Here We Go Again?

If there is one assumption most property experts agree on, it is that we are approaching the end of another cycle.

This has historically seen a surge of commercial property lending by the clearing banks and a relaxation of loan covenants. While there is evidence that across the market generally debt levels are on the increase, it would appear that most commercial real estate lenders are learning the lessons from the past – albeit that there are some signs for concern.

At the European level, there have been anecdotal reports, backed up to a lesser degree by the ECB Lending Survey’s statistical observations, of a more borrower-friendly approach to corporate loan pricing and structuring – particularly in respect of covenants which are said to be becoming looser, enabling borrowers to pile more debt onto acquired companies.

In the UK, there is similar evidence of this pattern; industry commentators and the Bank of England Credit Conditions Survey have to varying degrees picked up on a loosening of lending conditions. This latter source shows how in particular, in respect of lending to Private Non-Financial Corporations (PNFCs), covenants, fees and to a lesser extent spreads have been moving consistently in favour of borrowers for the last eighteen months.

Taking the UK corporate sector in aggregate, data suggests that companies are more indebted than ever before; figures from Link Asset Services put the total amount of net debt across the London stock market at £390.7bn at the end of the 2017/18 financial year, the highest level on record. This has been driven by a desire to return capital as much as the need to bolster returns through acquisitions.

The extent to which the same is true in the commercial property arena is debatable. Data from the latest edition of the CBRE Debt Map, as shown in Figure 2, shows that compared with 12 months ago lending terms in the UK have on the whole not swung significantly in either the borrower or lenders’ favour. While LTVs have edged up (from 55% to 60%) so to have margins (from 1.40% to 1.50%), with the total cost of debt also driven higher (from 2.52% to 2.92%) thanks to rising interest rates.

Meanwhile, continental Europe credit conditions have become more borrower-friendly over the same period. Of 14 Western European and Scandinavian markets covered by the CBRE Debt Map:

  • Six have seen LTVs increase, versus just two seeing LTVs fall.
  • Ten have seen margins decline, versus three seeing margins rise.
  • Total cost of debt has declined in 11 countries, compared to three where it has increased.

On the face of it then, it would appear that UK commercial property lenders have been more prudent than European counterparts over the past year.

Before becoming complacent, UK lenders specifically and market participants more generally should beware two factors that suggest this might be an overly simplistic and optimistic understanding of current conditions; firstly, that broader measures of risk are less universally positive about UK lending terms, and secondly, that change in underlying capital values over time renders lending terms generally, and LTVs in particular, dynamic when they may appear to have been static.

Figure 3 addresses the first point, showing three return and seven risk measures for senior lending to prime capital city offices in the four largest commercial property markets in Europe. From the lender’s perspective, a larger shape is better, indicating as it does either lower risk or higher return.

  • From the debt yield perspective, UK lending terms look more conservative than the three European peers; in pure debt yield terms and relative to current and 10year average property yields, UK lending is fairly conservative.
  • The UK’s DSCR (Debt Service Coverage Ratio) is less appealing however. This metric expresses the extent to which on a full cash-sweep basis a loan could fully repay within 25 years. At 1.10, the UK’s ratio is below the wider European average (1.17 for all 20 countries), weaker than Italy and only superior to Germany and France.
  • Finally, on an ICR (Interest Cover Ratio) basis, the UK has the weakest credit conditions of the four main markets, both on a current basis and on a “normalised” basis (assuming interest rates at the 15 year average). At 2.14, the former appears healthy, but a normalised figure of 1.34 shows a level of vulnerability to rises in interest rates.

If the above shows that real estate debt is not as low-risk as might be assumed using a set of current spot measures, the charts below indicate the extent to which risk has crept up over time.

Figure 4 shows how prime office capital values have reached historic highs, following 8-9 years of strong growth. With values on the rise, static LTVs actually mean that lenders are taking on increasing risk.

Figure 5 quantifies this point, showing that a Q2 2018 LTV of 60% equates to an LTV of almost 90% in Q2 2013. [With capital values of £1,713/sqft currently, 60% debt would be £1,028/sqft. That level of debt in Q2 2013, when capital values were £1158/sqft, would equate to 89%.]

In other words, although lenders consistently offering 60% LTVs over the last five years may feel they haven’t changed their risk exposure, in fact this is not the case because today’s loan of 60% is 2013’s loan of 90%.

All in all, lending standards are quietly loosening in commercial property, in the UK and across Europe, meaning that the record level of capital chasing exposure to the sector should tread carefully.

By Richard Dakin, Managing Director, EMEA, Capital Advisors, CBRE.