Gregor Bamert discusses the health of UK commercial real estate debt and the effect rising interest rates are having on the asset class.
Read this article to understand:
- The resilience of UK commercial real estate debt against a backdrop of rising rates
- Why a disconnect between property valuations and occupier demand can present attractive opportunities
- How the energy crisis is accelerating the drive towards sustainable buildings
Like all asset classes, the real estate debt market is having to adapt to the new economic regime of high inflation and rapidly rising interest rates. Following a banner year in 2021, when lending activity and transactions speedily rebounded from the shock of the pandemic, lenders and borrowers entered this year in an optimistic vein.
But with the global economy upended by Russia’s invasion of Ukraine, and with UK bond markets suffering dizzying gyrations in recent weeks due to political turmoil, what lies ahead for the sector?
Liquidity has been increasingly impacted in 2022, although financing remains available for high-quality assets. Lenders are insisting on lower loan-to-value levels, as debt service coverage ratios become a limiting factor given the increased cost of debt. And higher rates will create challenges for some borrowers when they need to refinance.
In this Q&A, Gregor Bamert, head of real estate debt at Aviva Investors, discusses the market outlook, how key lending metrics compare to previous crises, and why appetite for sustainability-linked financing continues to grow.
It has been an eventful year for all asset classes. How is the UK real estate debt market holding up?
It has been largely resilient. To some extent, you would expect this given debt is typically less volatile than equity. But there are also three positive developments worth noting.
First, there has been a focus in recent years on ensuring debt books can cope with major market dislocations, like the pandemic. We have seen comprehensive stress testing of loan portfolios and analysis to identify the pressure points. Most lenders were reasonably well-prepared going into this downturn and aware of where the challenges lay in their loan books. And while property values are under pressure because of rising interest rates, the occupier part of the picture remains strong. Therefore, the income position on many loans is solid.
Second, owners of real estate have become more proactive in their management of properties. We saw that during the pandemic, and it remains the case today. Owners are engaging with occupiers, not sitting back passively when tenants are experiencing problems meeting rental payments. As a lender, that is encouraging.
Finally, we are seeing the benefits of the drive towards sustainability, which has moved up to the top of the agenda. Owners are continuing to invest in and improve buildings to make them more sustainable and attractive to tenants. Besides the broader benefits this confers to society, it also helps underpin property values.
In summary, an environment of rising rates is a challenge, even if it was widely expected. And borrowers are going to have to adapt to higher rates when they come to refinance. But, overall, the asset class has held up well so far.
Which sectors or regions stand out, positively or negatively?
We are currently focused on situations where there is a disconnect between moves in property valuations and underlying occupier demand. We would cite four specific areas: industrials, secondary offices, residential and self-storage.
In industrials, which include warehouses and distribution centres, occupier demand continues to be robust. Rental rates are often running ahead of estimated rental values. However, from an investment perspective, valuations became rather frothy, even allowing for solid occupier interest, and have since rolled over. Therefore, our emphasis has become on finding attractive entry points in what remains a well-supported sector.
In the secondary office sector we are seeing soft occupier demand
In the secondary office sector – lower-quality offices or offices outside prime locations – we are seeing soft occupier demand. There has been a flight to quality, with tenants wanting high-quality offices in first-tier locations and landlords who are active and engaged in delivering the working environment that allows them to flourish. But valuations have not really fallen. Consequently, both the yield and rental parts of the picture are working against owners and lenders.
The residential sector – comprising areas such as the private rented sector and student accommodation – is performing extremely well. Rents are growing materially while valuations have remained intact.
Finally, we also see opportunities in the self-storage market. This is a niche sector that requires good locations and a strong operational management platform. We have seen this sector be resilient during previous downturns – including the pandemic – and expect it to perform relatively well.
Given the political and economic challenges, have you seen any evidence of a loss of confidence in UK commercial property by international investors?
UK assets and the UK economy have generally been viewed by international investors as stable and predictable, buttressed by a strong legal framework, respected public institutions and a sophisticated professional services sector. Combined with the favourable dynamics of the UK commercial property market, that has given our market a lasting appeal.
We have not seen international investors run for the hills due the political and economic situation. They will remain important players within the UK property market. However, the recent turbulence has had a reputational impact that will likely last a while.
How do leverage levels compare to those in economic downturns or market dislocations?
Debt levels are reasonable. They are meaningfully lower than they were entering the Global Financial Crisis (GFC), for example. Even the more leveraged, opportunistic lenders are probably sitting on loan books with loan-to-values of 60-65 per cent versus the 85-90 per cent levels that were par for the course heading into the GFC. Looking at the REITs sector, loan-to-value levels are currently around the 30-40 per cent mark, which is conservative from a historical standpoint.
