Q&A: How leverage influences market resilience

William Matthews, Head of UK Commercial Research asks these questions and more to Victoria Ormond, CFA, Partner, Capital Markets Research.

William Matthews: What impact could Covid-19 have on bank lending to commercial real estate?

Victoria Ormond: The pandemic has dealt a significant shock to the leverage market, which is yet to feed through in a significant way to the commercial real estate sector. Banks’ equity prices broadly remain below where they were at the start of the year, even as other sectors such as tech have seen growth. For example, at the time of writing, the Nasdaq 100 Technology Sector Index was up by more than 25% since the start of the year, while the Nasdaq banking index languished one-third lower. Similarly, the European banking index is 36% lower.

However, banks are generally in a better position in terms of their balance sheets than during the GFC. Globally, there has been extensive fiscal, monetary and regulatory support, ranging from government underwritten loans to the temporary reduction or removal of Countercyclical Capital Buffers (CCB) across several countries. For example, in the UK and Germany, the CCB is now 0%.

This, in effect, increases banks’ lending capacity by circa ten times what was lent in 2019. Similarly, in Hong Kong, SAR, the CCB has been halved to 1%.¹ Therefore, while banks are already undertaking provisioning and seeing subdued equity performance, lending distress may not appear in a significant way until 2021 or beyond. Several regulatory authorities have also encouraged banks to waive lending covenant breaches where the breach is due to general market conditions.

However, in time, there will likely be more loans breaching covenants due to borrower circumstances. At this point, we may see more loan restructuring, enforcement, and asset sales. Loans against poorer performing real estate, which struggle to be refinanced, could provide the impetus for more direct property transactions over the coming 18 months or so.

¹https://www.bis.org/bcbs/ccyb/

WM: What are the implications for non-bank lenders?

VO: Many global non-bank lenders, such as debt funds, only came into existence following the GFC and the implementation of amended regulatory capital rules for banks. As a result, it is a largely untested market, under stressed conditions.

Because non-bank lenders are not subject to the same regulatory capital rules as banks, many debt funds have higher loan-to-value (LTV) and risk exposures, so are more endangered by the fallout from the pandemic and may need to manage down their risks. Additionally, those debt funds which had purchased non-performing loans (NPLs) from traditional banks may need to reassess their business plans in the light of Covid-19.

However, more positively, due to not being impeded by the same rules as bank lenders, we do expect that many debt funds could have greater opportunity to work with existing loans, but also to continue lending, albeit potentially more selectively than previously.

We also expect new non-bank lenders to enter the commercial real estate market over the coming 18-24 months to fill both the lending gap (as existing lenders retrench) and to target non-performing loans.

WM: What impact is sustainability having on access to commercial real estate financing?

VO: Real estate with effective sustainability credentials could also be a draw to successfully securing finance over the longer term. Many central banks are including climate change and carbon benchmarking into financial stability reporting, incentivising green real estate assets. The European Central Bank (ECB) has indicated that green bonds could become part of its €2.8 trillion asset purchase programme.

Green bonds are also in increasing circulation and despite the onset of Covid-19, $50 billion were issued globally in Q2 2020, the third highest quarter on record. Green bonds form part of a wider group of sustainable finance. Europe currently dominates overall sustainable financing, having issued 63% of the world’s sustainable loans and 46% of the world’s sustainable bonds over the year to date.

Within real estate specifically, despite the pandemic, green financing has continued in 2020. For example, in May Guocoland secured a green club loan for a new 30-storey mixed-use commercial and residential development in Singapore and in Ireland, property company IPUT, agreed a green facility as part of a wider revolving credit facility.

In June, Link REIT also secured a sustainability-linked loan, with the loan interest rate tied to ESG performance. This suggests that real estate with truly green credentials, could find it easier to access funding in the future.

WM: What are the implications of the changing debt landscape on commercial real estate lending?

VO: We expected a more squeezed lending environment and lenders will not consider all real estate equally. This could lead to a bifurcation in performance of direct real estate between assets which are more easily lent against versus those that are not.

We expect traditional lenders to target the most core, liquid, lower-risk assets to lend against, while debt funds consider the geographical resilience, as they lend to a wider type of assets and risk profiles. This could mean that prime assets in core areas of global safe-haven cities will be at an advantage for funding. We also expect assets in good locations with strong sustainability credentials to have more options when it comes to lending.

In the short-to-medium-term, a funding gap could arise while banks retrench and non-bank lenders assess their loan books. If equity investors step in, they will be choosy over the type and location of real estate.

Over the long-term, we expect significant growth of new alternative lenders, such as debt funds, as debt offers a way to gain exposure to real estate and generate income, but is lower down the capital stack than direct investment. New debt funds may also purchase NPLs, providing an opportunity for enhanced returns for investors with higher-risk appetites.