Article | Creating Resilience

What does the economic outlook mean for debt markets?

October 21, 2022 8 Minute Read

By Chris Gow

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Interview with Chris Gow, Head of OPRE Debt

1) What are the biggest challenges in the debt market now?

The debt market has been impacted by a number of key events this year, such as the crisis in Ukraine, high energy prices and the repricing of risk. All have contributed to a higher interest rate environment and fears of a recession in a number of countries. However, it’s a complicated picture; the strength of the Dollar compared to Sterling and the Euro is making assets in the UK and Europe appear cheap to Dollar-based buyers. Furthermore, inbound tourism from the US, Middle East and some parts of Asia is up significantly, even on pre-Covid activity levels.

2) How are lenders adapting to the ever challenging and changing market conditions?

In the UK, SONIA, the base on which most commercial debt is written, has gone up by 200 basis points in the period since the mini budget. While we have seen some reduction since the new Chancellor was appointed, the all-in cost of debt has risen by around 4% in the last 12 months, and this is impacting the pricing of all real estate loans.

Lenders are moderating the LTVs they are prepared to offer, to ensure there is cash flow available for debt service. Depending on the asset class and location, we have seen LTVs fall by 5-10% over the course of 2022.

3) Debt markets remain liquid, so how have the emergence of debt funds facilitated the availability of credit?

Firstly, there is no sign of a credit crunch similar to what we saw in 2008/09. Borrower level LTVs at the start of 2022 were around 20% below where we entered the Global Financial Crisis, and the banks are 2-3 times better capitalised this time around. Debt Funds provide borrowers with a lot more choice than existed before and while they used to be known solely for higher LTV/higher cost loans, a number of funds have diversified their investor base and have access to funding that can be priced at, or close to the cost of, debt provided by large banks. We have seen this in a number of OPRE asset classes such as hotels and self-storage, and it has been difficult at times to differentiate offers received from banks and funds.

Across all asset classes in the UK, debt funds have around a 20% market share, with the banks continuing to be the dominant provider of debt capital, particularly to traditional RE asset classes. But it has been a different picture in the OPRE sectors and funds represent just over 50% of debt capital provided to the transactions our OPRE debt team has closed since the onset of Covid-19.

We believe banks and funds both continue to remain relevant, and we have seen a recent trend of sponsor and clients favouring lower LTV/lower cost debt, often more efficiently provided by banks, as the all-in cost of higher LTV debt has trended closer to their cost of equity.

4) Has the rising cost of debt presented any opportunities for investors and debt funds? Who are the winners and losers?

It’s too early to say as the market is still adjusting. But on the sponsor/client side, those with fixed rate loans or effective hedging strategies already in place for investments are well protected. Those investors with new capital to deploy (equity, debt or special situations) will also be well positioned once the market fully recalibrates.

Not losers per se, but we expect to see a Refinancing Wave in 2023 and 24, which some of our clients have already got ahead of by seeking Refinancing Terms now. Borrowers who have maturities in the next 24 months are going to be faced with a market in which the cost of borrowing has gone up (possibly by double) even on the reduced LTVs now available from lenders. This means they may need to either inject equity into deals to get the best refinancing terms or seek alternative and creative solutions from different lender groups and we are seeing a significant growth in clients seeking our advice and guidance in this area.

5) What do lenders and borrowers need to be aware of with the changing economic climate in terms of lending? Are the challenges different for OPRE compared to other sectors?

You need to scan the entire lender universe for the most appropriate debt product or lender for your particular cost of capital and investment strategy. Liquidity is absolutely available, but it is gravitating to the best located deals for the best sponsors. In some ways, OPRE borrowers such as Hotels and Healthcare have faced a dislocated market for some time and while the challenges are now being seen in other asset classes, I think OPRE borrowers and lenders are resilient and will pull through successfully.

6) How are ESG considerations changing debt, financing and lending discussions?

We are pleased to say we have supported several high quality ESG rated loans. It is clear an increasing number of lenders are becoming more prescriptive about ESG credentials, and this is a key part of their underwriting. The financial benefit to gaining the top ESG rating is, however, limited (say 5bps per annum reduction on the loan margin) but we expect this to become more of a binary discussion in the future, i.e liquidity will reduce significantly for non-compliant financings.

7) What do you think will be the big discussions lenders and borrowers will be asking in 2023?

They will be asking questions surrounding inflation, M&A and the Refinancing Wave, in particular:

Have governments got inflation under control? If not, we are going to have to live with higher interest rates for longer. The impact that has on the general economy is going to be significant because governments themselves are over leveraged post pandemic, and we are seeing that play out in Europe currently, especially in the UK. 

How quickly will the real estate market recalibrate? The feedback out of Expo was quite cautious regarding the next three to six months and what repricing needs to occur. The quicker the market recalibrates, and the quicker vendors and buyers are back in sync, the better it is going to be for lenders and borrowers.

And finally, even if there is no significant M&A recovery, there is going to a significant amount of refinancing and recapitalisation activity. Loans that were written 3-4 years ago need to be refinanced unless the assets can be, or have been, sold. How these loans are structured and priced, and at what leverage attachment points, is going to drive the bulk of demand and supply, especially in H1.

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