Rising yields and a frozen CMBS market are making life difficult for borrowers who must refinance loans this year. And even rental income may not provide solace
Refinancing loans secured against property in a rising market was, until recently, very easy to do. But with rising yields and shrinking available debt, refinancing is now a challenge. The flow of cheap and easy credit that fuelled the global property boom has evaporated. And with further price falls expected in the UK, selling assets or refinancing to meet loan repayments at maturity will only get tougher. Those investors that relied heavily on borrowed capital will face the biggest problems.
According to CB Richard Ellis’ UK Prime Rent and Yield Monitor, prime yields moved out across all sectors in the last quarter of 2007, from 5.1% in the third quarter to 5.7% in the fourth quarter. This reflects a sharp repricing of risk following the liquidity squeeze. However, yield shifts have been less explicit in continental Europe than in the UK, where the value of assets had become overpriced and the cost of debt unsustainable.
“In Europe, values have fallen for larger assets and secondary assets but we have not seen full evidence of the kind of fall in values that we had in the UK,” says Andrew Currie of rating agency Fitch’s structured finance team. “This is because Europe tends to lag behind the UK.”
This could have wider implications on the commercial mortgage-backed securities (CMBS) market, which many investors relied on as a source of liquidity before it became paralysed by the subprime crisis. Combined with a lack of available debt, falling prices could make problematic the refinancing of these loans, especially those backed by UK property.
Investors took advantage of rising values by indulging in the availability of cheap debt at the start of property’s bull run around five years ago. Typically, property is financed on five-year terms, so a number of these loans will mature this year and next. Borrowers with limited equity reserves are most vulnerable.
The highly geared Westport Land, a subsidiary of the Trehaven Group, has been put into administration after defaulting on a £95m (€127.7m) loan provided by Capmark Bank Europe in early 2006. The company fell in breach of its loan agreement after failing to sell a £100m portfolio last year. The assets are now for sale. However, the market is expecting a flurry of forced sales by highly leveraged investors who have seen the value of their investments fall.
Individual assets of high value are particularly vulnerable to refinancing problems because lenders are wary of large loan exposures that they cannot shift off their balance sheets. Short-term bridge facilities taken by investors who sought to flip their assets quickly have also been jeopardised by the credit shortage. However, this type of strategy is relatively uncommon, says Currie.
Fitch recently downgraded its rating on four CMBS loans against UK property. The transactions, worth £2.4bn (€3.2bn), were made in 2006 and early 2007, when values were at their highest. All four loans are due to mature before 2011.
“Although rental income from current tenants is stable, the concern is that property capital values may be insufficient to allow final principal repayments at loan maturity,” says Rodney Pelletier, a managing director at Fitch’s structured finance division. “Most CMBS transactions rely on the sale or refinancing of the charged assets – in most cases commercial property – for repayment of its debt. As values fall, the likelihood that a sale or refinancing will deliver sufficient funds to make such a principal payment reduces.”
Price falls could also create a shortfall between asset values and loan values. Thus, loan-to-value (LTV) ratios would shoot up and increase the likelihood of credit default. In the event that a borrower breaches its LTV covenant, a bank can take control of the loan and trap cash by forcing the investor to sell off its assets to raise equity. “This potential scenario could occur if a bank decided that it had to get out of its mortgage positions,” says Currie. As a result, fire sales would increase, and depress real estate values across the sector.
The risk of loan default could be mitigated by stable occupational markets. Rent can be used to repay debt, preventing a mortgage loan from defaulting. But the UK rental market looks far from certain, with JP Morgan forecasting 13,000 job cuts in London’s financial district in 2008 and a further 8,000 in 2009, resulting in a 10% fall in rental growth. The market may take comfort from the fact that a relatively small number of loans will refinance within the next two years and only a moderate amount will refinance in the next four years, according to Fitch. The loans at risk account for only 11% of those that it rated in 2006 and 2007.
