“Just when I thought I was out, they pull me back in,” grunts Al Pacino’s Michael Corleone in The Godfather Part III. The British commercial real estate sector will no doubt have been grunting similar sentiments following the collapse of Silicon Valley Bank (SVB) and Credit Suisse last month: just when an uptick in deal activity had them thinking that the end of the downturn was on the horizon, sort of a banking crisis has presented them with fresh problems.
Whereas last year the issue for commercial real estate was the cost of debt, the issue for the sector right now is the availability of this pricier debt. Anxious banks across the US are scrutinising their exposure to the sector worried that just as high interest rates devalued SVB’s assets, so too will they devalue real estate. Meanwhile, developers at Mipim – an annual real estate conference in the south of France that took place last month – were said to be wringing their hands over European banks’ unwillingness to lend following the implosion of Credit Suisse.
So far, the UK banking sector has muddled through the current malaise and there haven’t been any big-name bank failures in the weeks since Credit Suisse being taken over, but signs that the worst is over do not mean the storm has passed. The US Federal Reserve is warning that the banking repercussions could tip the US into a recession, while global banking regulator The Basel Committee on Banking Supervision is mulling tougher regulations to stop another SVB-style collapse. In short, the situation for banks is still uncertain – an issue for the British economy as well as its commercial real estate sector.
One senior real estate analyst says that the more bullish predictions about the speed of the real estate recovery made before the SVB collapse, now “need to be taken with a grain of salt”. Real estate loans that may have been close to agreement could get pulled or a bank’s attitude to risk might suddenly change.
“Banking problems globally mean banks tend to pull back and become more risk averse,” says Rupert Barclay, independent chair at care home landlord Impact Healthcare Reit (IHR), adding that it is likely lenders will become choosier about who they lend money to now. However, he believes this could benefit better-performing real estate investment trusts (Reits) as they will have access to finance that others will not.
Marcus Phayre-Mudge, fund manager of Reit investment fund TR Property Investment Trust (TRY), agrees. He says the amount of money banks are prepared to lend on inferior offices “has got smaller and the cost has gone up, but the amount they’re prepared to lend on a nice logistics building has gone up”.
Indeed, recent activity shows banks are still willing to lend to some Reits. Last week, LXi (LXI), which specialises in owning assets let on long leases, managed to secure £563mn of new debt and refinanced £200mn of existing debt at an “all-in rate” of 4.23 per cent a year fixed for three years. The cost is much higher than it would have been this time last year, but it is about as competitive as any borrower could achieve in the current environment.
The right Reit
There are several ways lenders decide which Reits are worthy of investment. For Phayre-Mudge, one key factor is the covenant strength of their tenants. He says Reits that own buildings let on long leases to international, blue-chip companies won’t struggle to access debt. Rather, they might find banks are more willing to lend to them as they look to move their exposure towards safer assets.
The investment yield – the annual net rental income of a building as a percentage of its value – is another factor. Banks might be more willing to lend against higher-yielding assets than lower-yielding ones as the increased cost of borrowing makes it harder for Reits that own lower-yielding assets to make money fast enough to pay down the debt.
At the same time, high property yields are not always a good thing. As Phayre-Mudge observes, a run-down out-of-town office building might have a very high yield because it has been heavily devalued, but it is unlikely to attract the sort of blue-chip covenant that would make it a safe investment.
Balance sheet strength is likely to be another factor in the decision to lend. Reits with a higher amount of debt relative to their total equity or with debt that is maturing in the next 18 months are likely to struggle more with loan availability than their peers.
Once again, though, this needs to be taken in the context of the rest of the business. Hospital and GP surgeries landlord Primary Health Properties (PHP) has the highest net debt to equity ratios among UK’s FTSE 350 Reits, but the covenant strength of its main tenant – the NHS – means many banks may consider it a safe investment.
Balance sheet strength might also explain why the concern around lending to commercial real estate – specifically offices in the post-Covid world – has been so much more vocal in the US than in the UK. As we reported in our comparison between the UK and US markets, US Reits tend to have a higher amount of debt to their equity on average, although some argue a lot of that can be attributed to the difference between accounting rules in the two countries, with US Reits’ net asset values (NAVs) less likely to be as up to date as UK NAVs.
Phayre-Mudge says that another reason for the US lending pullback from commercial real estate is because of specific sub-sector woes. Over there, offices in secondary city markets are seen as particularly risky because of high vacancy rates and low take-up post-pandemic. By contrast, he says, better-performing US Reits such as Prologis (US:PLD) that operate in sub-sectors with proven tenant demand will not be hit as badly by US commercial real estate’s debt liquidity issues.
Valuation differences are another explanation. In the UK, changes to the Royal Institution of Chartered Surveyors’ (RICS) valuation guidance to measure market sentiment, rather than just completed transactions, has meant that UK commercial property values have dropped much more quickly than they did in 2008, although the speed at which interest rates rose has also been a factor.
In the US, where valuations remain tied to transactional activity, commercial property values have yet to fall as sharply. But the SVB collapse and subsequent banking uneasiness around commercial real estate could well be the catalyst for forced sales leading to the sort of dramatic price correction that in the UK was sparked by last year’s ill-fated mini-Budget.
The UK market isn’t out of the woods yet either. The bounceback in transactional activity is predicted to slow due to lenders’ general lack of confidence in the macro environment. Care home landlord Target Healthcare Reit (THRL) says while it has “no concerns about debt whatsoever”, arguing that its balance sheet is robust, it concedes it is “definitely slowing the pace of what we’re acquiring right now”.
Reits could well avoid the worst of any banking credit crunch in the UK, however. Not only do they tend to have lower net debt than US peers, but they also tend to have lower net debt than UK private equity. Risky bets on low-yielding assets from private real estate companies with high loan to values (LTVs) are the sort of deals that will struggle to get debt finance, Phayre-Mudge suggests.
In the end, the grey skies in the banking world could turn out to be good news for Reits. “Yes, I expect there to be a reduction in debt availability, and I expect banks to be more choosy with who they lend to,” says Phayre-Mudge. “But actually, in the world of debt lending, many of the Reits – be they UK or European – look like attractive counterparties.”
