The small-print on UK real estate loan agreements has widely changed in response to the EU referendum result. Matthew Heaton, Francisca Sepúlveda and Diane Roberts of global law firm Reed Smith explain why and how.
Three financial quarters have passed since the UK voted to leave the European Union and the heightened uncertainty which the referendum result created has been reflected in more defensive terms within real estate loan agreements.
The UK property market already looked frothy in the run-up to the referendum, with some investors having called the top of the market. Lenders and investors were wary of rising prices, driven in part by the weight of overseas capital being pumped into the market. A correction or at least a plateauing of prices was expected. After all, yields could only be compressed so much.
Few in the market predicted the referendum result and a period of volatility followed. Lenders rapidly appraised their pipelines. Many deals were pulled, repriced or restructured. Buyers and sellers withdrew from deals as confidence in pricing evaporated. Valuers effectively said that due to unprecedented conditions they could not value properties with any certainty, and lenders’ credit committees started stress-testing prospective deals on the basis of a peak-to-trough in prices akin to that of 2007 to 2012.
Despite the volatility, some transactions did complete in the immediate aftermath of the result. In many cases, loan-to-value covenants were reduced and investors were expected to retain more equity. This resulted in less equity extraction by investors, with lenders loathe to fund cash-out deals. New-to-lender refinancings were also impacted, with lenders not wanting to inherit the potential problems of another bank or fund.
A consequence of the vote was even greater scrutiny of documentation by lenders. All market participants became more risk-averse and no-one wanted to be the person who missed a point on a deal or made a concession with unintended consequences. This extended the timeframe to complete deals and resulted in any deviation, whether or not reasonably material, from credit-approved terms being referred back to credit for sign-off.
Deals took longer and all parties became additionally wary. There seemed to be less sense of achievement on completion of a deal, rather a concern that one party might live to regret the transaction.
To an extent, there was a stabilisation in the market towards the end of 2016. Many deals put on hold in the immediate aftermath of the Brexit vote were resurrected and/or closed during the third and fourth quarters, albeit often on different terms than originally proposed. During this period, loan pricing ticked up, reflecting the increase in perceived risk.
The increases were perhaps not as marked as might have been expected – on some deals being no more than 5 basis points – and there seemed to be a more consistent approach to pricing, without the eye-opening differences from some lenders competing for business.
Towards the end of 2016, loan documentation became a lot tighter. As is always the case in any economic cycle, if players believe that documentation is more likely to be tested due to less certain conditions, a more cautious approach is taken.
Since the latter part of 2016, the documentation process has been elongated as all terms are scrutinised. Bankers are acutely aware of their credit committees and are sensitive to any changes that might be outside of the original sanction. Key items that are subject to greater scrutiny are:
– Security structures; to ensure that a robust security package is in place with options for a clean enforcement.
– Due diligence; to ensure that a complete picture of title and ownership is provided. Indemnity insurance and various forms of credit enhancement are being increasingly utilised to mitigate risks that might otherwise be absorbed.
– Reliance; whilst this has always been a crucial matter, lenders are keen to ensure that they have reliance on all material reports to maximise avenues for recovery should a deal go wrong.
– The profile of lenders in the UK market has continued to change, with potential implications on how deals are structured and documented in future. A plethora of new lenders brought a huge amount of liquidity to the market in 2015 and the first half of 2016, driving down pricing and leading to intense competition for deals. This trend has continued, and there are a significant number of new participants in the market.
Many of these new lenders do not have the platforms to originate the deals necessary to deploy the amount of capital that they have. This is expected to result in a significant increase in secondary debt trading in 2017, including performing loans originated by other lenders and sold at par. It remains to be seen how this practice will evolve, as this has obvious consequences for documentation standards.
If a deal is originated by a lender with a view to on-selling, it could impact the originating lender’s approach to documentation. Lenders may seek to make the terms as robust and as commoditised as possible to make the loan attractive to a wider market. It is difficult at this stage to ascertain how borrowers will react to this.
The types of property attracting finance have also changed, to a degree. While certain types of financing transactions such as speculative residential development have all but evaporated, new markets have opened up. The UK private rented residential sector is expected to boom once the inherent structural challenges surrounding funding a development that will be let over time are solved and a market practice is established. Many lenders have shown a clear commitment to PRS and it will be interesting to see how this pans out during 2017.
A geographical shift in financing deals has also been noted. In times of uncertainty, there is always a flight to quality. In a real estate context this has usually meant investors retracting back to London. However, with softening of values there might be better opportunities for yield away from London, and many large investors are backing regional schemes. This is especially true of PRS, where there is perceived to be much more value in the major regional cities such as Manchester, Birmingham and Leeds.
2017 and beyond
It is difficult to be anything more than cautiously optimistic about the market in 2017. Whilst there is an acknowledgement that deals will need to be done and an approximate equilibrium was achieved at the end of 2016, many risks remain. The Trump presidency is making international stock markets skittish, and could have a similar impact on real estate investor sentiments.
The triggering of Article 50 and the start of the formal process of the UK leaving the EU could also have a significant impact on investor appetite. Will the ring-fencing of the UK’s major banks and other regulated institutions impact not only the investor’s appetite to lend into real estate, but also the resource available to transact deals given the huge numbers of people required to actually implement the ring-fencing? Will upcoming elections in Germany and France spook investors?
As ever, there will undoubtedly be opportunities for investors irrespective of market conditions, but 2017 promises to be a challenging year for deal volumes and sentiment in the UK real estate market. A series of major events which could have profound impact on the market dot the calendar.