While real estate debt conditions continue to improve, supply and demand grows, and a mix of debt broadens, the risks are still ever present.

February 2014

The UK real-estate debt market recovery continues, with latest surveys pointing to further increases in supply and demand for credit. The overall amount of outstanding real estate debt has also declined further as bank deleveraging continues. But the pace of the decline is slowing and may soon end, while the diversity of debt providers has broadened.

Looking ahead, we expect credit conditions to ease further and this should help to propel the recovery of capital values across the UK. Risks remain, however, in relation to legacy debt issues and the possible impacts of rising interest rates as monetary policy tightens.

Deleveraging continues

According to December’s bi-annual De Montfort University (DMU) real estate lending survey, the total amount of outstanding debt secured against UK commercial real estate fell by £12 billion in the first half of 2013 to £256 billion. That was a slower pace of decline than a year earlier, as bank foreclosures fell and new lending rose. Nevertheless, UK banks appear to be taking a more realistic view of the market given the big increase in loans that were written-off.

Significant legacy debt issues remain

Despite the progress made so far, serious legacy debt problems remain. For example, the DMU survey said an estimated 21% of outstanding loans were either in default or in breach of their loan covenants. The total value of this ‘distressed’ debt was estimated at £39.6 billion. Encouragingly this is around 13% less than at the end of 2012, but it nevertheless confirms that many loans remain precariously placed.

Mix of debt providers is broadening

As UK banks reduce their exposure to real estate debt, partly due to tighter government regulations, the void is being partially filled by a mix of international banks and domestic non-bank lenders.

The past year has also seen a rise in the number of listed property companies successfully issuing debt via the markets. According to independent property consultancy PMA, Real Estate Investment Trusts raised around £1.7 billion this way in 2013.

Risk appetite improving

Lenders are becoming more confident. The amount of new lending (including refinancing and loan extensions) increased in the first half of 2013 by £18 billion, compared with a £15 billion increase over the same period in 2012.

Lenders’ risk appetite appears to have a risen with loan-to-value ratios rising. There’s a greater willingness to lend to developers, and for longer periods, and to provide mezzanine finance. Interest-rate margins, although high by historic standards, have also fallen rapidly.

Declining margins were recorded for lending against both ‘prime’ and ‘secondary’ assets. For example, the spread for loans secured by prime offices was reported to have fallen to 280 basis points (bp) by the middle of 2013 from 324 bp six months earlier. Loan-arrangement fees, and income-to-interest-cover ratios for new senior debt, were also reported have declined in the latest DMU survey. Anecdotal evidence suggests these trends continued in the second half of 2013.

Big rise in demand for real estate debt

More timely data supports this picture of easing conditions. For example, the Bank of England, in its December Credit Conditions Survey, reported a big increase in demand for commercial real estate debt over the last quarter of 2013. The same survey found the availability of credit had also improved.

We expect real estate debt conditions to ease further, but there are some risks for investors to consider. The prospect of an unexpectedly rapid rise in interest rates is one area of concern. This could reduce the availability of new finance and, with occupier markets still fragile, could negatively impact the ability of borrowers to service outstanding debt. Current market pricing, however, indicates only a gradual rise interest rates over the next few years.

Prospects for real estate debt remain appealing

Six years on from the global financial crisis UK real estate lending continues to recover. Although conditions remain far from normal, the latest surveys point to a further increase in the supply and demand for credit, while the amount of outstanding real-estate debt continues to decline.

The UK’s biggest lenders have pulled back in the face of tighter government regulations yet at the same time they are repairing their balance sheets. In the meantime, alternative debt providers, attracted by the prospect of attractive returns, have helped fill the void.

Looking ahead, we expect credit conditions to ease further, which will help propel the recovery of capital values across the UK. And although risks remain, we currently consider them to be weighted positively. Real estate debt should therefore remain attractive to investors in search of secure, long-term risk-adjusted returns.