BUILDING RESILIENCE
HOW WILL REAL ESTATE DEBT MARKETS RESPOND TO COVID-19?
HOW LEVERAGE INFLUENCES MARKET RESILIENCE
Traditionally, commercial real estate is heavily reliant on debt. Therefore, it is critical for real estate investors to consider how the real estate debt market will respond in the near and longer term to Covid-19 and what it means for the resilience of the markets they are operating in. There will be a further polarisation between the funding opportunities for well-located, income-producing real estate and assets which do not share these qualities, the entry of new debt funds, an increased focus on the sustainable credentials of assets, and other innovative financing strategies. The loan market could also contribute to an increase in transactional activity in the direct real estate market over the coming 18-24 months as direct and indirect loan distress and refinancing challenges feed through.
“In time, there will likely be more loans breaching covenants, which could provide the impetus for more direct property transactions.”
Victoria Ormond, CFA, Partner, Capital Markets Research
Q&A
Knight Frank's Victoria Ormond, CFA and Lisa Attenborough discuss the outlook and impact of the lending market on direct real estate and outline three key changes. Head of Commercial Research, William Matthews, asks the questions.
Q
William Matthews
What impact could Covid-19 have on bank lending to commercial real estate?
Victoria Ormond, CFA, Partner, Capital Markets Research
A. The pandemic has dealt a significant shock to the leverage market, which is yet to feed through in a significant way to the commercial real estate sector. Banks’ equity prices broadly remain below where they were at the start of the year, even as other sectors such as tech have seen growth. For example, at the time of writing, the Nasdaq 100 Technology Sector Index was up by more than 25% since the start of the year, while the Nasdaq banking index languished one-third lower. Similarly, the European banking index is 36% lower. However, banks are generally in a better position in terms of their balance sheets than during the GFC. Globally, there has been extensive fiscal, monetary and regulatory support, ranging from government underwritten loans to the temporary reduction or removal of Countercyclical Capital Buffers (CCB) across several countries. For example, in the UK and Germany, the CCB is now 0%. This, in effect, increases banks’ lending capacity by circa ten times what was lent in 2019. Similarly, in Hong Kong, China, the CCB has been halved to 1%13. Therefore, while banks are already undertaking provisioning and seeing subdued equity performance, lending distress may not appear in a significant way until 2021 or beyond. Several regulatory authorities have also encouraged banks to waive lending covenant breaches where the breach is due to general market conditions. However, in time, there will likely be more loans breaching covenants due to borrower circumstances. At this point, we may see more loan restructuring, enforcement, and asset sales. Loans against poorer performing real estate, which struggle to be refinanced, could provide the impetus for more direct property transactions over the coming 18 months or so.
Q
WM
What are the implications for non-bank lenders?
VO
A. Many global non-bank lenders, such as debt funds, only came into existence following the GFC and the implementation of amended regulatory capital rules for banks. As a result, it is a largely untested market, under stressed conditions. Because non-bank lenders are not subject to the same regulatory capital rules as banks, many debt funds have higher loan-to-value (LTV) and risk exposures, so are more endangered by the fallout from the pandemic and may need to manage down their risks. Additionally, those debt funds which had purchased non-performing loans (NPLs) from traditional banks may need to reassess their business plans in the light of Covid-19. However, more positively, due to not being impeded by the same rules as bank lenders, we do expect that many debt funds could have greater opportunity to work with existing loans, but also to continue lending, albeit potentially more selectively than previously. We also expect new non-bank lenders to enter the commercial real estate market over the coming 18-24 months to fill both the lending gap (as existing lenders retrench) and to target non-performing loans
Q
WM
What impact is sustainability having on access to commercial real estate financing?
VO
A. Real estate with effective sustainability credentials could also be a draw to successfully securing finance over the longer term. Many central banks are including climate change and carbon benchmarking into financial stability reporting, incentivising green real estate assets. The European Central Bank (ECB) has indicated that green bonds could become part of its €2.8 trillion asset purchase programme. Green bonds are also in increasing circulation and despite the onset of Covid-19, $50 billion were issued globally in Q2 2020, the third highest quarter on record. Green bonds form part of a wider group of sustainable finance. Europe currently dominates overall sustainable financing, having issued 63% of the world’s sustainable loans and 46% of the world’s sustainable bonds over the year to date. Within real estate specifically, despite the pandemic, green financing has continued in 2020. For example, in May Guocoland secured a green club loan for a new 30-storey mixed-use commercial and residential development in Singapore and in Ireland, property company IPUT, agreed a green facility as part of a wider revolving credit facility. In June, Link REIT also secured a sustainability-linked loan, with the loan interest rate tied to ESG performance. This suggests that real estate with truly green credentials, could find it easier to access funding in the future.
Q
WM
What are the implications of the changing debt landscape on commercial real estate lending?
