At debt and hedging firm Chatham Financial’s semi-annual market update for real estate on 6 October, attendees said that reviewing their debt financing strategy was their top priority, ahead of everything else including investment strategy.

Investors and debt advisers PropertyEU has spoken to have the same impression.

Philip Slavin, chief financial officer at UK developer Quintain, says: ‘Everyone is extremely busy, particularly with short-term refinancings, and people are talking about a lot of extensions.’

Paul Lloyd, founder and CEO of Mount Street, says the loan servicing and advisory business has never been busier. ‘For us, 2022 has been an unprecedented year, business-wise and by volume of work.’

Lloyd says the firm has seen a jump in requests for both extra servicing surveillance on existing loans and pre-closing asset diligence on new loans. ‘For example, can we provide more oversight on the portfolios? Can we get further under the hood of the transaction? Can we provide amendments and waiver oversights such as suggestions and opinions where a surrender of a lease comes in, or the effect on the portfolio if there is the sale of an asset and the substitution of another asset?’

Borrowers are having to contend with both the higher interest rates pushing up debt costs and the uncertainty about the pace and timing of hikes. On 3 November, the Bank of England’s 0.75% base rate rise to 3% was the first hike of that magnitude for 33 years and matched the ECB’s 0.75% rise on 27 October, to 1.5%.

Market volatility has been particularly severe in the UK where the five-year Sonia swap reached 5.2% at the end of September. The price fell back on 17 October after the new UK Chancellor’s reversal of his predecessor’s 28 September ‘mini-budget’, to 4.7%. After the 3 November BoE rate announcement, the 5-year swap traded at 4.13%, the 2-year at 4.40% and the 10-year GBP swap at 3.78%, all decreases, but still much higher than a year ago.

In early November, Chatham Financial said the market was currently pricing in a further 0.60% of hikes at the final BoE Monetary Policy Committee meeting of 2022.

These debt-induced headaches are having multiple effects on the operation of the property market, for both acquisitions and refinancing.

Focus on debt yield
Slavin says different lenders are changing in different ways in response to the higher risk, but the biggest trend his team has noticed is ‘a stronger focus on debt yield’ – the metric determined by dividing an asset’s net operating income by the loan amount and the one that tends to come to the fore when lenders prioritise the time it would take them to recoup their investment in the event of default.

Slavin adds: ‘People are still interested in loan to value and interest cover covenants, but debt yield is becoming the first thing lenders ask about.’

Quintain successfully finalised a £277 mln financing, its largest development loan ever, with US investment bank JP Morgan in September. The loan will finance the construction of two residential buildings at Wembley Park in north London, with 769 homes including 665 build-to-rent.

The company had gone through a process with lenders for the deal in April-May and interest was high, Slavin says, ‘from UK high street banks through to various specialist funds and insurance firms’.

He believes they liked Quintain’s track record at Wembley and the £227 mln construction contract the developer has signed with long-time contractor partner John Sisk & Son gave comfort. ‘From a lender perspective we’ve also got 98.5% occupancy, plus good proof of rents.’

Slavin says Quintain was looking for a good package, ‘a combination of rate and also leverage levels and various other terms’. Equally important was ‘the right kind of partner to work with because in development, things can happen’.

The developer has an ongoing relationship with JP Morgan which is an advisor to Quintain’s parent, Lone Star. Slavin declined to comment on whether JP Morgan offered relatively higher leverage than other lenders his team spoke to.

Lower LTVs
Lower leverage, however, may soon become another trend making life difficult for borrowers. European lenders’ trade body CREFC reported a decline in LTV sentiment to reflect market risk in its latest lenders’ 3Q22 sentiment survey. In European Real Estate Debt Markets Re-align, published in September by AEW Research, author Hans Vrensen noted that a decline in LTV sentiment was ‘likely to trigger a decline in actual LTVs in the rest of 2022 to 45-50%.’

Vrensen believes that ‘this potential of lower refinancing LTVs, together with the already accumulated capital value decline for some of the underlying collateral, amplified by the higher interest rates, might trigger significant refinancing problems for loan maturities in 2023-2025’.

