According to Bayes Business School, nearly 40% of outstanding UK commercial property loans are due to mature in 2024 and 2025, many of which were agreed at much lower interest rates than those available today. Last year saw fewer defaults by distressed borrowers than anticipated, which created a temporary reprieve, but this has just delayed the problem of refinancing.
Jonathan Long, head of corporate real estate at Investec, says: “We expect refinancing to look more challenging in 2024 as updated valuations are obtained and hedging products expire. Gaps in the funding stack are likely to be filled by mezzanine finance and alternative lenders.”
Debt costs have risen for those borrowers whose debt was not fully hedged or who have had to refinance away from cheaper, historic debt to more expensive new loans. So, the importance of hedging strategies and negotiation around the hedging requirements in finance documents has grown. Vincent Nobel, head of asset-based lending at Federated Hermes, says: “The era of cheap debt is, at least temporarily, over. That means that taking debt to leverage equity investments is no longer cheap nor can it be said to be low risk. Leverage does add risk, and borrowers are experiencing this risk when they are having difficulty refinancing their properties at maturity of their loans.”
Alongside higher debt costs, weaker rental income and reduced asset prices have put pressure on both interest cover and loan-to-value (LTV) financial covenants. According to Gary Bellingham, partner at law firm Faegre Drinker Biddle & Reath, these pressures will start to become more evident this year as more borrowers face having to refinance cheap debt with much more expensive loans so there will be questions about how much debt the underlying assets can support.
Average real estate values have fallen by more than 20% since mid-2022, according to M&G Investments’ Global Real Estate Outlook 2024 report published late last year. Although LTV ratios may be less exposed to defaults than during the global financial crisis, José Pellicer, head of investment strategy at M&G Real Estate, highlights that previously sound loans may fall foul of banks’ parameters, and some owners looking to refinance may have difficulty finding options open to them. He says: “With both the underlying cost of debt and debt margins having increased sharply, this points to a hefty rise in monthly repayments and a potential inability to meet interest coverage ratio covenants for loan renewals.”
Borrowers holding assets financed through alternative lenders at higher LTV ratios may also struggle in the current environment, which may lead to distressed sales. So, having high-quality collateral in this environment will be key this year. Nobel says: “Properties that feel dated, are in need of refurbishment or are in the ‘wrong’ location will struggle to attract new financing. This is, therefore, an important theme for this year – a continuing divergence between assets that can find occupiers as well as buyers and lenders, and those that cannot.
There is also a feeling amongst the industry that 2024 will be the year of the refinancing gap: the amount a new lender is willing to lend against an asset may be significantly lower than the amount needed by a borrower to repay its existing lender. Bellingham adds: “In this scenario, we are likely to see more forced sales of assets, which in turn could lead to more downward pressure on asset prices and lower valuations.”
Rising costs have also led many firms to take on increased levels of debt. This can often delay repayment or add increased costs later, according to Hugo Llewelyn, chief executive of Newcore Capital, a specialist investor in social infrastructure real estate. He says: “This can be a dangerous game to play in this macroeconomic environment, as we have seen with some managers taking on additional debt on profitable parts of their portfolios to finance losses and satisfy exit demands from their LPs [limited partners].”
Despite all this apparent doom and gloom, property market experts have identified opportunities for borrowers. For example, renegotiating covenants can, to some extent, help bring down borrowing costs; but more importantly, it can give borrowers more time to get through what may seem like the worst part of the market cycle. Time to recover may be all that is required for some properties. But for others, there is little to be gained by waiting. This is a judgement lenders must make on each individual asset.
The depression of capital values brought about by the challenging economic environment has also created significant investment opportunities. Llewelyn says: “If you have capital and the capability to deploy it effectively, distress can allow you to capture mis-priced assets with strong fundamentals at notable discounts – this is something our new core-plus fund is looking to capitalise on.”
There is also a resounding hope that interest rates have peaked, with Charles Ferguson-Davie, chief investment officer of specialist real estate investment manager Moorfield Group, says that as pricing adjusts to higher interest rates, transactional activity should pick up. “We expect sectors that benefit from structural, long-term growth drivers and are less sensitive to GDP fluctuations, like residential-for-rent and storage, will benefit most from increased investor appetite,” he says. Llewelyn adds: “Inflation figures are coming down and it looks like interest rate increases may have peaked. This might create a more certain environment and give hope to investors that they can ride out 2024 into a more borrower-friendly 2025.”
However, the question for many going into 2024 is: when will interest rates return to normal? Jackie Bowie, managing partner and head of EMEA at global financial risk manager Chatham Financial, highlights that different people in the market will have different definitions of ‘normal’, depending on when they began operating.
Federated Hermes’ Nobel adds: “Loan performance can be heavily impacted by the interest rate or yield environment at maturity. For our strategy to be truly defensive, our performance cannot be dependent on wishful thinking around exit assumptions.
“However, not falling victim to wishful thinking typically means the diligent application of analysis of the past. That assumes that past market conditions give some insight in what is a ‘normal’ market, and that can, of course, never be guaranteed.”
Information taken from Property Week.