COMMENT Given the UK’s macroeconomic environment – combined with the increase in underlying interest rates to their highest level in 14 years and the corresponding rise in the cost of commercial real estate debt – it would be easy to assume that the debt markets are closed. However, we are finding the reality somewhat different and, for the right transactions, markets remain open.
Early in 2022, the five-year Sterling Overnight Index Average swap rate was relatively stable at about 1%. This peaked at just above 5% after the government’s ‘mini budget’ at the end of September, although it has since tightened to approximately 3.75%. An improvement, but still elevated compared to what many had become used to paying in the last decade. In addition, there has been a slight uptick in the margins charged by some lenders.
Combined, these factors resulted in the cheapest liquidity disappearing from the market. While this has restricted the commercial real estate debt markets, particularly because cashflows do not support the quantum of debt they would have done previously, it has not closed them entirely.
For some debt funds and alternative lenders that previously needed to operate higher up the risk curve to generate their desired returns, the rise in underlying interest rates has enabled them to lend on lower risk opportunities, competing with the hesitant bank market and improving their risk-adjusted returns.
Beat the rush
As ever in a challenging market, there is increased focus on the quality of the sponsorship and the underlying assets, as lenders look to deploy capital on the best available projects.
Given low investment volumes, there is a scarcity of high-quality transactions, so those that do require financing can anticipate a warm welcome from a variety of potential lenders. There is no shortage of sponsors waiting to see if there will be an improvement in borrowing conditions in 2023 and with lower investment volumes it is anticipated that we will see more refinancing in H1.
With transaction volumes down and the markets relatively quiet, there could be an opportunity for sponsors to beat the rush and come to market early in the new year. With rising underlying rates, lenders are turning their attention to cash flow as the key determinant of debt structure.
Borrowers should expect enhanced due diligence leading to protracted processes, and for there to be more focus on interest cover ratios and debt yield as determining factors for the maximum leverage available. Potential lenders are also likely to put greater emphasis on hedging a greater proportion of the loan.
Hot money cools
Consequently, it is more important than ever that sponsors take the time to carefully prepare a transaction before going to market.
A detailed information memorandum with a defensible business plan backed with market insight and comparables as supporting evidence is essential. There is also value in running a fairly wide debt process, as the optimum lender for any given transaction is not necessarily the obvious candidate.
With such a diverse lender base in an ever-changing market, the hot money last week may not be from the same provider next week.
Charlie Bottomley is director at Savills Debt Advisory
