The higher rates regime is testing borrowers everywhere. Gregor Bamert considers the implications for real estate debt.

Read this article to understand:

  • Changing appetite for commercial lending
  • How facing refinancing challenges early can smooth the process
  • How the focus on sustainability is changing lending conversations

Commercial real estate debt activity has slowed as decision makers grapple with the higher inflation, higher rates world. Many borrowers are playing a waiting game, reluctant to overextend themselves in the hope the rate-hiking cycle will end soon. On the other side, lenders are equally cautious, paying closer attention to leverage, debt service levels and the purpose and nature of financing.

So, how should we assess the current picture and the prospects further ahead, with a sizable wall of loans due to be refinanced in the next couple of years? Is the recent slowing of activity temporary or more lasting? Do lenders still have appetite for larger transactions?

To get answers to these questions and more, we spoke to Gregor Bamert, head of real estate debt at Aviva Investors.

How would you assess the first half of the year?  

We started with very little activity and heightened concerns over macro factors, particularly high interest rates. But towards the end of the first quarter, borrowers realised the higher rate environment was something they had to get used to, and the notion of postponing financing decisions until rates were lower was not going to work. So, we started to see an uptick in activity for refinancing and funding for potential acquisitions, albeit significantly below levels you would see in a “normal” year.

Things have become more challenging again recently, with gilts at or slightly above the levels we saw immediately after the “mini budget” in September 2022. That puts extra strain on debt serviceability.

Is liquidity under strain?

There are more pressures in the UK, while the situation in Europe is more nuanced than headlines might suggest. Higher rates have put pressure on real estate values and most lenders are incrementally more cautious.

We are not seeing many instances where lenders are saying: “I’m closed to new business

We are not, however, seeing many instances where lenders are saying: “I'm closed to new business.” It is more typical to see borrowing terms being adjusted and leverage being reduced. With higher rates, funding costs are up and there is perhaps less appetite for big ticket transactions. Rather than doing a transaction on their own, some lenders are seeking to partner with others.

Overall transaction volumes are down, because one of the big drivers of lending volume in a normal year is to allow assets to be bought and sold. When that is not happening, that trigger is simply not there.

In a recent article, Darryl Murphy mentioned banks are having more conversations with institutional investors about club deal structures in infrastructure. Could we see the same in real estate?1

Real estate may be at an earlier stage of that journey. Institutional lenders and banks are active, but it is rare to see both taking part in the same transaction. In infrastructure, banks typically have capacity to do longer-tenor transactions, but that is rarely the case for real estate. Typically, banks do not have appetite for seven to ten years or longer.

We believe there is an opportunity for institutional lenders and banks to work together potentially on a multi-tranche or parallel facility basis. This would provide borrowers with access to both long-term and shorter-term financing and help deal with any capacity constraints.

You mentioned less appetite for leverage; what steps are you taking to manage risk?

One of the key actions during the pandemic was to have open dialogue with borrowers, trying to understand specific impacts to their businesses, what was working, how tenants were affected and the overall effect on portfolios.

We need to be proactive in talking to borrowers about where the pain points are

Now we have a more challenging macro environment. If we are looking at an upcoming refinancing, we need to be proactive in talking to borrowers about where the pain points are, where we need to address issues and then we can work together on a plan. That is critical.

We need to anticipate what scenarios will unfold in 12-months’ or even two years’ time. What is the environment likely to be like when refinancing takes place? Are there steps we can take now to ensure it goes well? That is an important focus.

On a sector basis, where do you expect sufficient rental growth to offset interest rate pressures?  

There are varying levels of confidence in different sectors. Some have seen significant repricing in terms of values. Industrials is an obvious example, but the underlying income performance and occupier demand in the right locations remains strong. The way to think about refinancing there, one year out, is very different to a sector facing longer-term structural challenges, like offices in second-tier locations.

Areas we have strong conviction in include parts of the living sector, such as build-to-rent and student accommodation. We also have strong conviction around life sciences. These are areas where there is solid underlying demand. The needs are structural, and that translates into greater tolerance on debt service costs.

There is talk about a funding gap over the next few years as borrowers hit a maturity wall. Where are the main vulnerabilities?

The most common vulnerability concerns interest service costs rather than loan-to-value (LTV) ratios. If somebody had borrowed money five years ago, they might have been looking at an LTV of around 55 to 60 per cent. Clearly values have come off since then, but in many instances, values went up in the interim before they fell back again. The net position may not be alarming.

The most common vulnerability concerns interest service costs

Probably the most concerning issue is that some borrowers may have accessed funding with three times debt service cover, but that could now be closer to one-to-two times. That becomes more challenging. Lenders might say: “I need a higher degree of debt serviceability than this now.” That's where you get the gap.

