The 2021 Bayes UK Commercial Real Estate report was published in May and includes plenty of positives. Chief among them are that lending volumes in the UK in 2021 rebounded to the levels of the last peak: new lending volume in 2021 reached almost £50 bn (£49.8 bn) which is 48% higher than 2020, more than 2019, and the strongest year since 2015.

Also encouraging was a reversal of the rising rate of defaults which had begun in 2020 due to problems associated with Covid. As tenants resumed paying rent during 2021, the result was a drop in the weighted average default from 4.6% in 2020 to 2.9% by December last year. The report notes that all lenders still have breaches and defaults outstanding across their books, but that they have ‘remarkably’ resolved their problem loans.

However, the report’s outlook is less rosy for borrowers, who already know that the era of ultra-cheap money is over.

Margins and interest rates
The survey found that margins jumped last year, while recent interest rate increases of UK 5-year swap rates have added to the cost of new lending. This will put pressure on income coverage ratios on some loans, says the report’s author Dr Nicole Lux, senior research fellow at Bayes Business School (formerly Cass).

Average margins for prime office financing rose from 2.29% at 2020 year end to 2.54% in 2021. While the average masks the variations between terms offered by different lender types and for different LTVs, the direction of travel has been clear, Lux said.

Margins increased most for debt funds (by 66 bps), while UK banks raised margins by an average 34 bps and international banks by 25 bps.

Insurance companies actually lowered margins by 15 bps but also lowered LTVs from 58% in 2020 to 56%. German banks’ margins are the lowest but they have been less active in the UK.

On a 60% LTV basis, average margins jumped from 218 bps in 2020 to 242 bps in 2021.

‘If you’re a lender in the very prime segment there’s always a lot of competition so you don’t really get to the point of increasing your margins that much,’ says Lux. ‘But if you look at the overall market, since 2015 the tendency has been upwards.

‘By the end of 2021 lenders were already pricing in the interest rate increase that happened in January 2022. This was already priced into the five-year fixed rate. The 5-year Sonia swap has increased this year to 1.86%, leading to an overall interest rate on loans of 4.4% for some properties - close to prime office yields.’

She adds: ‘And that’s why a lot of the debt funds told us in January, when we did the interviews for the report, that margins went up another 1%. If they were expecting an IRR of 6% before, it’s now 7%.’

Since the report came out in early May, the 5-year Sonia swap has risen again, reaching 2.8% on 21 June.

Another issue in 2022 flagged by UK banks - a group which still took almost 40% of the UK market in 2021 - is that they expect managing their balance sheets to get harder.

One reason is that borrowers with floating rate loans have been asking to switch and fix their rates. But Lux points out ‘it’s already too late to realise they have to do something, because the long-term rates have already increased. Banks now have to manage the balance sheet between all the facilities (and say) it is going to be a lot more complicated.’

ESG challenge
The other challenge for bank lenders is ESG. Only about half the 76 lenders surveyed (54%) replied to questions about their policies. Of these, 58% said they would allow for lower margins for properties with high ESG standards (an increase from 43% six months previously).

Lux sympathises: ‘There are so many issues and how do you price the loan if you don’t even know what the cost of getting an existing building up to standard will be and how the building will be priced when it’s all done? So they feel they have to be really careful with their decisions and also how and on what they use their balance sheet.’

UK banks have slotting, she adds, ‘and it’s now not clear how that’s all going to work’. Working parties and valuers are currently scratching their heads and conferring about whether a lending framework for assessing capital requirements for these transitional assets can be produced.

CBRE IM said recently in a report published in April called The role of credit in transforming European real estate that the cost of upgrading an office from the UK EPC rating of F or G, to B or C, has been estimated by PMA at circa €200-€300 per m2 - far more than the cost of standard maintenance.

Debt funds may be the beneficiaries. Lux says they tell her that they raise specific buckets from investors for certain strategies to deliver a type of return and risk profile. ‘They have a clear message and profile, while if a borrower goes to a bank they just don’t know their process or if they look at this type of asset.’

These non-bank lenders continued to increase their share of the UK lending market in 2021, the survey found, from a quarter to a third.

Commenting on the report last month, Peter Cosmetatos, chief executive of CREFC Europe, said: ‘Two questions for the future are will the market be as resilient to the consequences of geopolitical turmoil and inflation as they were to Brexit and Covid?

‘And, who is best placed to finance the repurposing and decarbonisation that so much of the nation’s real estate needs?’

At an event for lenders and sponsors to launch the report, held on the evening of 4 May in London, 67% of the audience said rising interest rates and a possible recession would be the most important issues in the coming period with another 18% naming inflation. Nobody named a possible resurgence of Covid as the most pressing issue.

Meanwhile, 58% said rising property yields would have the biggest negative impact on property returns while 63% said credit availability will tighten.

Lenders sceptical about co-living
As would be expected, the report finds that the lending market follows the wider real estate market and that ‘overall loan exposure to the traditional office, retail and industrial property types in proportion in outstanding loan books has been declining in favour of alternative property types and residential loans’.

Indeed, exposure to residential has reached a 20-year peak, standing at 21% (14% in 2018). Prime industrial and residential investments are the two sectors that most lenders are willing to finance (92% and 80%).

But lenders are careful about what type of residential they will lend to and Lux says she was ‘surprised that co-living is not going down so well..lenders are very sceptical about the concept... There’s too much movement in and out all the time and the maintenance is very high on these extra spaces. A lot of people mentioned this’.

She says another concern about co-living is that the young professional target audience ‘could get sick and tired of it, in other words there might be a very limited time after being a student that you’d be interested in that type of living. So they feel it’s too niche’.

Five key points from the Bayes Report pointing to tighter and more expensive debt

• The cost of UK real estate borrowing had already jumped by the beginning of 2022 due to higher swap rates and an increase in lenders’ margins
• Further interest rate rises are expected this year
• Banks anticipate that the rising cost of borrowing and ESG will make balance sheet management more complicated
• Non-bank lenders increased their market share in 2021 from a quarter to a third and they increased their margins more than banks and insurance companies
• At the report’s launch event to the UK lending community, 63% of the audience said credit availability will tighten; 58% said rising property yields will have the biggest negative impact on property returns