In comparison to the GFC, the lending community is now much broader
There have also been some favourable structural changes. In comparison to the GFC, the lending community is now much broader, too. There is now a wide range of different lenders active in the market. As for banks, they are far less leveraged than they were going into the GFC.
This downturn will not be straightforward, but it is difficult to identify a transmission mechanism that will lead to systemic issues for lenders.
How has client appetite for real estate debt been affected by higher rates and recent volatility?
Broadly speaking, we have seen two different camps emerge. The first camp – our preferred one – recognises real estate debt can be a long-term source of relatively stable income with less volatility. Therefore, it can look particularly appealing during periods of broad market turbulence of the kind experienced in recent weeks in the UK. Indeed, we have recently received several enquiries from investors considering an allocation to the asset class.
The second camp is focused on near-term relative value and argues the recent fall in the illiquidity premium makes the asset class less attractive. The reality is the illiquidity premium tends to be volatile during periods of market stress; it can fall significantly but tends to bounce back quickly. As you would expect, given we typically have a three-year deployment target, we encourage investors to take a longer-term view of the asset class.
What impact is higher rates having on new loan origination?
We have seen lower transaction volumes across the market following recent interest-rate rises, because a major chunk of loan origination occurs when market participants are buying and selling properties.
With greater market uncertainty comes greater dispersion in views of where value lies
However, it also creates opportunities. With greater market uncertainty comes greater dispersion in views of where value lies or about which transactions to pursue. The corollary as a lender is if you have conviction towards a particular part of the market and can underwrite a loan, you may find less competition. From a lender’s perspective, this often leads to more rewarding pricing on deals.
What about borrower appetite for funding?
Right now, we are seeing borrowers pause activity. That is understandable given bond markets have seen such significant daily movements. But we think this will be short-lived. Once markets settle, activity levels should return.
Where we do anticipate challenges are for borrowers who have taken on relatively high levels of gearing by current market standards – 55 to 65 per cent – in the past two or three years. There will also be tougher times ahead for borrowers who have been relying upon short-term loan facilities. These will soon come up for refinancing. While we do not anticipate issues in terms of the availability of liquidity, lenders will reprice that liquidity materially higher and demand lower loan-to-values. Borrowers may well be forced to inject equity, make a recapitalisation trade, or sell assets when their loans fall due.
Lenders will reprice liquidity materially higher and demand lower loan-to-values
It is also worth making a comparison to the situation after the GFC, when commercial property values fell sharply but debt-servicing costs collapsed. Many borrowers were highly geared, with leverage levels at or above 100 per cent. But because interest rates were cut so aggressively, the cost of maintaining these loans was relatively low.
We now have the opposite case. Many owners have borrowed with relatively low loan-to-values, but their debt-servicing costs have exploded or are about to. This will become a challenge. Just 18 months ago, we wrote loans costing barely over two per cent. For many borrowers, their debt costs are going to rise to around six per cent. As a borrower, if you bought a prime property that was yielding three and a quarter per cent and you were 50 per cent leveraged, that was not a high-risk loan. But when your cost of debt is six per cent and you cannot afford to service the debt, it has become one.
We have a 2040 net-zero target for real assets. What impact is this having on our strategy in real estate debt?
Apart from recent weeks, sustainability has been the number one topic in almost every conversation we have had with borrowers and investors. On top of financing new sustainably designed buildings, one of our main priorities as a lender has been helping borrowers fund the adaptation of existing buildings to make them more sustainable.
Earlier this year, for example, we provided a £227 million sustainability-linked refinancing to London-based property group Romulus,1 on behalf of Aviva UK Life’s annuity business. The full value of the loan is subject to sustainability-linked KPIs, with more favourable borrowing rates available upon Romulus achieving measurable environmental improvements in the assets being lent against.
We expect to complete two other similar deals by the end of the year. If these deals proceed, we will have converted roughly £500 million of loan exposure to sustainability-linked metrics in 2022.
Has the current energy crisis had any impact on our sustainability-linked lending programme?
The energy crisis has undoubtedly accelerated the push for sustainable buildings. Landlords investing in renewable energy at their sites, adopting better building management practices and implementing energy conservation measures, such as putting in better insulation, have a competitive advantage.
The energy crisis has accelerated the push for sustainable buildings
Collectively, these actions can financially help tenants by bringing down service charges, but they also make their buildings a more responsible proposition in the eyes of tenants. They give the tenant credibility when their customers or employees ask how they are contributing to the sustainable economy.