Restructuring Experts Say The UK's Distressed Property Problem Can't Be Postponed Much Longer
The logic is impeccable: Distress ought to be hurtling toward commercial real estate like an angry summer storm. Squeezed between the suddenly escalating costs of refinancing and their suddenly falling portfolio valuations, plenty of individual buildings and many landlords must be heading for trouble.
A tidal wave of distressed property loans ought to be about to crash. And yet the storm has not come, and distress is relatively scarce.
But the advisers to lenders from the restructuring and insolvency worlds, those people who try to avoid financial cataclysm when loans become distressed, and take over when it can't be avoided, have a message. Lenders are beginning to deal with problems. The storm is about to hit.
“Every lender you speak to says, 'Yes, we expect stress in the market, but our books are clean.' The trouble is I remember this being said in 2008-2010 right up until the point when it was clear they weren't,” said Fraser Greenshields, EY partner and corporate finance leader.
Findings from the latest Bayes UK Commercial Real Estate Lending report show that something is starting to stir, but by no means is it a tsunami of trouble. Around 42% of lenders have reported breaches and 47% have reported defaults across their loan book. In total, the average amount of loans in defaults reported was 3.5%, showing an increase since 2021 when it was 2.9%.
Bayes said that by the end of 2022, defaulted loans reached £2.7B and loans in breach were £4.7B. The risk metrics varied across lender types: For lenders of all origins, 25% of outstanding loans of loan books by value are at 60% loan-to-value or higher. However, lenders with overall smaller loan book capacities have 59% of their loans above 60% LTV, while at the same time showing overall a higher risk profile, with more junior loans and fewer prime London assets.
Distress has been slightly delayed, but not averted, Greenshields said, with this process having multiple possible causes in different circumstances.
First, either lenders or borrowers or both are kidding themselves about valuations, income streams and the interest rate/inflation outlook, and hoping they can sit it out. “I agree there's some kidding going on, but that is getting more difficult to sustain when you look at interest rate outlooks,” Greenshields said.
A more realistic kind of kidding might be going on during conversations about loan-to-value ratios. “You could choose to ignore a technical LTV breach if the borrower is still servicing the loan," he said. "And if the lender thinks values are uncertain in any case, maybe doing nothing is not the wrong thing to do. But if the borrower isn't paying, and there isn't enough cash in the structure, then the kidding stops.”
The second possibility is that the distress is already causing pain, but the pain and the distress are both largely out of sight. Only when lenders and borrowers have canvassed other options, including borrowers sacrificing equity to restore LTVs, will the public signs of many fraught but so-far private conversations be seen. Those conversations will end pretty soon because it is in lenders' interests to get moving.
“When interest doesn't get paid there's nowhere to hide," Greenshields said. "Buildings that looked good four years ago now look decidedly tricky when existing tenants lease expires. So there's argument for lenders to get the asset on the market now because the situation its only going to get worse; more will hit the market and at least if you act now potential buyers will look at the asset and you'll get a price, even if you don't like the price. In a short while, when six similar buildings are on the market, buyers may not even look at yours.”
Greenshields is not expecting a huge crash, but he is expecting a serious price correction.
“For now, though, there is definitely equity-curing going on, and supportive lenders kicking the can down the road. That period is beginning to come to an end.”
Distress In Secret
The theory that distress is alive and well, but discretely hidden, is a popular one.
“In all honesty the real estate market does a good job keeping things ‘out of sight’," FTI Consulting Restructuring Practice Senior Managing Director Ali Khaki said. "That said, after we were recently linked to a potential distressed opportunity in the market we probably received a dozen or so inbounds from potential parties, interested in either the debt or the asset."
It could well be that lenders are exiting discretely by selling their debt to third parties that may have a different risk appetite, he said. The current UK lending market is full of different types of lenders — banks, funds, insurers — each of whom have a different risk appetite and who take a different approach to distress and resolving it, some proactive, others much more reactive, perhaps hoping that any issues will be resolved by the borrower or the markets before they have to play hard ball.
"These lenders also have different regulators whose requirements may help to support these different strategies and the differing approaches taken by lenders helps to keep some distress out of sight,” Khaki said.
What's mostly happening out of sight, he said, is amend and extend arrangements in which funding gets rolled over while lender and borrower wait for stability, with reassessment due in 12-18 months. Presuming, of course, the borrower can still make regular debt payments.
