Lessons from the recession for real estate finance
11 March 2013
"The deepest recession since the war" is a tale which every reader will be familiar with. So too are the profound effects it has had on the real estate sector in particular, which include banks and other lenders being forced to wipe off billions of debt from their books, once it became apparent that vast amounts of money they had lent were secured by over-valued properties.
Five years on from the onset of the economic crash and the debate goes on about whether we have been through the worst of it or whether in fact we are heading towards a "triple dipper". While answers to that question will vary depending on which newspaper column you read (or which Twitter feed you follow), most people will agree that lessons have been learnt since the onset of the recession (which for these purposes we will take as being the collapse of Lehmans in September 2008). A few of them are discussed below.
Due diligence – a closer look
Prior to the recession, many lenders took a relatively soft approach to due diligence other than a title report in relation to the relevant asset. Today, it is common to see lenders undergo a thorough due diligence process not only on the relevant property but often including full lease reviews, assessments as to mechanical, engineering and environmental soundness and energy efficiency.
Lenders now also routinely undergo enhanced accounting, tax and legal due diligence on the borrowers themselves and will obtain comprehensive opinions/reports to that effect.
Covenants – focus on property
The two main financial covenants in any real estate investment finance deal (the loan to value ("LTV") and interest cover ratios ("ICR")) are both more tightly monitored and defined in the current market than was generally the case prior to the Lehmans collapse. For example, rather than focus on pure rent, interest cover routinely excludes approved SPV running costs, tax liabilities and rent arrears. In addition, lenders will often include draw stops based on the borrower's compliance with LTV and ICR ratios in order to protect against the risk of a transaction fundamentally changing between commitment and drawdown (for example with interest rate movements).
Even in the heady days of the mid 2000s, security packages would generally extend above the level of the assets themselves and would include share security. However, upon the enforcement of share security, a lender may struggle to find a buyer for the company if the company is saddled with debt. Therefore, in addition to subordinating any shareholder debt, lenders will now as a matter of course also take security over that subordinated debt (particularly where it effectively constitutes equity in the structure). That enables the lenders to cancel and/or sell that debt, when enforcing the share security and selling the company.
Hedging – limiting exposure
Another significant shift in attitudes/market practices has centred around hedging issues.
Firstly, lenders will insist on pre-agreeing any hedging strategies and on the swap counterparties not being able to change those strategies without the consent of all the lenders.
Secondly, "over-hedging" (broadly speaking, a situation where the notional amount of the swap is greater than the outstanding amount of the loan) is being addressed by lenders now including provisions which require the borrower to make a proportionate reduction in the notional amount of the swap where there has been a prepayment of the loan.
In a similar vein, the long dated swap is (for now) consigned to history. Lenders are generally restricting borrowers from entering into swaps for a period which is longer than the term of the loan – such restrictions may help to avoid the conflict which could otherwise arise between a lender seeking to dispose of a secured asset at the term of the loan and a swap counterparty who might prefer for the security to remain in place until the expiry of the swap.
A number of the new positions being taken by lenders as discussed above are now enshrined in the new LMA Real Estate Finance Facility Agreement, which was published only after extensive consultation with a number of lenders. The Commercial Real Estate Finance Council Europe has also produced the useful European Commercial Real Estate Lending Principles and is in the process of drafting guidelines for intercreditor agreements in UK commercial real estate finance transactions.
From an advisor's perspective, we have seen much if not all of the above being factored into new transactions over the last period. We expect those lessons will continue to guide the markets during the course of what will no doubt be another challenging period over 2013. That can only be a good thing as the markets move forward – only time will tell how long the lessons last.