The refinancing requirement for UK commercial property investors is expected to climb next year, as extended loans during the pandemic expire. Overall, we expect alternative lenders to further increase market share, in a year when interest rate increases push up borrowing and hedging costs.
The good news for borrowers is that liquidity in debt markets remains broad-based and deep, particularly among alternative lenders. Most UK property sectors benefited from increased liquidity as the year wore on. However, multiple catalysts pose an upside risk to borrowing costs in the coming quarters.
At the macro level, the Bank of England increased interest rates in December after more than a decade of base rates hovering near zero per cent. The long-awaited shift in monetary policy is driven by rising inflation, which surged to its fastest pace in almost a decade, hitting 4.2% in the 12 months to October, the Office for National Statistics (ONS) data shows.
UK inflation has soared in the past 12 months due to strong demand, higher energy costs, supply chain disruptions and labour shortages. It risks blunting consumer demand and economic growth, which would eventually trickle down to reduce net demand in occupier markets, property yields and loan pricing. More broadly, the outlook for the UK economy is for GDP to slow.
Higher UK base rates will increase demand for fixed-rate loans and interest rate hedging costs. Borrowers must navigate the renewed interest rate risk alongside a raft of external (e.g. health crisis and macro environment) and internal headwinds and priorities (e.g. ESG requirements and property sector-specific headwinds). These risks, if not managed, may create downside pressure on asset valuations and obscure cash flow predictability.
Persistent inflation and receding GDP would create a stagflationary environment which would risk the occupier market recovery and potentially stymie investment activity and financing demand. Historically, commercial property investors try to offset interest rate hikes by capturing inflation in rental growth, but this strategy is not always possible. For example, rising operational costs (e.g. higher energy costs) can restrict landlords’ ability to inflate rents in sectors with an oversupply of stock.
Possible NPL wave
A stagflation environment could also be a catalyst for more non-performing loans (NPLs) and asset liquidations. Since the onset of Covid, borrowers who suffered interrupted cash flows benefited from at least four layers of protection:
- Government-backed covid loan schemes;
- Extension of temporary covenant waivers from lenders;
- Loosened insolvency measures; and
- Low-interest rates.
All four protections have or are close to expiry or reversal. Therefore, loans secured by distressed assets, where cash flows have not recovered post-pandemic, will find it harder to refinance.
Lenders are carrying some UK commercial property loans in default and past maturity across hard-hit sectors by the pandemic (e.g. hospitality, retail, leisure and hotels). To date, there has been surprisingly limited NPL sales and loan restructuring workouts, particularly in the hotel sector, where NPL/asset sales were anticipated. But lenders chose to extend covenant waivers and push matured loans into next year to be refinanced in better market conditions. However, if a stagflationary environment emerges, this better environment may fail to materialise, and it may mean NPL and asset sales were deferred and not averted.
Most UK property sectors have benefited from a rebound in debt liquidity. In the first half, liquidity was deep in logistics, the private rented sector (PRS) and life sciences, but this has broadened to more liquidity for the office market and in pockets of the retail sector, particularly for assets supported by a mixed-use repositioning play.
Inflationary pressures have not yet impacted logistics rental growth, supported by solid occupancy demand, as companies continue to near-shore supply chains. Lenders favour new, refurbished or redeveloped assets which meet logistics providers’ ever more demanding technological requirements.
In the office market, the economic model is shifting more towards hotels, emphasising amenities (e.g. wellness, catering, events, etc.), accelerated by the pandemic-era working from home (WFH) trend and labour shortages. It is prompting employers to work harder to tempt employees back. The implication for financing is each loan is more bespoke than ever. Lenders now spend more time underwriting business plans with specific covenant-related events, which may disrupt cash flows. Alternative lenders are well suited to operationally complex assets.
Alternative lenders were able to capitalise on banks’ accelerated retreat since the onset of the pandemic as they are more agile and unconstrained by rigid protocols. The pandemic also served to stress test pre-Covid vintage loans issued by debt funds that exercised early intervention clauses to remedy potential loan defaults. According to the Bayes lending report, alternative lenders provided almost one-quarter (24%) of all new UK property financing in the first half of 2021, second only to banks. Borrowers opted for financing certainty over debt economy and show an increased understanding of how debt funds work (e.g. increased cost for increased structural flexibility). With a large refinancing wall of maturities over the next two years – mainly from the banking sector – we expect debt funds to emerge as an even more dominant provider of debt capital.
ESG and climate risk
Debt funds are also heavily focused on climate change and ESG risk analysis in loan underwriting. For example, lenders must evaluate how a building’s operating costs will be influenced by climate change-related costs which often comes down to a mix of insurance and capex that feeds into loan covenants and pricing more than ever before. Ignoring these considerations can lead to quicker asset obsolescence and reduced exit liquidity, a risk which borrowers and lenders share.