Commercial Insights - Real estate debt: the view from research
Will Matthews, Head of Commercial Research, speaks to Victoria Ormond, Partner in Knight Frank’s commercial research team.
9 minutes to read
The provision and management of debt is a fundamental component of developed real estate markets, and understanding its implications can offer valuable insights into future market trends.
Will Matthews (WM): Victoria, can you provide some background to the current lending environment? What did the market look like prior to the onset of COVID-19?
Victoria Ormond (VO): To answer that, first, we need to look back a bit further in history. Pre-global financial crisis (GFC), we had a predominately bank-led lending environment. However, banks were already starting to rethink their lending, catalysed in 2007 by new Basel regulatory capital rules which more closely aligned the amount of regulatory capital banks had to set aside with the riskiness of the loan.
During the GFC, commercial real estate bank loan performance declined and become more capital intensive. This, combined with the new regulatory
capital rules, meant that coming out of the GFC, banks generally lent less risky, lower loan-to-value (LTV) senior loans, creating space for new, non-bank lenders to enter the market. Nevertheless, this didn’t happen straight away, leading to a dearth of lending, particularly against development financing, in the early years post-GFC.
Bringing us up to before the pandemic, banks had broadly continued to focus on senior debt and some international banks were already indicating an intention to moderate their lending. Non-bank lenders, ranging from debt funds to insurance funds, were an increasing share of the real estate lending market, in part because they are not subject to the same regulatory capital rules as banks, albeit other rules may apply for some types of lenders, such as insurers.
Non-performing loans (NPLs) from the GFC and later Eurozone crisis had continued to be sold down and in Europe, NPLs were down to about 3.2% of bank's balance sheets. Specifically, within the UK, the banks were well capitalised. At the end of 2019, according to the Bank of England (BoE), bank's riskweighted assets (RWAs) had declined to just under £2.7 trillion, their lowest level since current records began in 2014. Total regulatory capital (Tier 1 & Tier 2), as a percentage of RWAs, was at its secondhighest level, at 21.3%. As a result, the lending environment prior to the onset of COVID-19 was in a relatively robust state – capitalised better than it was previously – and the banks were operating at a lower risk level than pre-GFC. Some non-bank lenders were lending at higher LTVs, but these were generally overall smaller sized loans than the banks were originating pre-GFC.
WM: How has this situation changed since the onset of the pandemic?
VO: In the first quarter of the year, bank RWAs increased by 8.8% on the previous quarter, to just over £3 trillion, the highest since Q1 2017. These are likely to 16 have increased further since then. Total capital reduced to 20.4% of bank RWAs, however, considering this ratio was 16.2% at the start of 2014, this is still robust. The Prudential Regulatory Authority (PRA) has also issued post-pandemic amendments to certain bank capital requirements, changing these from a percentage of these RWAs to an absolute amount. These RWAs and regulatory capital influence banks abilities to lend.
The BoE has also increased quantitative easing (QE) by £310 billion over the period of the pandemic. For context, £200 billion of QE was deployed in 2009. UK gilt yields have dropped significantly and the Bank of England (BoE) cut the base rate from 75 bps to 10bps over two successive cuts in March.
Bank's five-year credit default swaps (CDS) initially spiked to 2018 levels and beyond over March and April, although they are now towards more ‘normal’ levels. A spike in LIBOR largely offset the cuts in interest rates, applying upward pressure on funding costs. As a result, we saw some banks increasing loan margins on real estate debt and/or enhancing fees, particularly in those sectors most impacted by the resulting COVID-19 lockdown, such as retail and hotels.
At the onset of COVID-19, many bank and non-bank lenders around the world were focused on getting a sense of their potential risk exposure, rather than lending. In the UK, we remain somewhat in a period of stasis; quite early on into the pandemic, the PRA wrote to banks, essentially asking them to be lenient where loans are breaching covenants, or otherwise non-performing, where this is due to general market conditions, rather than specific issues related to the loan.
As time goes on and supportive measures by the government unwind, for example, the furlough scheme, the balance between loans triggering covenants due to general conditions and due to considerations specific to the loan is likely to change to the latter. This could prompt a shift away from banks simply waiving covenant breaches and could prompt asset sales. However, we may not see this in the real estate sphere until towards the end of this year, or even 2021 and beyond.
WM: What impact could COVID-19 have on banks and their capacity or inclination to lend?
