Real estate, alternative real assets and other diversions

Underwriting to the downside… Why current debt market conditions are both a difficulty and an opportunity

The Fund Manager

US dollars on a wooden table

UK lending teams reconvening after the summer this autumn and scrutinizing unspent budgets will be looking warily with their credit committees at the challenge of successful deployment in Q4.

Most debt investors would acknowledge that there is simply not as much borrowing as appetite to lend in current market conditions. Limited requirement for secured loans against prime assets bought by overseas investors, and a highly liquid bond market for bigger borrowers, leaves senior lenders with reduced scope for business. Defending the book and harvesting further business from best relationships, at the expense of margin will probably be the story of 2017 for risk-averse banks and insurers, as it was last year.

Certainly, there are few signs that hunger to deploy is overruling risk appetite, and to that extent credit policy makers and risk controllers appear to have an effective handbrake on a peak market creep to poorer assets and looser covenanting to win market share.

Despite all the available liquidity in the debt market (bolstered behind the frontline by strong appetite from secondary investors such as pension funds and Asian banks), we often hear equity investors complain about the struggle to find lenders with latitude to structure loans supportively around an asset improvement plan.

Whilst clearers do still have budgets to fund development, it is limited to a small percentage of the book, and is largely directed at core clients, and de-risked assets, leaving ‘anything spec’ to hedge funds whose flexibility comes at a very high price. Therein lies both the difficulty, and opportunity created by current market conditions and the slightly blunt tool of regulation.

Debt market analysts have pointed to ‘tipping points’ where risk of default rose clearly with indiscriminate market correction during the GFC. Bank of America Merrill Lynch produced some excellent analysis of the drivers of CRE loan losses, highlighting cliffs equating broadly to LTV of 60%, ICRs of 2%x and debt yields at 10%, beyond which defaults rose markedly. Many lenders are now broadly regulated, or internally controlled around these sorts of assumptions.

LTV and default rates

ICR and default rates

Debt yield and default rates

However, two issues arise from this slightly blanket approach to risk control, which will play out through the next cycle and for which there is no real precedent. Firstly, a whole swathe of capital working broadly to the same parameters has created strong price pressure for loan assets fitting the criteria, and dearth of flexibility within those organisations. Absolute return for senior debt looks weak, and perhaps even weaker against underlying risk assumptions.

Which brings us on to standard covenants and their distortion by prime asset valuations and low interest rates. Can lenders really place value on the three ‘traditional’ criteria when underlying drivers don’t ring true to property fundamentals?

The Fund Manager

About Emma Huepfl

Emma Huepfl

Emma Huepfl is a Founder and Co-Principal of Laxfield Capital, an investment management business specialising in real estate debt. With more than 25 years’ experience in UK CRE debt markets, she has overseen more than £10bn of debt deals. In 2015 she founded Laxfield National, aiming to address imbalances in regional and mid-market funding. She is a board member of the Commercial Real Estate Finance Council of Europe and authors the bi-annual Laxfield CRE Debt Market Barometer, analysing changing finance demand from a pool of more than £110bn of loan requests.

Articles by Emma Huepfl

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