Currently able to secure 10-year funding at little more than 3%, many borrowers are looking to lock in cheap rates. Lauren Parr reports
At a time when most of the real estate market is engulfed by uncertainty and the cost of bank debt has increased, the picture looks rosy for long-term financing in the UK.
Borrowers have been taking advantage of the opportunity to lock in lower costs of funding for longer this year, underpinned by low gilt and swap rates which, at 10 years, hovered below just 1.5 per cent for most of Q1.
The past six months saw a large uptick in funding requests in excess of seven years, to 28 per cent from between 4 per cent and 12 per cent since 2012, according to Laxfield Capital’s latest UK CRE Debt Barometer.
Appetite for long-term debt has been met by the asset class’s growing appeal to insurance company lenders. For them, real estate debt offers better relative returns than gilts and also provides capacity for liability matching.
Brexit has further enhanced this appeal, with 10-year gilts falling by circa 50 basis points since 24 June.
“The reason government bond yields have fallen so substantially from what were already low levels is that a lot of investors are really worried and are looking to put money into ultra-safe instruments. The expectation is that the government will always pay its debts,” says Ashley Goldblatt, head of commercial lending at Legal & General.
“The proportionately massive decline in risk-free rates mirrors what happened post-global financial crisis,” he points out.
“But the reaction in terms of margin movement has been far less dramatic than it was back in 2007 when there was so little understanding of what had caused the episode. Although most people hadn’t expected the outcome of the referendum, everyone knew a vote was going to happen and that it would be reasonably close.”
The amount margins have moved so far (circa 25 to 50 bps) is less than the decline in risk-free rates, therefore long-term money is fractionally cheaper now than it was before.
This means institutions can be more competitive in their offering than they were.
It’s entirely plausible that a borrower could obtain 10-year senior secured funding at 3 to 3.5 per cent, which is “a charitable donation, it’s so cheap” Goldblatt quips.
Five to ten years ago, the 10-year rate was 10 times as high as it is now, meaning long-term debt was much more expensive.
“A number of people think the low interest rate environment is the new world order and are looking at the next 10 to 20-year horizon, thinking ‘how much better can it really get? We don’t need to wait and see if we can save another 10 bps. Now is a great time to lock things in’,” says Alexandra Lanni, head of transactions at Laxfield.
Liquidity is expected to recede with lenders nervous about what’s going on and focused on their underlying cost of capital. UK clearing banks, for example, will be restricted by having to hold more capital against their loans to protect them against an increased risk of losses caused by a decline in asset values.
“It’s difficult to see how banks can be more aggressive. If RBS’s share price has fallen by as much as it has, that has got to have some impact on its cost of capital at some stage,” says the finance director at a listed property company.
Through-the-cycle lenders or those less worried about interbank lending costs, such as life insurance companies and pension funds, are able to take more of a view.
“We’re still very much open for business and have significant ambitions in this area,” says L&G’s Goldblatt.
Chris Bates, head of real estate finance at Cornerstone Real Estate Advisers, believes “a period of uncertainty with reduced liquidity will bring the stability of long-term debt into greater focus”.
The enhanced debt market liquidity of the last few years gave borrowers renewed confidence that continually rolling relatively short-term finance maturities could be met by the market.
Feedback from debt brokers denotes that some clients are looking to review their holding strategies, from five years to seven to ten, set against a backdrop of cheap long-term money.
“Out of the previous crisis, people became aware of creating a mixed maturity portfolio and diversifying their debt funding. You saw the Derwents of this world approaching US insurance companies owing to their different denomination and a different set of motivations,” recalls one adviser.
The expectation is that borrowers who have traditionally used floating rate debt will think more seriously about fixed-rate loans in future.
Long-term debt is not suitable for all assets and management, however.
“It works well for investors that have bigger portfolios, providing flexibility to move assets between fixed and floating. Borrowers often ask ‘what if there’s a knock out offer for the asset, what then?’ The swap would have to be unwound on the floating rate debt, if in place,” Bates explains.
From a sponsor’s standpoint, “it’s a two-edged sword. New debt is undoubtedly cheaper. Your problem is if you have existing debt, and it’s hedged to some extent, the cost of breaking the hedge has gone up.”
Providing a borrower has a long-term business plan and can build in sufficient flexibility, “it makes eminent sense to do it,” he concludes.
“Not only have you got extremely cheap, fixed-rate long-term money, but you have control as you know the cost of this every year for as long as you’ve got the deal in place,” says Goldblatt. “This could be very important if you are concerned about what might happen in the future with inflation because if you expect it to rise this will likely lead to a rise in base rate. If you take shorter-term bank finance now you might find when you come to refinance it that the cost of money is above what you could secure long term for now.”
As a result, the referendum outcome “should reflect something which is good for deploying institutional money” he reiterates.
Long-dated debt: Not for everyone
Alluring as certainty of inflows may be, long-dated finance is not available or appropriate for all investors.
Strength of covenant quality is important and deals tend to be low leverage.
“The nature of long-term finance suits clients looking to match secure cash flows with predictable debt costs, typically the likes of family offices, institutions, private wealth, small private propcos and landed estates which are usually conservative in nature and have a portfolio of long-term, stable assets that neatly lend themselves to long-term finance,” outlines Barclays’ national head of real estate, Dennis Watson.
Martin’s Properties is a prime example – a family business with a 60-year history of property holdings in Chelsea. Canada Life provided a £33 million long-term loan secured against part of the firm’s estate in July.
REITs and larger sponsors looking for tenor would be more minded to go to the bond market or private placement market, while developers and opportunistic funds are incompatible by nature.
There are some drawbacks however, such as the fact that long-term debt is very expensive to break.
“It doesn’t afford you the same level of flexibility around how you draw down a facility and repay it, or flexibility around changes to the collateral. You need to be confident the security you are pledging is core, long-term, stable stock with matching cash flows that you can lock up and leave alone,” says Watson.
The market has gone some way to meet borrowers’ needs over time.
Notes Laxfield’s Lanni: “Substitution parameters and protection for under-gearing have become more sophisticated as long-term debt providers have looked to structure things to help borrowers still actively managing portfolios unlock long-term funding.”
“You have to make sure a deal is documented correctly to give you the right amount of operational flexibility. It’s about making sure your business strategy matches the term of your debt,” says BMO’s Rob Mackenzie-Carmichael.