“With stubbornly high inflation in the UK such that interest rate expectations continue to move, it is challenging to make a fully informed decision,” he said. “A recovery in the market is likely to take longer than we all anticipated at the start of the year, leading to some challenging decisions in the upcoming months."
Distress For Mezzanine Lenders?
The distress crisis is going to play out on a matrix that is more about who does the lending than who does the borrowing, some in the restructuring field said. The Bayes data pointed to different degrees of risk facing different lenders. There is another version of this theory that points to mezzanine finance.
“We've seen a gradual increase in appointments [property receiverships] across the board but sometimes when you delve into reason for appointment it was an issue between senior and mezzanine lenders," CBRE Senior Director for Loan Services Tim Perkins said. "Because for mezzanine lenders the value might break [at a point where they don't decide on the fate of the asset], and the senior lender might take control. Nuance is required, because where mezzanine finance is involved it is not just equity potentially losing out, but the mezzanine lender who might face distress.”
FTI's Khaki made a similar point, albeit looking at the problem from a different direction. Asked if refinancing options are still sufficiently plentiful and affordable even if if it involved an equity injection by borrowers, he was cautious.
“There remains significant liquidity in the market and therefore competitive tension for the majority of asset classes. That said, the market fundamentals have materially changed given higher interest rates," he said. "A number of loans reaching maturity will be unable to service the revised interest cost based on their current rent profile and there will need to be serious discussions over a medium-term solution. This may present growing opportunities for mezzanine lenders or whole loan solutions to bridge the gap from reduced senior leverage.
Calm Before The Storm
"I do not think there will be a wave of distress given the volume of liquidity in the market, but we are all watching and tracking a number of opportunities in Q3 and Q4."
“It's coming,” he said, of a wave of distress. “Remember, it's only 12 months since interest rates started going up, and nobody then envisaged them going this high, of demand softening in the way it has. Nobody, for instance, expected the negative land values we're now seeing thanks to high debt costs,” Webb said, adding that in these circumstances it has taken lenders (and borrowers) a while to grasp that this wasn't an inflationary blip.
Webb said some sectors will wait a lot longer than others for their day of reckoning, placing sectors like build-to-rent residential and student housing in the far-distant category, but even here there could be a few upsets. “We come across a lot of chat with numbers that don't support it,” he said.
Randeesh Sandhu is co-founder and CEO at Precede Capital. The real estate development lending platform hasn't been deterred by a winter and spring of crisis, providing a £188M five-year whole-loan facility to a joint venture between Apache Capital, Harrison Street and NFU Mutual for the £302M Great Charles Street build-to-rent scheme in central Birmingham. This follows a partnership with QuadReal Property Group in January.
“The living asset classes are the area least likely to be distressed, and watching the other sectors I don't know why we're not seeing distress — I guess conversations with lenders are still not concluded, or it is just too soon in the cycle. But it has definitely become a lenders' market again,” Sandhu said.
Sandhu said he suspects that the institutional nonbank lenders are cushioning the blow via refinancing, “not because they are doing dumb or crazy lending, but because they have different requirements from banks, and can do different things”.
Moreover, despite confidence in the living sector, Precede is extremely watchful for signs that borrowers aren't quite on the same page as the lenders. “Our exit yield assumptions have to be put into the new context of higher interest rates," he said. "The risk premium for illiquid residential assets has to be taken into account and lenders are very nervous about lazy yield assumptions. Borrowers could [previously] make schemes work assuming zero rental growth, now the mathematics doesn't work like that.”
Like Webb, Sanhu's best guess is that distress in many sectors is on its way, just taking time to worm its way out into the open.
Everyone agrees that, in private, lenders are already taking action. Almost everyone agrees that many borrowers know they are living on borrowed time, even if technical loan-to-value covenant breaches aren't top of lenders' worry list. More or less everyone agrees that this crisis — if it is a crisis — is in its very early days.
“There is always a lag between a fall in values and enforcement action. Look back to the Global Financial Crisis and we saw property values fall 45% over 18 months from their peak in 2007, but the bulk of receivership appointments were not made until post-2010,” CBRE's Perkins said.
“The key point is the date of loan maturity. Unless an asset is so far underwater that the borrower is throwing their hands up in despair, or posting the keys back to the lender, then loan maturity dates are the issue. That is when we will see more enforcement activity. The question is, when is that?”