COMMENT Although LTV ratios for new senior loans declined in the first quarter, the total cost of debt for prime real estate has stabilised and there remains liquidity for lending across all real estate sectors, but especially for the living, logistics and life sciences asset classes.
LTV ratios for new senior loans are notably lower than they were 12 months ago, which reflects the much-changed conditions in both financial and real estate markets, and a higher interest rate environment has brought the ability of rent to cover interest payments more into focus.
While interest rates and real estate yields have increased in recent months, the increases in interest rates have been quicker and steeper.
Therefore, senior lenders have reduced the LTV ratios they are prepared to apply, mindful of maintaining interest cover on new loans at an acceptable level. This trend has been seen across most European markets and all real estate sectors.
Mind the funding gap
For a number of borrowers looking to refinance, the combination of recent falls in asset values and reduced LTV ratios has created a funding gap. It has been difficult to replace the amount previously borrowed with like-for-like debt.
Borrowers in this situation have been faced with injecting more equity or obtaining subordinate debt to cover any shortfall, but existing lenders have been working with borrowers to find solutions.
Good offers are being made at loan maturity, as well as the use of trapped cash from the existing loan to reduce the LTV required at extension or provide interest reserves, which can improve the terms on which a new loan is offered.
Another notable trend has been the substantial rise in interest rates, and therefore debt costs, over the past 12 months. Central banks have increased policy rates to combat high levels of inflation, and this has had a knock-on effect for both short-term and long-term interest rates.
Reassessed margins
While short-term interest rates have continued to rise, long-term rates moderated during Q1. As a result, our estimates of the total cost of debt for prime real estate (which use the five-year swap rate relevant to each country as a reference rate) were slightly lower for Q1 2023 than for Q4 2022.
Despite this, the total cost of debt for senior lending has increased by 200-300 basis points year-on-year.
We have also seen lenders reassess margins in the light of increased uncertainty in the economic outlook and changing market conditions. The average margin for senior loans on prime property assets has increased by 20-30 basis points in all sectors since last March, though with some variations across locations.
However, relativities in margins between the main property types have remained stable. Prime multi-family residential assets are still seeing the lowest margins, while margins remain highest for the retail sector.
SVB aftermath
Although we have seen comparisons made with the previous real estate downturn that followed the financial crisis in 2007-08, the situation today is different in several respects. Levels of leverage were not as high prior to the current market downturn, and many borrowers continue to retain some equity in their investments.
Moreover, the monetary policy environment is different owing to high inflation, which has led central banks to increase interest rates despite fears of recession. As a result, new loans will be more expensive than they have been for several years.
The aftermath of the financial crisis also saw greatly reduced liquidity in debt markets, but this will not be the case this time around, especially in Europe.
It is true that liquidity in debt markets and the wider real estate market has been hit by the economic slowdown, not helped by recent volatility in financial markets after the failure of Silicon Valley Bank.
However, banks are better capitalised than they were 15 years ago and the range of non-bank lenders has increased markedly. This provides borrowers with many more options than in the past.
In the UK and continental Europe, debt funds have become active lenders across all sectors, while insurance companies are also originating more loans.
We are seeing most liquidity in the living sectors, but there is also liquidity for lending on logistics and life sciences assets. Hotels and other operational assets rank behind this, while office and retail are attracting less interest at present.
Nonetheless, we continue to be able to price loans on attractive terms across all sectors, while existing lenders remain supportive at loan maturity for most asset types, albeit at lower LTVs and higher margins.
Chris Gow is head of debt and structured finance, UK and Ireland, at CBRE
