After years of a strong real estate finance market, the sector faces an immediate retrenchment triggered by Covid-19. The pandemic presents the first real test of banking relationships in more than a decade.
The real estate finance market is at the centre of an entirely unprecedented threat and market disruption. Debt markets are too volatile to know how pricing and structures will be affected, but people are displaced and the market has instantly lost its efficiency.
When this kind of disruption occurs, banks immediately focus on existing clients, reassess the risk across their portfolios and hit pause on any deals that are not financially contracted.
Where borrowers are at the advanced negotiations stage and banks are willing to continue, there is likely to be a discussion on pricing, the initial loan-to-value and financial covenants.
For existing loans in certain sectors, financial covenant breaches are likely. How banks respond will be critical. Some degree of forbearance and access to liquidity will be paramount to ensure clients are supported given the circumstances we find ourselves in.
The first covenant check will be a quarterly interest cover ratio test, which is likely to incorporate a forward-looking element. This will provide an early warning system for cashflow being generated from the asset as regards the loan performance.
A loan-to-value test, with updated valuations, may be sought, but this usually involves third-party reports and, without immediate market evidence, the valuations could be challenged and would undoubtedly come with caveats.
As a stress test – and to remove valuation subjectivity – a review of the debt yield may be carried out. This measures the income of the asset against the outstanding debt and will enable funders to determine where investment yields would need to shift before a loan impairment is likely.
Transparency and pragmatism from borrowers will be the initial litmus test and is likely to frame the context of the relationship in the future, where support and forbearance will required.
What black swan events such as the Covid-19 pandemic highlight is a need for robust capital structures from the outset. Exit strategies and downside risk mitigation should always form an essential part of the underwriting and investment thesis. The downside scenario should never be ignored, even in a rising market.
Even the best-laid business strategies never go completely according to plan. The current market disruption will undoubtedly result in certain business plans being laid aside and contingency strategies being implemented.
If loan-to-value levels were to be reviewed by funders, equity injections might be required to support ongoing refinancing transactions. Unquestionably, cash-flow projections and the assumptions supporting these will be revisited.
Operating assets that have been immediately hit by the sudden downturn are likely to withstand a short-term decline, but will not be able to support a sustained scenario. This could have serious implications, as projects would have been underwritten and funded on the basis of strong occupancy, income levels and future growth.
Interest payment moratoriums may need to be considered to ensure cash reserves are protected. Whereas in the last crisis funders moved to lock down income streams to amortise debt, a similar approach now would have a disastrous effect on operating assets and the platforms managing them.
Notwithstanding, this market disruption will certainly test operating platforms running assets such as student accommodation, hotels and aparthotels that have yet to experience a downturn. Experience within these teams will be critical.
Flexible office providers are likely to come under pressure, with revenues expected to decline sharply as memberships are cancelled and corporates reassess their occupational strategies.
For the retail sector, which was already under pressure, this market disruption will exacerbate declining valuations and weak tenant covenants. With store closures, landlords will incur non-recoverable void costs and so a double negative impact on their net rental income. While it is too early to predict, we may see distressed sales occurring; an opportunity for some investors.
Most European bank lenders have remained conservative during the current market cycle. While loan-to-value ratios are at moderate levels, compared with pre-financial crisis underwriting, many loans have been underwritten against buoyant market conditions and assumptions.
For alternative lending platforms that entered the market after the financial crisis, this is the first real test for their portfolios, client relationships and the funding lines supporting their platforms. Unlike banks, alternative lenders are not constrained by the capital requirements of traditional banks, imposed by financial regulators, but liquidity is still vital. It will undoubtedly be a real test of their commitment to the market.
The Covid-19 disruption is likely to make banks reassess their risk appetite and growth plans and will bring the first real test in the relationship between borrowers and funders. This particularly applies with the nascent alternative investment assets – student accommodation and private rented sector – which have become an attractive funding prospect for banks and institutional investors.
In general, however, European banks are in good health compared to a decade ago. Taking my own bank, BNP Paribas, for example, the capital base compared with 2008 has grown 2.5 times, with a similar-sized balance sheet. So, its ability to absorb a temporary shock like this is stronger.
The Covid-19 outbreak is not a financial shock; it is social dislocation. If it is contained to one to two quarters, the bounce-back to banks and other financial institutions should be quite quick.
Anecdotally, there is evidence of companies fully drawing their revolving credit facilities to enhance their liquidity requirements in the coming months, while there has also been a surge in deposits.
The European Central Bank also seems willing to support the banks and lending to help reignite certain sectors after the Covid-19 disruption has passed.
Robert Murphy is a director at BNP Paribas Real Estate Ireland and a chartered accountant with extensive real estate and capital markets experience, including structuring and executing real estate transactions in Ireland and other European markets