VO
A. We expected a more squeezed lending environment and lenders will not consider all real estate equally. This could lead to a bifurcation in performance of direct real estate between assets which are more easily lent against versus those that are not. We expect traditional lenders to target the most core, liquid, lower-risk assets to lend against, while debt funds consider the geographical resilience, as they lend to a wider type of assets and risk profiles. This could mean that prime assets in core areas of global safe-haven cities will be at an advantage for funding. We also expect assets in good locations with strong sustainability credentials to have more options when it comes to lending. In the short-to-medium-term, a funding gap could arise while banks retrench and non-bank lenders assess their loan books. If equity investors step in, they will be choosy over the type and location of real estate. Over the long-term, we expect significant growth of new alternative lenders, such as debt funds, as debt offers a way to gain exposure to real estate and generate income, but is lower down the capital stack than direct investment. New debt funds may also purchase NPLs, providing an opportunity for enhanced returns for investors with higher-risk appetites.
Q
William Matthews
How have you seen lender appetite impacted since the pandemic?
Lisa Attenborough, Head of Debt Advisory
A. In the UK, lenders paused on most, if not all, new lending opportunities to assess the risk on their loan books, although many have since begun to consider new lending opportunities, albeit rebasing pricing and leverage to reflect the higher risk environment. Clearing banks were initially focussed, and still are to a degree, on their existing client base. These banks crucially need to carefully manage their balance sheets and must consider their wider loan book exposures outside of commercial real estate, for example, to the retail sector at a corporate level. Debt funds which are financed by private capital and not constrained by the same Basel regulatory capital requirements do not have the same restrictions and considerations and as such, are busier than ever. The reactions of UK lenders have been echoed elsewhere around the world. For example, across Europe, retail banks initially reined in their financing on amortising loans to around 55% LTV or 50% on an interest-only basis. We have started to see higher LTVs achieved across Europe since lockdown began, however this has been for absolute prime deals in the most resilient sectors. In the US, federally backed Fannie Mae and Freddie Mac now account for upwards of 60% of borrowing, compared to below 40% in a ‘normal’ market. This is largely due to alternate lender groups pulling back and lending on a more selective basis. Large banks with greater exposure to sectors such as retail and hospitality are also now taking a cautious approach to balance sheet management and as such, to originating new loans.
Q
WM
Are there specific property types that lenders are more willing to lend against today? Has that changed in recent months?
LA
A. Logistics real estate and residential investment opportunities are underpinned by solid underlying demand, so continue to attract lender interest. Student accommodation, on the other hand, saw lenders initially pull back, but this may well change, particularly if we see increased demand due to gap year students cancelling their plans due to restrictions on travel. Some traditional office space lenders are unsure about investing, but the full effect is yet to be seen.
Q
WM
How has pricing been impacted? How much is additional risk a premium applied by lenders, and how much is it a function of market interest rates?
LA
A. Broadly speaking, lenders are following varying pricing strategies: Insurance lenders: Insurance lenders are pricing on relative value, with corporate bond spreads initially spiking upon the announcement of lockdown. As a result, insurers increased their real estate debt pricing. Corporate bond spreads have now returned to more ‘normal’ levels, so debt pricing has come down (but not to pre-Covid-19 levels). Investment banks: Several investment banks have introduced pricing floors. Loan syndication (the process by which investment banks distribute and manage their exposure) slowed significantly during Q2 this year. This led to congestion in the market and investment banks are managing their balance sheet cautiously. Debt funds: Debt funds target returns remain the same, but leverage has reduced, therefore achieving the same level of return for lower risk transactions. More generally, we have seen lenders apply a country-risk premium for those countries which may be worst impacted by the pandemic. German real estate lenders appear to have bounced back the quickest. Margins tightened at the height of the pandemic, but we have since seen them soften with competitive terms still available for low risk or long-income core assets.
Q
WM
What about future appetite for lending? How do you expect the pool of lenders to evolve over the next year?
LA
A. Much depends on what happens with the expected second wave of Covid-19 and the shape of the economic recovery, and how both of those impact the amount of bad debt banks will have to deal with. We are already hearing of clearing banks provisioning for losses which will impact future lending appetite. In the UK, Barclays has set aside a higher than expected £1.6 billion to cover a possible rise in loan losses in the second quarter and Lloyds has announced recently an impairment charge of £2.4 billion for the three months to June 30 – a significant increase from the £1.4 billion in the first three months of the year. In Europe, Banco Santander reported the highest provisions by a bank in continental Europe so far. The bank is holding back €1.6 billion for losses linked to the virus. This will impact the appetite for commercial real estate lending in the coming months and years.
Q
WM
Do you envisage a more competitive environment as debt funds raise more capital?
LA
Not immediately. One lender told us recently: “We have money to invest, but we’re in no hurry to invest it.” For the short-term, there will be a flight to quality both in terms of deals and sponsors who are being backed. That said, we have seen several new debt funds being set up, which eventually will drive competition, but I do not expect that will result in more competitive terms until the economy begins to recover.