Ultimately, whether it is equity or senior or mezzanine financing, lenders want a return. You will probably be fine if you are in a sector with rental growth built in. It will be more difficult if you operate in an area where there is less appetite from lenders.

Lenders are negative around offices generally, so if you have a large refinancing, it is going to be challenging. We have seen the first situations in London where loans have come to maturity and have not been repaid. As a result, there have been enforcement proceedings from lenders. Clearly that is a situation where there has been a complete breakdown of communication and trust.

When that happens, enforcement is seen as the only option, rather than attempting to come up with a viable plan to move forward. It is difficult, of course, given the uncertainty about when interest rates are going to peak and what level they will normalise at.  

How do you make the case for long-term lending in this environment?

It needs to align with a property owner’s long-term strategy. If somebody has core assets they want to own for the long term, for ten, 15 or even 20 years, times like the present remind you of refinancing risks.  

Legal costs, valuation costs and transaction costs all add up

If refinancings are due when market conditions are tough, the issues become difficult to address. It helps to take a long-term view and avoid refinancing every few years, because refinancing involves costs. Legal costs, valuation costs and transaction costs all add up. Rather than taking those on every three to four years, doing it once over a 20-year period makes more sense.

The final point is about certainty. If somebody has a portfolio and knows the debt cost of holding assets for the next 20 years, it might allow them to participate in other shorter-term, higher-risk activities elsewhere, because some important financing elements are locked in. This approach is not for everyone but can work for some.

What appetite is there from borrowers and lenders for sustainable loans, given macro conditions and where we are in the cycle?

Higher rates have impacted appetite for borrowing of all sorts. In pounds, shillings and pence, the total volume has fallen but, as a proportion, we still expect sustainable lending to grow. There are discussions on how to structure sustainability features within most loans we are working on, and we anticipate well over half our lending this year to be sustainable. In the last two years, the proportion was just over 50 per cent.

Appetite is being driven by a combination of factors. Many lenders and market participants have net-zero goals; we are also seeing sustainability filtering through from the occupier side, not just in offices, but areas like logistics and retail. Their choices can help or hinder their story when reporting to stakeholders.

It has been exceptionally hot in the UK recently. Is there appetite from borrowers to make their buildings more resilient to a changing climate?

That’s a fascinating topic, but not as high on the agenda as it should be. The exception in the UK is flooding risk, which has been a focus for many years.

Borrowers and occupiers are thinking harder about measuring their carbon footprint and emissions

Where we are seeing interesting trends is borrowers and occupiers thinking harder about measuring their carbon footprint and emissions, particularly as many building management systems struggle with variable occupancy. Modern systems can be optimised for physical occupancy, but big swings in external temperatures, as well as the number of people using a building, tend to mean a lot of energy is being used to cool buildings and heat them at different times of the year.

That does not quite fall into the pure adaptation category, but it is something people are struggling to deal with. We need more sophisticated ways of measuring these impacts, because traditional metrics like EPC ratings do not capture them.  

Are you seeing demand around financing nature-positive real estate?

We have not had any direct requests, but we have had conversations with borrowers about how they might incorporate nature-positive aspects into their building management. That might include anything from creating green walls to using outside space more creatively and adding beehives for pollinators.

This is moving up the agenda; it’s like the point we reached discussing building efficiency about five years ago. Borrowers are aware natural capital is something they should be thinking about, but there are not the same clear linkages that exist in other areas, such as carbon management.

The issue is what the occupier is expecting and wants to achieve, how that could be reflected in the value of the real estate and then factored into the availability and cost of debt.

What do you need to make confident lending decisions given the challenging backdrop?

There are several contributing factors. By far the most important is who we are lending to. Who is the sponsor? What is its strategy and approach, not just in the short term but over the long term? Time and again this comes out as the key factor.

By far the most important factor is who we are lending to. Who is the sponsor?

Of course, there are additional considerations such as the type and quality of building, its location, the tenancy line up and approach to sustainability as well.

If the details in all those fields are right, we are comfortable writing large transactions. We would rather back borrowers with conviction and a large financing that meets all those criteria rather than doing many small transactions. We are fine with concentration in that context.

Key risks

Investment risk

The value of an investment and any income from it can go down as well as up. Where investments or loans are in other currencies or countries, values can fluctuate in response to changes in exchange rates. Investors may not get back the original amount invested.

Illiquidity risk

Certain assets held could, by nature, be hard to value or to sell at a desired time or at a price considered to be fair (especially in large quantities), and as a result their prices could be very volatile.

Complexity risk

Counterparties can be diverse, so successful investment requires appropriate credit analysis and the expertise to understand investment risks.

Related views

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