between cash-out refinancing from yield compression and value created from managing an asset.”

Garfield added: “The refinancing market is competing really strongly. There will be a lot of refinancing deals in the next two years.”

While differing views were expressed on the future shape of lending deals and the covenant packages they come with, borrower and lender sides of the debate agreed that financing is available, although non-vanilla will cost. Filling the gap in the market pointed to by Chen Davison will be the challenge for many.

Borrowers have their say at LMA conference

Headroom on covenants and flexibility in loan agreements are paramount in sponsors’ minds when closing a lending deal, according to borrower panellists assembled at the Loan Market Association’s Real Estate Finance conference, held in London.

Agnes Abosi, partner at Brown Rudnick, asked the borrower panellists what they consider to be key terms when structuring deals and where they require flexibility on debt terms. Alex Riches, director with asset management firm Curzon Advisers, which handles investments made by private equity firm Kildare Partners, explained that opportunistic investors need lenders that understand their business plans.

“In the opportunistic market, you won’t have access to the whole lending market. We are currently looking at financing previous acquisitions in Italy, each with different income profiles,” said Riches. “So structuring a loan with a lender who knows there may be no income for a period of time is very important. Lenders need to buy into your business plan when it’s a simple wholesale-retail play, accepting that sales velocity is unlikely to be wholly predictable.”

Riches added that much of Curzon’s work relates to investments in value-add properties in countries which many lenders may have limited experience with.

“Our current lenders tend to follow us into jurisdictions which are new for us, making those relationships of paramount importance,” he said.

For borrowers with debt requirements outside the core markets, building an understanding with lenders is essential, explained Jai Madhvani, finance director at The Collective, a provider of ‘co-living’ residential, which develops micro-apartments with communal living areas, that has so far delivered a scheme at London’s Old Oak Common.

“As a relatively young and growing company we want the most out of our deals to support growth. Key for us is minimising all-in cost while avoiding commitments which lock up cash such as upfront guarantees,” said Madhvani. “Hence educating lenders as to the nature of the product is important.”

Panel moderator Elena Rey, partner at Brown Rudnick, asked the panellists whether the impact of Brexit had been felt in loan negotiations.

Since the UK’s vote to leave the European Union last June, Madhvani suggested that there had been a contraction of liquidity in the banking market which has created more opportunity for funds and alternative lenders.

Martin Skinner, founder and CEO of Inspired Asset Management, admitted that Brexit did affect debt provision in his firm’s experience.

“Brexit delayed a development refinancing, costing us £5 million, so I’m not a fan of Brexit,” he said. “However, in general, we are investor-developers; we’re still doing development but lower-risk refurbishment and value-add strategies. It’s very difficult to raise money for development in central London.”

For investment financing, however, Skinner said there is a “huge range” of funding available: “Residential at 60 percent leverage can be secured for 2.5 percent. There is a lot of liquidity around, although you pay for risk, speed and surety of execution. We recently spent three months negotiating with a major retail bank and did not progress beyond a term sheet, so we went with a debt fund instead, which is able to execute the deal in a month.”