The findings of our full-year 2017 Cass Commercial Real Estate Lending Survey – formerly the De Montfort lending report – show that lenders generally had a busy year in 2017 and are looking for equally high volumes of business this year.
Amid the positive sentiment, lenders expressed concerns about their market. However, some threats are considered more immediate than others. While economic uncertainties such as the potential impact of Brexit and the repricing of bond markets on the back of interest rate rises are on the radar of lenders, there is a sense that such factors are not immediate causes for alarm.
Lenders would be wise to keep macroeconomic threats in mind, but it is understandable that structural changes in underlying property markets are seen as the more fundamental concern going forward.
The changing landscape of the urban environment and real estate as an investment asset was a key theme mentioned by respondents. Other concerns included: the impact of changing work patterns, such as the rise of co-working and shared spaces; the changing living requirements of young professionals and young families and the increase of private rented sector housing; and changing shopping behaviour between generations.
Such factors raise questions about the future of mainstream real estate and how lenders perceive the financing risk to this asset class.
Hence, lenders are spending more time assessing the management capabilities of the borrower and the business strategy for an individual asset. To assess the future value of a secondary, regional shopping centre, for example, lenders are asking the following questions: What is the current tenant mix? What is the tenant quality? Is there an alternative use? Are there competing locations? Does the asset manager have a track record and specialisation for this type of asset?
Such concerns keep lenders up at night because they need to rethink how they competitively underwrite assets in a changing market. While debt strategies in the period between 2010 and 2015 were driven by the diversification of lending organisations due to an unequal playing field in terms of capital costs and regulation, lenders are now experiencing capital drivers based on their ability to adapt their lending policies and approaches to the changing real estate investment landscape.
With changes in property income patterns and little rental growth in some prime segments of the market, many lenders are examining debt yields – property income divided by the loan amount – as a key factor when determining a loan amount. Loans with a debt yield below 8 percent have historically shown a higher probability of default.
Current debt yields show there is little room to expand loan amounts for prime property in prime locations such as London’s West End. This translates into a maximum loan-to-value for a London prime property of 55 percent with a 2 times interest cover ratio covenant.
Although the impact of interest rate rises in the UK is not overly concerning lenders or borrowers yet, the latest interest rate announcements in the US should be taken into consideration by lenders.
Investment markets are increasingly global and the UK real estate investment market is particularly driven by foreign investors. These investment flows could be affected by the general repricing of US bond markets as the US dollar becomes more valuable and higher interest rates attract foreign investors to buy US dollar-denominated bonds. This repricing could potentially be the start of the end of the extended property investment cycle.
Nicole Lux is the author of the Cass Commercial Real Estate Lending Survey and a former real estate banker with Deutsche Bank.