VO: Banks are generally in a better position than during the GFC. There has been extensive fiscal, monetary and regulatory support, ranging from government underwritten loans to the temporary removal of Countercyclical Capital Buffers (CCB), which has the effect of increasing lending capacity for banks by more than ten times what was lent in 2019. The health of loans are likely to become impacted as borrower support unwinds, interest becomes due on COVID-19 related emergency loans and businesses face squeezed operating margins, for example, as restaurants and shops welcome lower density customer with higher costs.
"At the onset of COVID-19, many bank and non-bank lenders around the world were focused on getting a sense of their potential risk exposure, rather than lending."
This means that moving forwards, we’ll likely see more distress which is actually due to the individual corporate entity or property, rather than as general a condition. Previously, as these loans worsen in performance, increasing riskweighted assets (RWAs) banks need to set aside more regulatory capital, which will impede their ability to lend. However, the PRA’s changes to the relationship between RWAs and regulatory capital could mitigate this, which overlaid with the reductions in the CCB, could help support lending and bank health. It is too early to tell quite what the impact on banks will be, but it is likely to be a ‘slower burn’. I would expect to see an increase in non-performing loans over time and many banks have already announced significant provisions. However, again, the waters are muddied when it comes to comparing these provisions to other times in history, as the introduction of IFRS 9 impacts the required timing of when such provisions are made.
WM: What are the implications for non-bank lenders?
VO: For non-bank lenders, it’s even harder to say because it is a largely untested market. These lenders generally came into existence on the back of the last crisis, so we haven’t really been able to see what they look like through stressed conditions.
On the one hand, they’re not subject to the same regulatory capital rules (albeit some are subject to other rules), so are they are less impeded in terms of lending. On the other hand, as they are not subject to the same regulatory capital rules many debt funds have higher LTV exposures. Additionally, those debt funds, which had previously purchased NPLs from the traditional banks, may need to reassess their business plans in light of COVID-19, potentially impeding their performance.
However, we could see the entry of new non-bank lenders to the commercial real estate market over the coming 18-24 months, to fill both the lending gap, to the extent that banks and existing debt funds retrench, but also to hunt in the NPL market as these increase.
WM: What does this all mean for commercial real estate?
VO: Traditionally, commercial real estate assets are large, lumpy, heterogeneous and heavily reliant on debt, although more recently there has been an increase in equity-backed investment. Looking back to the GFC, when lending become squeezed, particularly development finance, it did create an issue for real estate. To the extent that riskier development finance is squeezed again, the current lack of supply in many markets could be exacerbated, which is likely to support pricing for those in-demand assets.
For commercial real estate investment, it’s probably going to be the more core, better-performing real estate which will be more attractive to lend against. In a retrenched lending market, this could actually create a split between the performance of core, well-located real estate, which is still attractive to lenders and the rest, which might struggle to source debt. Without means of financing, this could impact on demand for such assets.
It is likely we will see an increase in new debt funds coming to the market to provide leverage, however, to the extent that operating margins of borrowers are squeezed, regardless of rent adjustments, it could be harder to support the often wider margins that debt funds require to meet their own business plans.
We’ve seen a huge weight of demand for investment into property, so we could also see growth in demand from equitybacked investors, should sources of lending reduce.
Once we start to see lending distress, to the extent we see any, this may not appear in a significant way until 2021 or even beyond. We could see poorer performing real estate that struggles to be refinanced coming to market alongside better quality assets, increasing market supply and creating the additional impetus for transactional activity in the direct real estate markets, which we’re to an extent, missing at the moment.
Overall there are a lot of moving parts to think about. How much will a reduction in CCB be successful in offsetting the increase in bad loans to enable traditional bank lenders to continue lending? What will the fate be of existing debt funds and how quickly will we see new non-bank lenders enter the market? How will international lenders fare compared to domestic ones? To what extent will the move by central banks and regulators to incorporate climate change assessments into financial stability reporting or to target green bonds, change the type of real estate assets being financed?
These are just some of the many questions which for now remain unanswered. Nevertheless, in an uncertain environment with low yielding bonds and volatile equity markets, direct real estate continues to have a story for demand and lending against direct real estate will continue to be an alternative way to access exposure to this market, in a way which is lower down the capital stack than direct equity.
Will Matthews
Head of UK Commercial Research
Victoria Ormond
Partner, Capital Markets Research