Rising cost of back leverage threatens to impede returns

Alternative debt providers that use leverage to boost their real estate lending returns are facing rising funding costs as providers of loan-on-loan finance, also known as back leverage, price in higher interest rates.

Loan-on-loan finance has gained in popularity with European debt fund managers in recent years because it enables them to reduce the amount of investor capital they need to utilise in a loan deal, driving returns on the capital deployed.

However, market sources say debt fund managers that issued loans in recent months, prior to rapid rate rises, before securing the loan-on-loan finance necessary to meet their target returns, may now struggle to source accretive back leverage.

Meanwhile, debt fund managers aiming to write new property loans are expected to be able to raise the pricing on offer to borrowers, to compensate for their own rising funding costs.

But sources say the narrower margin between loan pricing and the cost of loan-on-loan finance means using back leverage – which some say could as much as double targeted returns in the low interest rate environment – is no longer as accretive.

This could impact the ability of levered debt funds to remain competitive in the current market, argues Adam Buchler, managing director of debt adviser BBS Capital. “If a debt fund that relies on back leverage is targeting returns based on rates that have materially moved, they will have little choice but to increase the cost of their lending in order to maintain the same returns,” he says. “A debt fund that doesn’t use back leverage is likely to have more flexibility and may therefore have the upper hand during times like these.”

Some believe debt fund managers will continue to demand back leverage despite the fact it will not be as accretive as earlier in the year.

William Trotman, partner and real estate structured finance and securitisation specialist at law firm Bryan Cave Leighton Paisner, does not believe the increase in the cost of funds will dissuade debt fund managers from using loan-on-loan financing, but the leverage debt funds will be able to secure may be reduced.

“This is similar to what people expect to see more widely in the senior real estate finance lending market. While the fundamental drivers to use back leverage remain in place, it could impact the extent to which leveraged debt funds are able to use back leverage to enhance returns to the same degree that they could earlier in the cycle.”

Cushioning risk

Meanwhile, sources expect to see more lenders entering the market to provide loan-on-loan finance. As a low-risk form of debt, such financings are popular with banks, says Trotman. He explains that, under Basel III regulatory capital requirements, loan-on-loan lending positions carry a lower risk-weighting than direct real estate loans and require banks to hold less capital against them.

Loan-on-loan facilities are provided at low loan-to-values relative to the value of the underlying asset. For instance, a 50 percent loan-on-loan advance rate to a debt fund that is itself lending at an LTV of 50 percent against the collateral value, means the loan-on-loan provider’s exposure to the value of the underlying property is low.

“This look-through LTV is effectively a double cushion against any risk,” Trotman adds. “For this reason, it may well be that reduced LTV levels elsewhere in the senior lending market have less of an impact of advance rates for back leverage transactions.”