Given the UK’s macro-economic environment, combined with the recent increase in underlying interest rates to their highest rate in 14 years, and the corresponding rise in the cost of commercial real estate debt, it would be easy to make the assumption that the commercial real estate (CRE) debt markets are closed. However, we are finding the reality somewhat different and, for the right transactions, the markets remain open.
Earlier in 2022, the five-year SONIA swap rate was relatively stable at around about 1 per cent. This peaked at just above 5 per cent after the UK Government’s ‘mini Budget’ at the end of September, although it has now tightened to approximately 3.75 per cent. An improvement, but still elevated compared with what many had become used to paying in the last decade. In addition, there has been a slight uptick in the margins charged by some lenders. Combined, these factors resulted in the cheapest liquidity disappearing from the market.
While this has restricted the CRE debt markets, in particular because cashflows simply do not support the quantum of debt they would have done previously, it has not closed them entirely. Interestingly, for some debt funds and alternative lenders which previously needed to operate higher up the risk curve to generate their desired returns, the rise in underlying interest rates has enabled them to lend on lower risk opportunities, competing with the hesitant bank market, and improve their risk adjusted returns.
As ever in a challenging market, there is increased focus on the quality of the sponsorship and the underlying assets, as lenders look to deploy capital on the best available projects. Given low investment volumes, there is a scarcity of high-quality transactions, so those that do require financing can anticipate a warm welcome from a variety of potential lenders.
There is no shortage of sponsors waiting to see if there will be an improvement in borrowing conditions in 2023, and with lower investment volumes it is anticipated that we will see more refinancing in H1. With transaction volumes down, and the markets relatively quiet, there could be an opportunity for sponsors to beat the rush and come to market early in the new year.
With rising underlying rates, lenders are turning their attention to cashflow as the key determinant of debt structure. Borrowers should expect enhanced due diligence leading to protracted processes, and for there to be more focus on interest cover ratios and debt yield as determining factors for the maximum leverage available. Potential lenders are also likely to put greater emphasis on hedging a greater proportion of the loan.
Consequently it is more important than ever that sponsors take the time to carefully prepare a transaction before going to market. A detailed information memorandum with a defensible business plan backed with market insight and comparables as supporting evidence is essential. There is also value in running a fairly wide debt process, as the optimum lender for any given transaction is not necessarily the most obvious candidate and, with such a diverse lender base in an ever changing market, the hot money last week may not be from the same provider next week.
For sponsors, the role played by a debt advisor has never been more important in ensuring transactions are properly prepared for market and that the right lenders approached, while all along ensuring that timelines are met and execution risk is minimised.
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