European CRE finance industry gets mixed signals on interest rates in the face of the UK’s EU referendum
Tomorrow morning we will finally know whether the UK is set to remain in or leave the European Union. For months, the referendum has loomed over the UK – and Europe – as a source of gnawing uncertainty.
Rumination on the result of the vote is for tomorrow. In the meantime, another external (and inextricably related) factor worthy of discussion is the impact of interest rates on the European real estate finance industry.
It is virtually impossible to predict the impact of a ‘leave’ vote on interest rates. In May, Bank of England governor Mark Carney warned that a Brexit could push the pound lower, stoke inflation and hit economic growth, leaving the central bank with the quandary of how best to use rates in response.
UK chancellor (and Remain campaigner) George Osborne stated his view in April that a Brexit would spark an interest rate hike. Not everyone in the City is so sure. In a research paper earlier this month, JP Morgan Asset Management said that a negative hit on the economy in the event of a Brexit would dominate the monetary policy response. “The first rate rise would likely be deferred even further into the future, and the chance of a rate cut or other stimulus measures in the UK would go up,” the firm said.
Brexit or not, the subject of interest rates weighs on the real estate finance market. Earlier this month, Real Estate Capital editor Andy Thomson moderated a finance panel at the European summit of our sister title, PERE. While a poll of the audience revealed that 93 percent expect a rate rise, the panellists admitted that did not expect it to happen soon.
Cyril Hoyaux, AEW Europe’s head of debt funds management, predicted a rate rise by 2018/2019, while David Wasserman of Sumitomo Mitsui Banking Corporation said that he didn’t see interest rates going up by 2020.
The low interest rate environment has been pleasant for borrowers, but challenging for banks. The situation is most acute in the Eurozone, where the European Central Bank’s negative interest rate policy remains a thorn in the side of many of Germany’s large mortgage banks. In order to stimulate the economy, the ECB is essentially penalising those parking their money by cutting interest rates to below zero and thus encouraging a greater flow of capital into the financial system.
Aareal recently cited the “known challenges” created by such an environment, including continued high competitive pressures in the CRE finance market, low margins and moderately higher leverage.
Finance specialists have also warned that negative interest rates can cause issues in CRE loan agreements. Many banks have introduced margin floors into their deals, meaning that if the reference rate in the loan – Euribor or Libor – falls below zero, it is considered to be fixed at zero for the purposes of the loan, and the borrower continues to pay the full basis points margin.
Interest rate floors included by banks in their loan agreements need to be matched by a similar provision in the associated hedging instrument which the borrower takes out, adding extra cost into the deal.
One UK banker told me this week that Libor floors are now typical in its loans and in many of its peers’ deals. Negative Libor might seem a distant prospect, but the banker said that a ‘leave’ vote today could start to make such provisions look entirely sensible.
At Savills’ most recent Financing Property presentation earlier this month, senior valuation director William Newsom addressed Libor floors under the heading ‘fancy new financial structuring we don’t fully understand’. Newsom even questioned whether they could be another bank mis-selling scandal in the making.
Explaining that point, Newsom said: “This is a complicated subject and it needs to be carefully explained to borrowers. There is a risk that smaller and less financially sophisticated borrowers might later claim that they didn’t understand what they had agreed to.”
Interest rates will always be a variable which requires careful consideration from real estate lenders, but the current uncertainty surrounding rates in both the UK and the Eurozone is giving many in the industry a headache. The likelihood is that lenders will have to deal with Europe’s low interest rate environment for some time yet.