Strong lending volumes, more defaults: Bayes’ key 2022 UK market findings

The London business school’s latest UK lending market survey reveals origination was only slightly reduced in 2022 despite economic upheaval.

Lenders continued to supply finance in the UK real estate market throughout 2022, despite a highly uncertain political and economic backdrop and a decline in property investment activity, according to the latest sector report by London’s Bayes Business School.

However, the Bayes UK Commercial Real Estate Year-End 2022 Report – for which 81 organisations were surveyed, including 37 banks, 11 insurers and 33 other non-bank lenders – showed debt providers were more cautious on loan terms, and many reported an increase in covenant breaches and defaults across their books.

Here are some of the key findings:

Lending was only slightly down from 2021

A total of £48.6 billion (€54.8 billion) of lending was recorded across the survey during 2022, representing a circa 2 percent decline from 2021’s total – which was the strongest year since the most recent market peak in 2015.

The relative stability in lending volumes between 2021 and 2022 came despite a fall in acquisition activity last year. According to JLL, 2022 investment stood at £48.7 billion – 22 percent down from 2021’s record volume. The consultant reported £30 billion of investment in H1, with the impact of the UK government’s September ‘mini budget’ and subsequent sharp rate rises resulting in reduced volumes of £18.4 billion in H2.

However, Bayes’ figures showed origination activity in the second half of 2022 – at £24.9 billion – was up from the £23.7 billion closed in the first six months of the year.

“You could say there was no liquidity issue because lenders kept finding solutions for borrowers,” Nicole Lux, senior research fellow at Bayes, and the report’s lead author, told Real Estate Capital Europe.

Refinancing dominated activity

A higher than usual volume of refinancing activity contributed to 2022’s lending volumes, Bayes’ data showed. Around 65 percent of lending was attributed to refinancing transactions, up from 52 percent of activity in 2021.

“Borrowers took immediate action,” explained Lux. “They have not been waiting to refinance, because few expect interest rates to come down significantly in the coming 12-18 months. Also, in the latter part of last year, banks had not started to demand valuations. So, if borrowers expected to lose tenants or the value of their asset to go down in 2023, they wanted to refinance as early as possible.”

A significant volume of refinancing activity involved sponsors agreeing new loans with existing lenders. “I think lenders did not want to have to deal with workout situations in 2023, so were willing to refinance.”

However, the data showed an equal split between refinancing deals closed with existing lenders and refinancing deals in which there was a change in lender.

Defaults increased

Despite strong volumes, lenders contended with problems in their existing loan books. The average default rate across all lenders increased from 2.9 percent at the end of 2021 to 3.5 percent by the end of 2022. In total, 9.3 percent of loans were in breach of covenant or default by the close of the year.

Bayes said 42 percent of lenders reported breaches and 47 percent reported defaults across their loan books. The highest default rate was among non-bank lenders, at 12.2 percent.

Rising interest rates put pressure on interest coverage ratios. Bayes said ICRs ended the year between 1.3x and 1.6x on average across asset classes. Assuming another 50 basis points increase in interest rates, it said, this will drop to “critical levels” of 1.2x to 1.5x, resulting in covenant breaches.

“People have said ICRs of more than 2x are history,” said Lux. “This is due to external factors. The quality of the building or the tenant has not changed, so the income side has not changed. But if sponsors lose a tenant, they will be much closer to default.”

However, Lux believes lenders remain unwilling to accelerate loans following defaults. “They feel if borrowers are forced into sales, values could go even lower and there will be more disruption in the market.”

UK banks and alternative lenders increased volumes

Despite market sources reporting greater caution among banks and more opportunity for non-bank lenders, Bayes’ data showed no major change in the provision of loans from lender groups. UK banks and non-insurance company alternative lenders increased their origination volumes slightly, while foreign banks’ and insurance companies’ volumes decreased slightly.

In total, 41 percent of new loans were provided by UK banks, while ‘other’ non-bank lenders and international banks – excluding German lenders – each accounted for 21 percent of the lending total.

Lux expects banks to remain the major source of capital in the market, with non-bank organisations’ growth to be limited. “[Non-banks] have tripled in size since we began measuring them in 2012, but I think there’s a natural limitation now and I believe we have reached that for now, because they rely on external investors. As these investors may shift now back to other bond markets there might be less interest in real estate debt. It will always be a niche investment.”

Pricing increased; leverage decreased

Lending margins increased across sectors, with pricing for loans on prime assets up on average by 4 percent to 7 percent. Office loan margins increased by 6 percent, from 254bps to 270bps. Retail margins increased by 7 percent, from 317 bps to 341 bps. There was a 4 percent increase in margins in the industrial sector, from 253 bps to 263 bps. Secondary margins increased more sharply, by 14-15 percent for offices and retail, and by 24 percent for secondary logistics, year-on-year.

“Bank pricing for senior debt has increased, and debt funds have adjusted downwards due to more competition among them and are now closer to the banks,” said Lux. “There is now less differentiation between banks and alternative lenders in the senior debt space.”

Meanwhile, loan-to-value ratios declined across all lender types and all properties by 1-2 percent, with a decline for prime properties between 0.5 percent and 1.5 percent. The average LTV for prime offices declined from 56.6 percent to 54.8 percent. Non-bank lenders reported the largest adjustment in lending policies, with prime office LTVs down from 61 percent to 57.4 percent.

There is a potential problem in smaller lenders’ books

According to Lux, there is a divergence in the quality of loan books between smaller lenders with loan portfolios of below £1 billion and more established, larger balance sheet lenders with more than £5 billion on their books.

The report showed the weighted average default rate of portfolios of larger lenders was 1.5 percent, compared with 8.2 percent for smaller lenders. It also noted 41 percent of loans in smaller lenders’ books have an LTV of more than 60 percent, compared to 14 percent in larger lenders.

“This is where the concern is for me,” said Lux. “The smaller books belong to challenger banks and [smaller balance sheet] non-bank institutions, and that market has taken on more risk because they may lend at high LTVs against assets of potentially lower quality, because they take on smaller assets, often in peripheral locations.”

The smaller end of the market is also less regulated than the larger loan market. “This is becoming a clear risk point,” she added.