Following the boom in the property market, which was fuelled by the banks’ enthusiasm to provide debt, lenders have been left nursing a hangover consisting of troubled loans. The years 2005-2007 saw around £232bn of new lending flood the UK commercial property market, so the scale of the potential crisis is daunting.
It is clear that most loan-to-value covenants of above 60% have been breached. Breaches in interest cover ratio (ICR – the ratio of rental income divided by interest costs) depends on an asset’s vacancy rate and its exposure to the ever-increasing list of insolvent businesses.
A bank will usually view an LTV default as a less urgent problem than an ICR default, where the interest on the loan may not be covered by the rental income. LTV defaults are still a major concern, however, both from a risk perspective in terms of loan recovery, and from a regulatory capital perspective (the amount of capital set aside by banks to cover potential losses), which can be particularly costly and onerous for balance sheets.
Consensual restructuring
Defaults cause bad publicity and expensive legal proceedings for all involved. But if the borrower is unwilling to co-operate with the lender and has little equity or expertise to offer as a solution, there is, unfortunately, no other option.
A consensual restructuring is, where possible, the best solution for everyone. A good starting point for this is a restoration within the original covenant. This would mean the use of fresh equity to amortise the loan, or the inclusion of new, unencumbered properties in the security pool.
Sometimes, however, the capital simply is not available, or borrowers are unwilling to commit cash. Failing a restoration, the borrower could be asked to provide additional commitment or changes to the terms/covenants/duration of the original facility, giving the property a chance to recover its value. This process also includes negotiations around increasing the price of the debt (restructuring fees payable now and a raised margin) to cover both the cost of the additional regulatory capital required and the increased risk incurred with higher-level LTVs.
A proportion of the fees may be paid when the restructured facility expires if the running income does not support an increase in the bank’s margin. In the case of a more severe breach, and where very little new equity is contributed, the bank may gain profit shares and “equity-type” returns.
Restructuring can be a time-consuming process and, therefore, larger banks have established teams dedicated to “working-out” non-performing loans. As a guide, the following points summarise what, in my experience, constitutes good borrower behaviour and the best methods for dealing with banks.
Good borrower behaviour
Dealing with the bank
Restructuring provides an opportunity to revisit loan terms and covenant structures, ensuring security and certainty of funding for the borrower. In my experience, if a borrower stands behind the investment, the bank is likely to be supportive.
Ahsan Ellahi is co-head of Eurohypo’s London office and leads its loan restructuring group.
