Pressure on LTV covenants creates refinancing headwinds

Lower valuations and higher interest rates are creating pressure on LTV and interest cover covenants, which can have significant implications when investors come to refinance or restructure a loan.

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Many loans that were originated in a lower interest rate environment will need to be refinanced in the next few months. According to the Bayes Business School's commercial real estate lending report, over £200 billion of UK commercial real estate loans were originated from 2018 to 2022 and nearly 40% of outstanding UK property loans are due to mature in 2024 and 2025 [PDF].

However, declining real estate values in the market are severely impacting loan to value (LTV) ratios. When investors come to refinance or restructure a loan in today's less borrower-friendly market conditions, there is a risk that there will be a gap between the level of debt required, and the level of debt lenders are willing to offer based on the current valuation of the asset.

Some loans will also have a requirement to obtain valuations periodically to test the LTV covenant. In the event an LTV covenant is breached, a lender may insist additional equity is injected to cure the breach, or accelerate a refinancing.

This is something that borrowers need to anticipate and prepare for now.

In addition, after interest rate rises throughout 2022-23, many borrowers have seen their monthly interest payments significantly increase. As well as the impact on cash flows, it may also impact the ability of a borrower to meet interest cover covenants.

Falling valuations impact LTV ratios

The higher interest rate environment has impacted investor and lender demand across the commercial property market, contributing towards a downwards pressure on valuations.

According to M&G's Global Real Estate Outlook 2024, average real estate valuations have fallen by more than 20% [PDF] since mid-2022. This trend is more pronounced in certain sectors, including offices which have been negatively impacted by hybrid working, more stringent energy performance certificate (EPC) requirements and a flight to quality as corporates look to entice people back to the office.

This has led to a growing pressure on LTV ratios. We are starting to see lenders flexing their muscles when it comes to enforcing a loan due to a breach of an LTV covenant. For example, there have been high-profile enforcements over 20 Canada Square and 5 Churchill Place in Canary Wharf, as well as 60 Curzon Street in Mayfair. As valuations remain under pressure, many borrowers will find their lenders are unwilling to extend the same level of finance they had previously. That may mean raising more expensive equity, mezzanine or unitranche facilities, which in turn will reduce returns for owners.

Low transaction volumes and distressed sales place further pressure on valuations

The volume of UK commercial real estate transactions has also been very low. Data from both CoStar and Colliers suggests that volume for 2023 will be approximately £40billion - down a third from £60 billion in 2022 and the weakest year since 2012. Market activity is expected to remain weak in H1 2024, albeit recovering in the second part of the year.

Within the office market, the downturn was even more pronounced with total investment for 2023 expected to be £9.6 billion, the lowest level for 20 years.

With few comparable transactions in the market price discovery is challenging, and it can be difficult for investors to gauge an accurate valuation for their assets. There are concerns that the lack of transactional activity, combined with how fast conditions in the market have declined has led to a significant valuation lag which will only exacerbate refinancing risk.

With offices showing a greater level of stress, it is likely there will be an increase in defaults in this sector together with a rise in the forced sale of assets. This would contribute further downward pressure on asset prices and valuations. For example, on 6 February 2024 it was reported that 5 Churchill Place (a Canary Wharf office building) was sold by receivers at a 60% discount to its last sale price. The building was purchased in 2017 at 70% LTV. This sale is expected to set a significant benchmark for valuing other buildings in Canary Wharf - of which, according to the report, there are at least two more that are likely to be sold.

Higher interest rate environment impacts interest coverage ratios

The long period of low interest rates prompted a move in the commercial real estate sector towards fixed rate borrowing. While economists believe that the Bank of England base rate has peaked at 5.25% and should come down towards the second half of 2024, the prevalence of fixed rate debt means that there is a lag between current interest rate changes and the impact on the sector.

Many borrowers who last raised debt or hedged in a low interest rate environment have therefore not yet felt the full effect of higher interest rates. When they do come to refinance, careful attention must be paid to cash flow, to ensure borrowers can remain compliant with interest cover covenants in their debt facilities and that with a higher proportion of rental income allocated to interest payments, the business is still sustainable.

Other sector challenges impact lender demand

Borrowers need to manage the impact of lower valuations and higher interest costs at the same time as dealing with other sector challenges.

For example, in the offices sector, the national vacancy rate throughout the UK stands at 7.5%, the highest in 9 years. The rate of vacant office space is expected to continue to rise through to 2025, when it is expected to exceed 9%.

If the Government proceeds with current planned legislation, all commercial properties will need to achieve an EPC rating of A or B by April 2030. Currently, 60%^[1] of commercial properties are rated C or below and will therefore need significant additional capex. The costs of upgrading to EPC level B may be unviable for properties in sub-prime locations where premium rents cannot be achieved.

This is contributing to the development of a two-tier office market. Well located quality offices in central locations that meet minimum EPC requirements and tally with the expectations of their tenants' ESG strategies continue to be able to command premium rental rates, which will mitigate higher debt costs to some extent. Investor and lender demand for these assets is expected to remain robust.

However, the office market outside of the prime locations in major cities or in more provincial locations, remains relatively weak, exacerbated by over-supply, changing work patterns, an uncertain political outlook and a challenging market for SMEs. Owners of these assets, especially where significant capex is required to bring them up to minimum EPC standards, may find it difficult to attract new financing.

What can borrowers do?

Borrowers may need to approach their existing lenders to renegotiate existing loan documentation. Options include extending the current debt facility or amending existing LTV or interest coverage ratios.

There are a wide variety of alternative lenders which thave proliferated in the market since the GFC to take advantage of opportunities where mainstream lenders are unwilling to lend. These lenders, including private debt funds, have greater risk appetites, more flexibility around interest coverage ratios and LTV. They can also act in transactions with greater levels of stress or distress, or where significant capex is required.

Planning early for any refinancing or covenant testing will always maximise the chance of a successful outcome.

For more information or advice, contact Oliver Haunch or Nick Wilson

_{[1] Department for Levelling up, Housing & Communities data}

• Article
• Real estate
• Restructuring

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Authors

• Oliver HaunchI have more than 15 years' experience in advising lenders, senior management teams and other stakeholders in financially distressed situations.View Profile
• Nick WilsonI am a chartered accountant and JIEB-qualified with over 15 years' experience advising corporates, lenders and other stakeholders.View Profile
• Gemma SampsonI have been providing turnaround, restructuring and debt advisory services to lenders and corporates for over 12 years. Prior to this I spent four years in the Grant Thornton London audit team, working on the audits of a wide range of businesses.

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