Private debt funds deliver second weakest year of loan origination since before Brexit

The latest Commercial Real Estate Lending report for mid-year 2023 led by Dr Nicole Lux, Senior Research Fellow at Bayes Business School (formerly Cass) shows a 22% decline in new loan origination compared with 12 months ago, as steep interest rate rises and property value decline take their toll.

Key findings from the report, which covers data up to June 2023, include:

• Development lending totalled £2 billion and comprises 20% of new lending, the majority of which goes to residential development.
• The overall default rate has increased from 3% to 4% in the six months to June 2023. Many loans are still hedged, meaning that defaults are only gradually appearing on lenders' balance sheets.
• New loan Interest Coverage Ratio (ICR) levels remain stretched and vary by property type, ranging from 1.3x to 1.6x for a 50% Loan-to-Value (LTV) loan on prime properties. This leaves little room for additional debt.
• Day-one loan LTV levels have significantly decreased over the past five years, declining by 4-5 percentage points. The average LTV across property types now ranges between 50% and 55%.

With a significant portion of the £178 billion of loans outstanding needing to be refinanced in the next three years, as outlined in the report, there will also be increased stress moving forward.

Neil Odom-Haslett, President, Association of Property Lenders, said:

“Overall, the LTVs across all lenders is still at fairly conservative levels, noting that for new lending and refinancings, LTVs have reduced and margins have increased.”

The bi-annual report, notes the latest structural changes not only taking place in the real estate investment market, but also in the lending market.

Lenders are increasingly specialising in specific areas to position themselves as experts in their chosen segments. As a result, the practice of providing diversified loans across various property sectors and regions is being abandoned by most lenders. German Banks and Insurance Companies, for instance, typically offer loans exceeding £100 million for best-in-class prime assets. This is also confirmed by CBRE Capital Advisors.

Chris Gow, Head of Debt and Structured Finance, CBRE Capital Advisors Ltd, one of the key sponsors of the report, added:

“We continue to see liquidity for all asset classes and loan types, but with a clear bifurcation between ’the best of the best‘ and the rest. Comparatively lower levels of liquidity are evident for certain sectors such as office space, however very strong offers continue to be received for well-located and well-specified buildings.”

The report still finds good liquidity in deals larger than £200m. These deals are orchestrated by groups of predominantly International Investment Banks, but also private debt funds are gearing up to provide larger loan amounts. Among eight lenders in the market offering loans exceeding £200 million in June 2023, only four are traditional banks.

However, for the majority of lenders, especially in a challenging lending market, there has been a reduction in overall loan sizes with larger exposures (more than £80 million) being shared among a consortium of lenders to minimise individual risk. This approach has already been validated post the Global Financial Crisis in 2008/2009.

Nick Harris, Head of UK and Cross Border Valuations and Joint Head of Strategic Advisory EME Savills, a long-term sponsor of the report, said:

“Commercial property transactions have been limited thus far in 2023, making the deployment of new debt more challenging. In addition, lending transactions are taking longer to conclude as there is a greater focus on due diligence in a more cautious market. The current lending picture arguably presents a further opportunity for debt funds and alternative lenders who are increasingly able to lend on lower risk assets to meet their desired returns.”

Specialist debt funds are the primary source of development finance, contributing 42% of residential development finance, while private debt funds account for 41%. Furthermore, 61% of riskier and speculative finance for other property types is sourced from private debt funds. Overall, development lending constitutes 37% of their loan portfolio.

Peter Cosmetatos, Chief Executive of CREFC Europe, said:

“It remains to be seen whether the market will be as resilient to the consequences of geopolitical turmoil and higher interest rates as they were to Brexit and Covid, and who is best placed to finance the repurposing and decarbonisation that so much of the nation’s real estate needs.”

Despite continued development lending, lenders are less willing to provide capex loans for refurbishments often necessary for landlords to comply with new building standards. Lenders have expressed the expectation that capital expenditures should really be funded through equity rather than loans, given the risk profile.

Dr Lux said:

“Some asset values might have been near their fair value point, but lenders still have doubts about the right value as a base for lending and are therefore very conservative with their loan-to-value ratios.

“Looking ahead to the second half of the year, it is anticipated that further transactions and lending activities will occur. Some borrowers may no longer delay asset sales or loan restructuring, driving this expected increase in activity.”