Lenders defend their territory

UK real estate lenders are striving to maintain their client bases as the property cycle matures, writes Nicole Lux, the author of the De Montfort University report on UK CRE lending.

Nicole Lux

The latest De Montfort University report on UK commercial property lending confirms many observations on the real estate investment market in 2016. The data demonstrates that the market has been more stable than some anticipated, despite the uncertainty surrounding the EU referendum.

The property investment market is experiencing a maturing but extended cycle with structural economic support due to very low interest rates. Historically, we have seen high capital values driven by high leverage, but today we have high capital values driven by equity with relatively low leverage.

While the political environment is fluid, the slow growth, low interest rate outlook and favourable property market fundamentals – such as low and declining property yields, as well as continued local market performance – are likely to maintain the lending market’s resilience.

At this stage of the cycle, however, expectations for price appreciation of core assets is low and, as the report has identified, lending levels for these assets will stay extremely low. While there is increasing investment interest by property investors in local markets – focusing on submarket dynamics and asset specific characteristics – in the search for yield, lenders might be less interested in following the investors’ steps.

Instead, lenders are extending the definition of the ‘real estate investable universe’, increasing acceptance of so-called niche property types (such as hotels, self-storage, senior housing, and student housing), from allocations traditionally focused on the four standard property sectors – office, retail, industrial and apartments.

What these property types have in common is the diversity of income streams based on the turnover of a large amount of rooms or beds – as well as good, reputable operators. While lending against these assets still requires specialised teams, we note the absence of riskier and more unstable assets like restaurants, pubs, casinos, petrol stations or trailer parks, which were popular alternative assets during the previous cycle peak 2006-07, as a positive.

While current loan-to-value levels look conservative (55-60 percent), Asian investors and German open-ended funds have bought prime London properties at ultra-low yields during 2016. The question will be how will senior lenders react when property yields move up to normal levels, from 3.5 percent for City offices to 5.5 percent, and a 60 percent LTV could become 80 percent?

Also, what is going to happen with mezzanine positions? Despite conservative LTV levels, we can already see that low property yields put pressure on interest rate coverage for prime property loans. There are limitations with
LTV-based approaches as they rely on current property valuations. But during the crisis, lenders stopped trusting these valuations.

Also, debt service coverage ratio seems to be non-conclusive in the current low interest rate environment and those lenders, who have identified this risk, are focusing more on income sustainability and debt yield – property net income over total loan interest – to determine the overall loan amount.

Total new origination volume was down by 17 percent year-on-year from 2015, including the demand for junior and mezzanine financing, leaving many lenders behind their annual targets. However, only 39 percent of the £44.5 billion (€52.4 billion) originated during 2016 was the result of new acquisition financing.

It seems that banks are defending their territory and keeping their customer base. Most likely this will continue during 2017 since many have been given high targets leaving little room for a team to lose a deal.