The return of commercial property distress

Robert Insall

The long-term impact of the pandemic on vulnerable commercial property sectors and landlords’ business models, remains, at least in part, uncertain at this stage.

It is, however, possible that some sectors and investment strategies may see permanent changes in demand drivers. Investment convictions within the property sector run the spectrum from foretelling seismic disruption to an eventual sanguine return to business as usual, with variation between owners and across property sectors.

It is perhaps safer ground to consider the fate of the commercial property sector through a near-term assessment of expiring debt, the options and consequences for landlord and investors.

The Business School (formerly Cass), which produces the UK Commercial Real Estate Mid-Year Report, estimates that over the next two years, loans of £23bn secured against retail assets, student housing, hotels and care homes will be refinanced – including £9.5bn in the retail sector alone. According to their estimates, by the time most of these existing debt facilities expire, LTVs (loan to values) will be between 85% to 120%.

The near-term wall of refinancing presents a different kind of challenge for lenders, relative to the 2008 financial crisis – investors’ leverage levels remain significantly lower and bank capitalisation is far more robust. There is also wide variation between commercial landlords and across sectors.

Most lenders are no longer lending to retail assets – particularly shopping centres – for example, only seven surveyed lenders were still willing to consider new financing requests for secondary retail property, according to the Business School.

Underlying this shift in sentiment is, of course, the uncertainty connected to the viability of businesses to survive the pandemic which has manifested in depleted consumer demand and depressed rent collection levels.

By contrast, there is a perception that residential – in particular the private rented sector (PRS) – has strong defensive characteristics; the sector attracted most new financing during H1 2020 at 29%, followed by offices with a share of 24% of new loans.

Overall, new commercial property lending declined by one-third (34%) to £15.5bn, compared to the same period last year. Margins across all property types rose by 20 to 50 basis points, while LTVs reached a new historic low with an average of between 50% and 55%.

On existing loans, interest payment shortfalls are expected for retail, leisure and hotel properties. However, default rates are moving slowly due to the lack of revaluations, new transactions and lenders’ early adoption of Covid covenant waivers after the UK first entered lockdown in mid-March.

Critically, as these waivers expire, lenders are likely to scrutinise borrowers’ requests for new waivers, mortgage holidays, loan extensions and refinancing more closely. All of which should focus the attention of commercial landlords, constrained by the impact of long-term diminished rental income, in the direction of survival navigation and improving financial resilience.

Investors with less than two years remaining on their loans – and who do not plan to sell the secured assets within that time – should make early refinancing a priority. Waiting for the pandemic to blow over could leave investors exposed to the possibility of further equity erosion. Investors must mitigate such portfolio risk.

For some, refinancing may require new lending relationships with alternative lenders, including debt funds who often provide higher LTVs, quicker due diligence and credit approval processes, but at a higher cost of debt. It is a premium for execution and liquidity some investors will determine is worthwhile.

Beyond refinancing, investors must also weigh up whether the need for near-term corporate liquidity requires asset disposals. Some investors will need to consider the relevance of existing business plans. It is always best to begin defensively.

Investors, both large and small, should conduct liquidity scenarios for the next six months to identify covenant risks in their portfolios and scenario-based rent collection levels, as well as revise asset management schedules.

For some, the decision will turn to whether to sell assets to generate cash and reduce debt to better manage the coming winter. These are not straightforward decisions.

Every board, to an extent, will see the world through their unique business perspective. For example, some investors may conclude it would be prudent to sell some assets now – despite sufficient liquidity for the next six to 12 months – to safeguard against thinner liquidity in 2021 if the health crisis turns out to be little or no better.

Assets and portfolios most resilient to the pandemic disruption – such as PRS, logistics, data centres – will likely be the most attractive pricing for vendors, but may also be the preferred sector holds.

On the contrary, retail, leisure and hospitality, which all have experienced yield expansion nationwide, will have to be sold at distressed levels. Elsewhere the fate of offices is less clear cut, with yield shifts in many locations.

Long-term underlying demand for office space may be influenced by the protracted global ‘working from home’ experiment, which may undercut long-standing investor convictions on CBD and regional net office occupancy trends.

All these uncertainties make a clear case for early planning. But the process of quantifying all this – making sure all relevant factors are considered – is complicated. It is easy to miss elements with so many fast-moving parts. Independent third-party advice from advisory firms such as BTG Advisory can enhance business strategy execution and help support the approval process from relevant stakeholders – ultimately boosting survival chances.

If any of these issues relate to your business and you would like some independent advice on your options, please do contact us.

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