AEW estimates the degree of refinancing challenge by calculating the debt funding gap. This is defined as the gap to be bridged between the original debt amount due at loan maturity and the new debt available to repay it. The firm estimates that across the UK, France and Germany there could be a cumulative €24 bn debt funding gap for the next three years.

On the plus side, he comments, this is ‘relatively modest’ compared to the global financial crisis, and will ‘likely be bridged by a combination of equity top-ups, junior debt plugs and senior loan extensions as well as loan write-downs and discounted loan sales’.

Moody’s also sees a refinancing problem looming driven by capital value decline. In a 26 October research note, the rating agency says: ‘Weakening CRE values will hamper borrowers’ ability to refinance CRE loans and increase the risk of losses in a workout scenario…Weakening property values imply a heightened risk that CRE loan borrowers will be unable to refinance their debt without equity injections.’

Dr Nicole Lux, author of the twice-yearly Bayes UK Commercial Real Estate Lending Report, believes significant value falls are inevitable because in many cases, property income won’t meet the higher debt costs on refinancing or acquisitions. ‘Our analysis shows that property net income yields need to increase to over 6% across different property types, or property values need to adjust downwards by circa 35% to reach a new market balance,’ she said on publication of the last report in October.

Public market shutdown
Those borrowers able to access the public debt capital markets before they slammed shut in February are counting their lucky stars. Not only will they have cheap and possibly longer-term finance in place but, as it is usually unsecured capital, DCM finance leaves investors with unencumbered assets.

This, in turn, makes any subsequent financing in the private debt market much less difficult, as Andrew Coombs, CEO of German and UK business parks investor Sirius, points out.

‘We were lucky enough to have got away €700 mln of unsecured corporate debt in the nick of time, with the second €350 mln tranche last year at 1.25%,’ he says. This represents around 75% of the listed company’s €964 mln of borrowings. ‘And it gives us €1.6 bn of unencumbered assets, meaning the company represents a much lower risk today despite the (more difficult) market.’

Of the remaining €264 mln of secured debt, Sirius recently refinanced €170 mln one year early with existing lender Berlin Hyp. The new seven-year loan will kick in next November 2023 when the cost will roughly triple, going up to 4.26% (of which 2.61% is the base rate and 2.05% the margin) but still only taking the group’s blended cost of debt from 1.4% to 1.9%.

The bank agreed to fix terms now – and even to soften some of the covenants – partly because it knows Sirius and its business well having been a lender to the business park specialist since it launched in 2007. But a further reason, Coombs stresses, was because ‘when you’ve got €1.6 bn unencumbered, your cure provisions and your ability to steer away from danger is much greater than when most of your property is related to mortgage backed loans’.

What Sirius gets from the early refinancing is certainty. ‘We have 90% of our lending locked down at less than 2% blended for more than four years,’ he continues. ‘Our average lease length in our portfolio is three years so that gives us four years to go through the whole customer base and increase pricing before our interest costs rise above 2%.’

He says one of the things the group has learned and that’s really been emphasised since February’s DCM shut down is: ‘You must have a broad range of debt options. You cannot be complacent enough to think you can depend on one bank, one type of lending. You’ve got to have the flexibility all the way around the cycle.’ ?

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The alternative route: mezz finance

For borrowers facing capital shortfalls on upcoming refinancings at increased lending rates, mezzanine or preferred equity may be an option to bridge the gap instead of topping up equity or selling properties.

Dr Nicole Lux, academic and COO of fintech CRE loan company FinLoop, says: ‘This is a trend that is already happening in Germany.’In its latest annual Mezzanine Report, Berlin-based FAP Group, which focuses on debt products, says: ‘The current situation is creating a lot of opportunities for subordinated capital providers...Banks’ hesitance and the rising interest rate level are stoking expectations. We are thus expecting a significant rise in new business over the coming years.’

FAP counted 159 capital providers active in the subordinated bracket in Germany, slightly more than in the previous year (plus four). The number of institutional investors lending directly fell again, while the number of debt funds increased. 55 market participants took part in the survey, providing €5.5 bn.