This article is sponsored by Trimont
Anxiety is looming large on European lenders as rate increases, volatility in the banking sector, refinancing concerns and a decline in commercial real estate property investment activity continue to fuel market uncertainty. The current market environment is making lenders more selective about the loan positions they want to back, says Dean Harris, executive managing director for EMEA at global loan managing and servicing firm Trimont.
This challenging environment is also making the market for new loan originations more polarised as lenders become cautious about their underwriting, terms and exposure. In Harris’ view, some funding opportunities could receive eight to 10 lender bids, while others, especially in sectors such as secondary offices, might receive no lender interest at all.
How is the commercial real estate lending market faring so far against the uncertain economic backdrop?
Looking back, 2022 really was a year of two halves. During the first six months, we closed a significant number of deals, but new loan origination came to a shuddering halt during the second half of the year as the market took stock of the sudden increase in interest rates. This abrupt change in market conditions caused lenders to focus on their existing loan books, re-underwriting and stress testing their loans in light of the new interest rate environment.
Overall, the reaction of lenders in 2022 and the first half of 2023 has been markedly different from the global financial crisis. Loans are better structured, with lower LTVs and better debt service cover metrics, which has given lenders and borrowers more headroom to work together to address potential breaches and find solutions. And whilst property values have fallen, for unregulated lenders we have not seen a widespread call for updated valuations during the past 12 months, and neither have we seen lenders or borrowers make rash decisions in relation to their respective positions.
In recent weeks, however, we have started to see an uptick in calls for updated valuations, and we anticipate that these will trigger restructuring discussions between lenders and borrowers, particularly on loans that are maturing during the next 12-18 months.
What, in your view, is the biggest challenge facing the industry today, and have you had to rejig Trimont’s loan portfolio to mitigate its impact?
Refinance risk concerns me the most today. Most lenders we work with include hedging as a condition of their loan advances. However, borrowers with existing loans that are maturing in the next 12-18 months will face a significant increase in their finance costs, at a time when the value of their assets is likely to have diminished. In many of these cases, borrowers will need to provide additional equity as part of these refinancing discussions.
In the UK, average loan terms are slightly shorter than on the continent, and a significant percentage of loans in the UK are due to mature in the next two to three years. This causes me the most concern because refinance risk will be sector agnostic.
In Europe, we work with over 30 lender clients, and service or manage in excess of 250 loans with a total AUM of €40 billion. We are spending more time on existing loan positions, working with lenders and borrowers to facilitate real-time analysis and help mitigate concerns before they turn into risks to the lender’s return and capital.
We are also working closely with lenders to ensure that lender consent is provided before any surplus cash leaves the agent-controlled accounts. From our experiences during the GFC, we understand the importance of preserving and controlling cash in the transaction and we continue to work closely with all parties to achieve optimal results for our clients.
Has the current cycle, and the headwinds that triggered it, impacted lending strategies and the overall appetite for the CRE industry?
Lenders will continue to be much more selective about the opportunities they want to pursue and consider. Whilst lending conditions have clearly tightened in recent months, there are definitely lenders with capital to deploy and an appetite to lend. We are seeing new lenders in the market, and these entrants do not have legacy loan positions they need to worry about, so they can be selective about the loan positions they want to consider.
I think there will be a real polarisation in the loan origination space. There will be certain loans that multiple lenders will be prepared to issue terms on, and this will create competitive tension amongst lenders. At the same time, there will be other loans where there will be no lender appetite, and this could be for a number of reasons, be it sector, jurisdiction or internal credit policy.
Separately, we are also seeing more and more lenders asking for independent loan reviews to help them identify potential trends and risks on their existing loan positions. We have been proactively hiring in this space on the back of these requirements from our clients.
What are the sectors that pose the biggest risks for lenders, and where are the opportunities?
I still see some appetite and scope for recovery in the prime office sector. However, lenders and occupiers will generally be more selective about the type of office premises they lend against and occupy. Secondary offices, as well as those requiring refurbishment and major capital expenditure, especially to comply with ESG regulations, will be challenged going forward, and I anticipate that yields will continue to move out further on these assets.
All forms of residential use have performed very well during the current economic cycle, and supply/demand issues may well insulate part of the residential sector from any downside. Whilst new loan volumes for the logistics sector have fallen, the sector has performed well in terms of occupancy and rent growth, and I believe that there will be continued interest in the sector for the right assets and portfolios.
What is your outlook for the development finance sector?
Development finance is a complex area of commercial real estate lending, which is why there is a smaller pool of lenders in that space. Development loans require a lot of management and understanding, and current cost inflation, contractor failures and rising finance and insurance costs have all added to the challenge.
A high percentage of the development loans that we see in the market are likely to experience time delays and cost overruns, arising for a number of reasons, whether it be changes to specification and design or supply and labour management.
This is why development loans carry a premium compared with investment or even transitional loans. A development finance lender, for example, will aim to achieve a target IRR of 12 to 18 percent.
Given these challenges, some lenders in the development finance sector will be re-underwriting some of their existing loans and performing a line-by-line review of these positions. Our credit and asset management team works with lenders on development loans, reviewing project monitor reports, development costs, cashflow forecasts and use of contingency, often as part of each draw request. This in-depth analysis requires a good understanding of the loan position and sector.
Debt-on-debt funds and gap financing appear to be niche, but promising, areas of CRE lending. Are you seeing opportunities in these segments?
The market share for alternative lenders has increased during the current economic cycle, and even more so post-covid. These alternative lenders are able to act more quickly and flexibly than typical lenders, but they also have higher IRR targets, and participating in debt-on-debt helps them achieve these targets. Unlike banks, debt funds are not bound by strict regulations. So, as long as debt funds and alternative lenders continue to be present in the market, the debt-on-debt market will continue to grow.
There will also be more opportunities for gap financing for some lenders, both for single loans and portfolio loans, in the near to medium term. So far, however, there is still some pricing disconnect between people holding their assets and either the potential buyers or the lenders they are looking to refinance with.
How is the role of ESG playing out in the industry?
In the past, ESG was talked about regularly, but it always felt that not much action was taken. We have observed a change in mindset over the last six to 12 months, and ESG now seems to be at the forefront of lenders’ minds when considering loan positions, new and existing.
Whilst it is not possible to quantify how much a property might be worth without or with ESG compliance, we anticipate that lenders will start to ask more questions of valuers in relation to the potential cost of making properties compliant with current and future regulation and legislation, and then taking that cost into consideration when looking at their gearing position. We believe that lenders will gradually introduce more language into finance documentation around ESG reporting and covenants.
How can lenders and servicers best navigate challenges and protect their positions?
Lender decisions are taking longer, which is understandable. We are also seeing some stressed positions start to develop into distress, which will cause challenges to the lender/sponsor relationship.
Being proactive and actively communicating with borrowers is key for most lenders and loan service providers. Make sure the reporting is received on time, and that it is analysed and considered in a timely manner. Identify the positions that need additional attention and start discussions early with your sponsors: 12 months prior to loan maturity as a minimum. For example, we are now spending 50 percent more time on loans than we did two years ago and are having frequent catch ups with our lender clients to review loan positions and identify areas where there might be concerns.