Article | Intelligent Investment

A financing gap is no longer the concern, but a cash trap might be

June 13, 2023 8 Minute Read


The ability of borrowers to refinance real estate loans is under scrutiny after increases to interest rates and a fall in commercial property values in the second half of 2022. Many loans that need refinancing in the next 12 months were originated during stronger market conditions and in a more favourable lending environment. Data from Bayes Business School’s Commercial Real Estate Lending Report suggests that over £200bn of UK commercial real estate loans were originated from 2018 to 2022. An interesting question is to what extent fresh equity or subordinated debt might be needed to bridge the gap between current levels of borrowing and any new loans that might be offered when existing loans reach maturity.

Current market conditions are also presenting challenges for loans originated more recently. Commercial real estate loans typically specify loan-to-value (LTV) thresholds that, if exceeded during the life of the loan, can trigger a cash trap or cause the borrower to be in default. In a cash trap, the income from the property is first used to pay any interest due and then the remainder is set aside to provide additional security to the lender. Declining capital values have caused some loans originated recently to enter a cash trap. Here, we examine some of the issues presented by the downturn, both for loans falling due in the near future and loans that still have some years to run.

Loan timing will be key for logistics

Prime yields for the best industrial and logistics assets in the best locations were below 4% for much of 2021 and 2022, but rose to 5% by end-2022, causing falls in value of 20-30%. Nonetheless, many loans that were originated in 2018 or 2019 will have been protected because of yield compression in the industrial and logistics sector post-pandemic. This is illustrated in figure 1, which shows how an asset valued at £100m at end-2018 could have changed in value based on movements in prime yields and prime rents to end-2022. The figure also displays how the LTV ratio would have moved for a fictional loan against this asset of £60m at end-2018.

Figure 1: Changes in value and senior LTV ratio for a prime UK logistics asset bought using leverage in 2018

Source: CBRE Research

Actual investments will have experienced some depreciation or incurred some capital expenditure over this period, but the illustration suggests that there should not be a significant debt funding gap for industrial and logistics assets that were last financed in 2018 or 2019. Capital values are still ahead of where they were in 2018, owing to positive rental growth in the sector, and the LTV ratio for the simulated loan remains below 50% at early 2023. In comparison, our data suggests that LTV ratios would be above 50% for simulated loans in the office and retail sectors. This is important given the recent downward shift in the LTV ratios applied to new loans for UK real estate investments.

However, recent movements in values could be more challenging for loans on industrial and logistics assets originated in 2022. As illustrated in figure 2, a 20-30% reduction in capital values is unlikely to threaten the principal outstanding on a senior loan, but it could leave a number of loans in a cash trap until market conditions and capital values improve.

Figure 2: Simulated position for senior loans originated in 2018 and 2021 against a prime logistics asset

Source: CBRE Research

Cash trap can aid retail refinancing

The retail sector has seen quite different trends to the office and industrial sectors over the last few years. Values of retail assets were under pressure prior to the pandemic, and the impact of lockdowns in the UK impacted rental and capital values even further. This is illustrated in figure 3, which traces how a £100m retail warehouse asset could have changed in value based on trends in prime rents and yields, while also assuming a £60m loan was made against this asset at end-2018. Although values improved from mid-2021, retail warehouse values are still some way beneath their 2018 level. Many other retail assets are in a similar position.

Figure 3: Changes in value and senior LTV ratio for a prime retail warehouse asset bought using leverage in 2018

Source: CBRE Research

Moreover, the impact of the pandemic on retail values is likely to have pushed up LTV ratios for existing loans to a point where many would have entered a cash trap situation. Yet this has had a silver lining. Where borrowers prefer to refinance rather than sell at the end of the loan, the money in the cash trap can potentially be used to reduce the refinancing gap caused by movements in property values and the loan terms now available.

For instance, trends in values for prime retail warehouses would suggest that, at a 50% LTV, less than £40m could be borrowed now versus the £60m borrowed at end-2018. Yet if the original loan included a cash trap at, for instance, a 70% LTV threshold, then we estimate that the money which accumulates in the cash trap would account for more than half of the refinancing gap in this scenario, leaving the rest to be bridged either by fresh equity or subordinated debt. This is illustrated in figure 4 below.

Figure 4: Simulated position for senior loan originated in 2018 against a prime retail warehouse asset

Source: CBRE Research


Recent market conditions have rightly raised concerns around debt that needs to be refinanced over the next couple of years. Yet the near term picture may not be as bad as some believe. Post-pandemic capital value appreciation will mitigate the impact of recent falls in value in certain sectors, making it easier to refinance loans that were originated in 2018 and 2019. Meanwhile, money locked up in a cash trap can be used to reduce the refinancing gap in other cases. However, this does not mean there should be no concerns, and borrowers will continue to need advice around how to address the refinancing gap or manage more recent loans where LTV covenants may be coming into play.

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