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Risky business

Participants in real estate debt deals should resist the temptation to relax financing standards.

Suggestions that some in the borrower community are testing real estate lenders’ appetite for risk have cropped up in recent weeks.

Take, for example, an observation made in the recent Cass Business School report on UK commercial real estate lending: “There is increasing demand from investors for higher loan-to-values to take out equity”.

Sponsors aiming to capitalise on toppy capital values by attempting to dial up leverage to release a portion of equity is the sort of request that ought to sound alarm bells across Europe’s property debt markets. The Cass report was quick to add that banks cannot respond to this demand, but pointed out that insurance companies and other types of non-bank lenders have more flexibility to accommodate such requests.

Another area in which lenders’ resolve is being tested is loan covenants. At the recent CREFC Europe Spring Conference in London, lender panellists admitted the emergence of covenant-light loan structures in the European market is a hot topic. Such is the intensity of competition for lending mandates in parts of the market, some sponsors are demanding fewer restrictive terms and conditions to the loans they want to source. The return of CMBS issuance in Europe – a market in which covenant-light structures are more common – may exacerbate this trend.

Also at CREFC’s event, discussion turned to some of the more eyebrow-raising financing requests crossing lenders’ desks. ‘Last-mile’ logistics facilities in truth located several miles from civilisation and properties euphemistically tagged ‘core with personality’ – in other words, not core – were noted as examples of deals seen, and dismissed, by lenders.

While debt market participants need to be aware of these factors, it would be incorrect to suggest the European lending space is sliding towards the reckless practices seen in the build-up to the global financial crisis; far from it.

The market generally remains disciplined. Despite the Cass report highlighting borrowers asking for higher LTVs, it also noted that leverage across the UK market remains below 60 percent on average across all property types. The same is true across several Continental European markets. There is also a strong concentration of debt capital towards the senior, core part of the market – indeed, some in the market argue the lending community is too risk-averse and should be financing more value-add business.

The issue of waning covenants is worrying, but not straightforward. As one lender pointed out, fewer covenants does not mean no covenants. Such conditions are built into loans to provide lenders with the ability to force a conversation with their borrower. There is an argument for covenants structured to allow flexibility for sponsors to execute value-add business plans, but lenders need to ensure they work in their favour as early warning signals.

Lenders should also keep an eye on those within their ranks offering finance in situations most would wince at. One market player at CREFC’s event described seeing debt offered at 80 percent LTV to fund land acquisitions in Spain, for example. With the volume of private debt capital in the market growing, there is a danger that competition for high-yielding deals might lead some to take undue risk.

At this advanced stage of the cycle, with property fully priced in certain markets and large reserves of equity and debt chasing deals, it is crucial lenders stay within their risk parameters and ensure they dictate the adequate safety measures in their deal structures to ensure their top-of-the-market loans do not come back to bite them.

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