Three ways to reduce loan book risk in 2023 

Trimont’s Michael Delaney says lenders should focus on loan events, cashflow and covenants to mitigate current risks. 

Michael Delaney , Trimont Real Estate Advisors

With 2022 rapidly receding in our rearview mirror, many will be glad to look past twelve months that will be remembered for the wrong reasons. Russia’s invasion of Ukraine, supply chain issues, surging inflation and sharp interest rate increases have all impacted an already covid-battered commercial real estate sector.  

Additionally, due to weakening occupier demand, falling asset values and the rising cost of capital, it is not surprising to hear some lenders have quietly closed shop and effectively shut their doors to new lending.   

Many lenders are sensibly shifting their focus from underwriting new business to taking charge of their existing loan books. For lenders wishing to better manage portfolio risk and potentially avoid losses through loan defaults, proactive loan management must be top of mind. 

Here are three practical strategies they can consider today to minimise risk and strengthen the overall robustness of their loan books.

1. Maintain and monitor a loan events diary

The first step to proactively managing risk is knowing your loans. This involves carefully reviewing finance documents to ensure all loan events are monitored in a loan events diary. This helps you manage your loans proactively and respond to any deterioration in loan performance. 

The prompt review of loan events helps identify potential risks at an early stage, which in turn helps reduce risk in the long run. We recommend sharing your loan events diary with your borrowers, so that all parties can work together. 

The most obvious risk in the current environment is refinance risk at loan maturity. While many loan agreements have built-in maturity date extension options, all lenders should be reviewing these conditions and asking whether the borrower can meet the criteria required to exercise them. If not, what happens next? If an extension is possible, will further hedging be required? If so, at what cost? What implications will longer loan terms have for your funding sources?  

Knowing the answers to these questions early and identifying potential issues and solutions may help reduce refinance risk and avoid the requirement for a material loan restructure. 

Valuation is another structured loan event that may trigger a default. In some markets, values are understood to have fallen by more than 20 percent since October. The potential implications of calling for an updated valuation, and your borrower’s ability or willingness to remedy any potential loan-to-value breach, need to be carefully considered. 

Other loan events that should be closely monitored include hedging expiry dates, milestones that have financial implications for borrowers such as development milestones, and lease expiry dates. 

2. Keep an eye on cash

We all know ‘cash is king’, especially when there is less of it going around. But what good is cash to a lender if it is not accessible? 

Loan asset managers need to be aware of the various sources of income across loan books to identify any gaps in clarity, or a lender’s access to it. With cash often flowing into deal structures from several different sources, such as via property managers or hedging counterparties, the possibility for funds to be misdirected increases.  

Therefore, it is important to look closely at how funds are flowing through their deals and verify that this fund movement matches the loan documents.  

Big questions to ask include: are borrowers receiving income into unblocked accounts – particularly hedging proceeds? If so, what visibility over, or access to the funds, does the lender have?  

Most loan agreements stipulate that all net rental income is paid to the rent account. Is the cash available in the rent account exactly the amount needed to cover finance costs? It is important to know how the available cash compares with the net operating income anticipated in the borrowers’ quarterly reporting. 

Asset managers should ensure all funds flow via controlled accounts so there is adequate protection if a cash trap or cash sweep event occurs. 

3. Stay focused on covenant calculations

Loan asset managers should do a deep dive of all financial covenant calculations. These covenant tests can have a massive impact on the financial health of a loan book and double-checking their accuracy – even the calculations of the most institutional borrowers – is highly recommended. 

Aside from the immediate impact on how the waterfall of payments is applied under the loan agreement, breaching a financial covenant can result in higher interest costs, increased equity requirements and, in extreme cases, loan enforcement. 

A borrower’s covenant calculations should be checked alongside their most recent quarterly reporting, current business plan and the precise definitions of the loan agreement. Is your borrower correctly reporting its net income? Has it correctly accounted for rent-free periods, rent arrears and void costs? How much headroom to a breach does it have looking forward? 

Identifying discrepancies or misrepresentations will help the asset manager analyse the loan performance – and identify where future risk may lie. 

Michael Delaney is managing director of credit and asset management for EMEA at loan servicing firm Trimont Real Estate Advisors