Q&A: How is the pandemic changing the real estate debt markets?

William Matthews, Head of UK Commercial Research interviews Lisa Attenborough, Partner, Capital Advisory, to find out.

William Matthews: How have you seen lender appetite impacted since the pandemic?

Lisa Attenborough: In the UK, lenders paused on most, if not all, new lending opportunities to assess the risk on their loan books, although many have since begun to consider new lending opportunities, albeit rebasing pricing and leverage to reflect the higher risk environment.

Clearing banks were initially focussed, and still are to a degree, on their existing client base. These banks crucially need to carefully manage their balance sheets and must consider their wider loan book exposures outside of commercial real estate, for example, to the retail sector at a corporate level.

Debt funds which are financed by private capital and not constrained by the same Basel regulatory capital requirements do not have the same restrictions and considerations and as such, are busier than ever.

The reactions of UK lenders have been echoed elsewhere around the world. For example, across Europe, retail banks initially reined in their financing on amortising loans to around 55% LTV or 50% on an interest-only basis. We have started to see higher LTVs achieved across Europe since lockdown began, however, this has been for absolute prime deals in the most resilient sectors.

In the US, federally backed Fannie Mae and Freddie Mac now account for upwards of 60% of borrowing, compared to below 40% in a ‘normal’ market. This is largely due to alternate lender groups pulling back and lending on a more selective basis. Large banks with greater exposure to sectors such as retail and hospitality are also now taking a cautious approach to balance sheet management and as such, to originating new loans.

WM: Are there specific property types that lenders are more willing to lend against today? Has that changed in recent months?

LA: Logistics real estate and residential investment opportunities are underpinned by solid underlying demand, so continue to attract lender interest.

Student accommodation, on the other hand, saw lenders initially pull back, but this may well change, particularly if we see increased demand due to gap year students cancelling their plans due to restrictions on travel. Some traditional office space lenders are unsure about investing, but the full effect is yet to be seen.

WM: How has pricing been impacted? How much is additional risk a premium applied by lenders, and how much is it a function of market interest rates?

LA: Broadly speaking, lenders are following varying pricing strategies:

Insurance lenders: Insurance lenders are pricing on relative value, with corporate bond spreads initially spiking upon the announcement of lockdown. As a result, insurers increased their real estate debt pricing. Corporate bond spreads have now returned to more ‘normal’ levels, so debt pricing has come down (but not to pre-Covid-19 levels).

Investment banks: Several investment banks have introduced pricing floors. Loan syndication (the process by which investment banks distribute and manage their exposure) slowed significantly during Q2 this year. This led to congestion in the market and investment banks are managing their balance sheet cautiously.

Debt funds: Debt funds target returns remain the same, but leverage has reduced, therefore achieving the same level of return for lower risk transactions. More generally, we have seen lenders apply a country-risk premium for those countries which may be worst impacted by the pandemic.

German real estate lenders appear to have bounced back the quickest. Margins tightened at the height of the pandemic, but we have since seen them soften with competitive terms still available for low risk or long-income core assets.

WM: What about future appetite for lending? How do you expect the pool of lenders to evolve over the next year?

LA: Much depends on what happens with the expected second wave of Covid-19 and the shape of the economic recovery, and how both of those impact the amount of bad debt banks will have to deal with.

We are already hearing of clearing banks provisioning for losses which will impact future lending appetite. In the UK, Barclays has set aside a higher than expected £1.6 billion to cover a possible rise in loan losses in the second quarter and Lloyds has announced recently an impairment charge of £2.4 billion for the three months to June 30 – a significant increase from the £1.4 billion in the first three months of the year.

In Europe, Banco Santander reported the highest provisions by a bank in continental Europe so far. The bank is holding back €1.6 billion for losses linked to the virus. This will impact the appetite for commercial real estate lending in the coming months and years.

WM: Do you envisage a more competitive environment as debt funds raise more capital?

LA: Not immediately. One lender told us recently: “We have money to invest, but we’re in no hurry to invest it.” For the short-term, there will be a flight to quality both in terms of deals and sponsors who are being backed.

That said, we have seen several new debt funds being set up, which eventually will drive competition, but I do not expect that will result in more competitive terms until the economy begins to recover.