Overcoming underwriting obstacles in a pandemic and beyond

Along with every other asset class in 2020, the real estate debt market has not been immune from the economic fallout of the coronavirus, which has presented unforeseen obstacles to underwriting.

Apart from new lending, around £43 billion worth of loans are due to be refinanced in 2020 and 2021¹ in what can only be classified as an opaque economic environment. The measures taken to slow the spread of the virus have had a debilitating impact on economic activity in some areas, but others have been comparatively buoyant, making conditions as difficult to understand and predict as any we have seen.

Meanwhile, there is still considerable uncertainty around the way lockdown measures might be used to manage the spread of the virus and for how long. Questions are also being asked about how broader structural and societal changes, like the shift to e-commerce and appetite for homeworking, might impact real estate markets. Add Brexit into the mix, and you can appreciate why the range of forecasts is wide.

In the short term, the consensus is for GDP to contract around eight per cent in the UK and euro zone in 2020 before recovery next year. The more bearish have not ruled out a decline of 11 or even 12 per cent, even with targeted fiscal and monetary support.² Contractions of this scale will inevitably take a toll.

Looking through near-term challenges

Nevertheless, it is important to remember the current uncertainty will pass. From a lending perspective, we aim to take a more constructive view over the medium-to-long term. We expect to see a shift to a genuinely ‘new’ normal, where pharmaceutical intervention can be used to counter the spread of COVID-19 and a high degree of mobility will be possible again. Over the life of a loan that may stretch fifteen or even twenty years, this phase is likely to last longer and be more significant than the current one.

Secondly, we concentrate on gaining a granular view of the fundamentals, taking the downturns that inevitably occur across the business cycle into account.

In our experience, it makes sense to address the experience of the sponsor, as they are actively committed to the assets, and the robustness of their business plans before moving to loan term and structure. How sponsors have managed operational decisions and adapted to the pandemic are excellent indicators of the degree to which further lending might be appropriate.

Many sponsors have been working tirelessly and proactively with tenants to ensure their portfolios are well looked after during the downturn. They have provided help when required and been transparent about how their assets are performing. These are clearly sponsors worthy of support.

Our data allows us to calibrate a sponsor’s business plans, rent collection experience and lease re-gearing and/or restructuring activity against their peers. We have seen a strong overlap between better-managed operations and those prioritising environment, social and governance considerations in their investment and operational decisions. Being able to access this information is enormously valuable in our underwriting process.

Grounding underwriting decisions as change accelerates

Strong governance is paramount now, as the market environment has led many existing trends to accelerate. With the retail environment in flux, a transformation in the way companies think about the trade-offs between office-based and remote working and a greater focus on supply chain resilience, it is vital to ensure exposure is in the right locations and businesses. It is also important to be mindful of how fast conditions can change.

Underwriting decisions must be based on detailed analysis, with the specifics of each property ideally broken down to unit level. In an office property, for example, the detail extends to individual floors or even suites. Each unit is assigned a use class, a measure of quality and a tenant if it is let. We seek clarity on the nature of the tenants, their lease position and trading performance, as well as the corporate entities in the hierarchy and any guarantor arrangements in place.

Our data set is extensive, as we collect information and lend against more than 2,200 individual properties in the UK alone. By monitoring information closely, any change in usage or tenancy can be picked up at a granular level, and up-to-date credit and valuation views can be maintained. That makes it possible to quickly form a comprehensive view on risks and potential rewards if we are approached to lend against specific assets.

Altering stress scenarios to reflect COVID-19  

Modelling stress scenarios is an important part of the underwriting process, but it has been particularly difficult recently to define what appropriate stress cases might be. Some reframing has been needed, as the measures taken to check COVID-19 have led certain tenants to experience an unprecedented slump in income. Conversely, others have benefitted or been able to trade through largely unscathed.

We recognise that any immediate pressure points do not necessarily reflect a borrower’s longer-term prospects. Whether the outlook for a loan shows marked improvement or deterioration three months after funding is unlikely to be the ultimate driver of returns.

Balancing risk and reward   

Once we understand the context in the round, we can set out an appropriate loan term and structure. Clearly, this needs to reflect the differences between senior debt and equity, with protection for the senior lender from downside risk, coupled with potential for upside performance for equity holders.

Overall, loan-to-value ratios (LTVs) have tended to be more conservative than at the time of the global financial crisis, and lenders are mindful there may be further downside across a variety of asset classes. This is a factor we have on the radar, but we do not dwell on LTVs. Instead, we look closely at the quality and experience of the sponsors and the nature of proposed collateral to reassure ourselves. If we are uncomfortable with the risk, we will not participate at a lower LTV; we will not take part at all.    

While the environment is challenging, taking an appropriate perspective, focusing on the fundamentals and using the full depth of information available are making it possible for lenders and investors to be suitably confident in the opportunities they are pursuing in commercial real estate. To work effectively, trust is vital; well-grounded relationships make it more likely that information is shared, issues are flagged early and solutions to problems are found.