Many loans that were originated in a lower interest rate environment will need to be refinanced or restructured over the next two years. According to the Bayes Business School’s commercial real estate lending report, over £200 billion of UK commercial real estate loans were originated from 2018 to 2022, with nearly 40% of outstanding UK property loans due to mature in 2024 and 2025.
However, higher interest rates and declining real estate values in many sub-sectors of the market mean that when investors come to refinance or restructure a loan there is a risk that there will be a gap between the level of debt required, and the level of debt lenders are willing to offer.
Some loans will also have a requirement to obtain valuations periodically to test the LTV covenant. In the event an LTV covenant is breached, lenders may look to restructure ahead of maturity.
In addition to this, commercial real estate borrowers have to navigate other challenges such as structural changes in the office sector, sector-specific tenant demand issues, as well as Government legislation for more environmentally friendly assets.
Falling valuations impact LTV ratios
The higher interest rate environment has impacted investor and lender demand across the commercial property market, contributing to downwards pressure on valuations.
According to M&G’s Global Real Estate Outlook 2024, average real estate valuations have fallen by more than 20% in the UK since mid-2022. This trend is more pronounced in certain sectors, including offices, which have been negatively impacted by hybrid working, more stringent energy performance certificate (EPC) requirements and a flight to quality and prime locations as corporates look to entice people back to the office.
This has led to a growing pressure on LTV ratios. We are starting to see lenders flexing their muscles when it comes to enforcing their loan. For example, there have been high-profile enforcements over two Canary Wharf office buildings (20 Canada Square and 5 Churchill Place), as well as a luxury residential development (60 Curzon Street in Mayfair). As valuations remain under pressure, some borrowers will find their lenders are unwilling to extend the same level of finance they had previously. That may require raising more expensive equity, mezzanine or unitranche facilities, which is likely to reduce returns for owners.
Low transaction volumes and distressed sales place further pressure on valuations
The volume of UK commercial real estate transactions has also been very low. Data from both CoStar and Colliers suggests that transaction volumes for 2023 was approximately £40 billion – down a third from £60 billion in 2022 and the weakest year since 2012. Market activity is expected to remain weak in H1 2024, albeit recovering in the second part of the year, closely linked to market projections for a reduction in interest rates.
Within the office market, the downturn was even more pronounced with total investment for 2023 expected to be £9.6 billion, the lowest level for 20 years.
With few comparable transactions in the market, it can be difficult for investors to gauge an accurate valuation for their assets. There are concerns that the lack of transactional activity, combined with how fast conditions in the market have declined has led to a significant valuation lag which will only exacerbate refinancing risk.
With offices showing a greater level of stress, it is likely there will be an increase in defaults in this sub-sector together with a rise in the forced sale of assets, albeit not necessarily through formal insolvency procedures. This would contribute further downward pressure on asset prices and valuations. For example, on 6 February 2024 it was reported that 5 Churchill Place was sold by receivers at a 60% discount to its last sale price. This sale is expected to set a significant benchmark for valuing other buildings in Canary Wharf – of which, according to the report, there are at least two more that are likely to be sold.
Higher interest rate environment impacts interest coverage ratios
The long period of low interest rates prompted a move in the commercial real estate sector towards fixed rate borrowing. While economists believe that the Bank of England base rate has peaked at 5.25% and should come down towards the second half of 2024, the prevalence of fixed rate debt means that there is a lag between current interest rate changes and the impact on the sector.
Many borrowers who last raised debt or hedged in a low interest rate environment have therefore not yet felt the full effect of higher interest rates. When they do come to refinance, careful attention must be paid to cash flow, to ensure borrowers can remain compliant with interest cover covenants in their debt facilities and that with a higher proportion of rental income being spent on interest payments, the business is still sustainable.
Other sector challenges impact lender demand
Borrowers need to manage the impact of lower valuations and higher interest costs at the same time as dealing with other sector challenges.
For example, in the offices sector, the national vacancy rate throughout the UK stands at 7.5%, the highest in nine years. The rate of vacant office space is expected to continue to rise through to 2025, when it is expected to exceed 9%.
If the Government proceeds with previously proposed legislation, all commercial properties in England and Wales will need to achieve an EPC rating of A or B by April 2030. Currently, 85% of commercial properties in England and Wales are rated C or below and therefore are likely to need significant additional capex to achieve a rating of B[1]. The costs of upgrading to EPC level B may be unviable for properties in sub-prime locations where premium rents cannot be achieved.
This is contributing to the development of a two-tier office market. Well located, high quality offices in central locations that meet minimum environmental credentials and tally with the expectations of their tenants’ ESG strategies continue to be able to command premium rental rates, which will mitigate higher debt costs to some extent. Investor and lender demand for these assets is expected to remain robust.
However, the office market outside prime locations in major cities remains relatively weak, exacerbated by over-supply, changing work patterns, an uncertain political outlook and a challenging market for SMEs. Owners of these assets, especially where significant capex is required to bring them up to minimum environmental standards, may find it difficult to attract new financing.
Growth in alternative lenders
Borrowers may need to approach their existing lenders to renegotiate existing loan documentation. Options include extending the current debt facility or amending existing LTV or interest coverage ratios.
There are a wide variety of alternative lenders which have proliferated in the market since the Global Financial Crisis (GFC) to take advantage of opportunities where mainstream lenders are unwilling to lend. These lenders, including private debt funds, have greater risk appetites and more flexibility around interest coverage and LTV covenants. They can also act in transactions with greater levels of stress or distress, or where significant capex is required.
What can borrowers do?
Planning early for any refinancing or covenant testing will always maximise the chance of a successful outcome. Questions for borrowers to consider include:
- Do you know what your plan B is if your incumbent lender cannot provide terms that work for you when your facility matures?
- What is your forecast covenant compliance over the next two years? Have you stress tested this? What will forecast compliance look like if interest rates stay higher for longer?
- When is your next valuation due? Do you have any views on what this will look like? Could it result in an LTV breach? If so, what actions can you take to remedy the breach?
- If you think you might have a covenant breach, do you know how your lender will react?
- Do you have any material ESG-related capex requirements? Do you know how you will finance this?
Early communication with lenders, investors and stakeholders is key to maintaining support during pressure points. Despite the ongoing challenges, there remains a large amount of capital to deploy and continued appetite from investors and lenders in the commercial real estate sector. An experienced adviser will be able to help with the many nuances of the debt and restructuring markets.
To discuss these topics further, contact Oliver Haunch or Nick Wilson.
[1] Department for Levelling up, Housing & Communities data
