How can real estate businesses manage borrowing in tough times?

Businesses within the real estate sector have been under a lot of pressure in recent years, initially due to the Covid-19 pandemic, which reduced footfall in sectors such as hospitality, leisure and retail, and now due to ongoing challenging economic conditions.

To mitigate the risk to businesses during Covid-19, the government introduced measures including business rates holidays, access to government funds, and worker support schemes. However, with the current close-to-recessionary situation – and no government support schemes to help, I the sector now faces different, but no less pressing, challenges. Key among these is the interest rate situation, as rates continue to rise, affordability of borrowing is now a focus for most companies.

Despite the demanding economic environment, real estate companies still need to borrow. According to data gathered for our Real Estate 360 survey at the end of 2022, 47% of real estate companies believe that access to funding has become more difficult in the last 12 months – a significant increase from 33% the previous year. 46% are also expecting it to become more difficult in the next 12 months.

Over the last 12 months, do you feel that access to funding has been easier, more difficult or about the same, compared to the previous 12 months?

Banks still key lenders – but appetite reduced

Banks remain at the core of the market, albeit appetite has reduced. Banks typically provide the widest range of loans to companies large and small, with their pricing typically being the lowest in the market. However, what this means is that they tend to be more prudent – in short, pricing reflects risk appetite.

Within the banking category, though, we can divide banks into two categories: mainstream lenders with the lowest pricing and the most conservative lending requirements, and a wide range of ‘challenger’ banks. The property sector has attracted a good number of these, many of them offshoots of overseas lenders, as the sector benefits from a perception of being easy to understand and well-secured compared to industrial and commercial lending.

Private debt funds also compete with the banks in this area of the market and are excited by the opportunities perceived from the tightening of bank appetite. These funds typically specialise in providing loans at higher LTVs than banks will, but at a correspondingly higher price. For example, while banks might cap out at 65% LTV, a fund might push towards 80%, but would expect mid-teens returns. 

Lenders sticking to what and who they know

The debt markets are undoubtedly choppy at present, with base rates on the move and lenders facing the classic ‘greed vs fear’ quandary, as they must lend in order to make returns but have credit teams anxious to avoid issues in the portfolio in what is expected to be tough year.  In the past, we’ve seen a ‘flight to quality’ effect, with lenders aggressively chasing deals they perceive as good, while finding it harder to do more marginal deals – in the real estate sector we recognise this with lenders expressing a preference for areas they know, such as London and the South East, and being more sceptical of properties in areas perceived as less desirable or more risky.

With interest rates set to rise still further in the coming months, preferences could change. However, the living sectors have an inherent supply shortage, which underpins prices. Therefore, markets are likely to get worse before they get better.

Certain sectors, such as residential, student accommodation, care homes, and industrial properties, are also more attractive than other sectors such as casual dining, offices and retail, with our survey respondents predicting that these sectors would see the most growth in the next 12 months.

Banks are also filtering according to who they know – with many avoiding providing debt to new potential clients, focusing instead on their existing relationships. This presents opportunities for those banks and debt funds who are still open to lending in the market. 

Which two property sectors do you think will see most investment growth over the next 12 months?

Source: RSM UK Real Estate 360 Survey

Debt service is the ‘master’ parameter

Essentially, debt serviceability is the new LTV. As base rates have increased, lenders are considerably more focused on debt service and this should now be seen as the ‘master’ parameter, from which LTVs are then derived. When assessing the serviceability of debt, lender focus is on net interest cover post costs. This tends to even out the field between properties on low yields but with low landlord costs (such as supermarkets) and those that are higher yielding, with higher costs (such as residential portfolios). Required cover varies according to the type of portfolio and the market position of the lender. A challenger lender or debt fund might go as low as 1.3x, whereas a high street lender might insist on 2.0x.  Depending on yield and rates, this is tending to lead to lower LTVs, in some cases below 50%, albeit the higher levels can still be attainable based on the lower cover requirements.

Experience is key in the market, with lenders keener on clients with a proven track record, who have ideally seen higher interest rate environments in the past. It is also important for clients to hold EPC credentials as lenders are understandably reluctant to fund clients with a portfolio of potentially uncompliant properties ready to trip them up down the line. 

Review your options widely

In conclusion, we’d always advise real estate borrowers to review their options widely. The review should incorporate an assessment of which type (or combination of types) of borrowing is the most suitable for them, and which lenders are best placed to provide that. This can be summarised as ‘go smarter, go wider’. 

• Go smarter: Work hard with your advisers on the presentation of the credit, in particular the mitigation of the downside risks, to present yourself as being in the ‘quality’ category.
• Go wider: Approach a wide number of lenders across the different categories – predicting which lender will ’click’ with you and be the most interested is becoming increasingly difficult, so it’s important to have access to the full field.

If you are interested in discussing your borrowing options in more detail, contact Greg Moreton or Ashley Suter.