Investors focus on the conditions of their loans

Coupled with a slowdown in China, prospects of a rate rise and volatility in the equity markets, it would seem that some investors are, if not yet battening down the hatches, at least looking around to check they have hatches. One area of particular focus will be on the condition of their loans.

Debt is often accused of being pro-cyclical and amplifying value swings in the real estate markets. Whether that is true or not and how we can collectively promote financial stability in our industry is a topic that merits far more extensive debate than can be covered here, but what was clear in the last cycle was the large number of loans in breach of financial covenants, which resulted in more forced sellers to market and therefore helped to drive values downwards. It is therefore worth considering how this covenant reacts to value movement.

Lenders use two primary indicators to covenant that a loan/asset is performing - one linked to income and one to value. The latter is typically tested via the loan-to-value (LTV) ratio and is often the one lenders put most stock in. It also seems to have been the covenant most frequently breached during the crash. In 2012, De Montfort University’s Commercial Property Lending Report said 42% of lenders holding non-performing loans cited a breach of LTV covenant as the reason for a loan being non-performing, with only 7% citing “interest wholly or partially unpaid”. This is perhaps not surprising, given that values are typically more volatile than income and are by their very nature a subjective metric. The value of an asset (per RICS Red Book) is an approximation of the price at which it would trade hands between a willing buyer and a willing seller. In a weak market, a willing buyer for some assets may not exist, so placing a numeric value on it can be challenging.

Where a lender sets the default LTV covenant is therefore important. The spread between the initial LTV ratio and the loan’s default LTV ratio should be scrutinised when agreeing to loan terms. A ratio of 50% LTV at closing may seem conservative but if the default LTV ratio is 55%, then around a 9% reduction in value would trigger a breach.

So-called conditional cash sweep triggers linked to LTV have become more of a feature of loan terms since 2008. These are ‘soft’ triggers that, if breached, result in all or part of the surplus income from the property/portfolio being used to amortise the loan.

The inclusion of a conditional cash sweep often enables the default covenant to be set further away from the drawdown LTV, thus giving the borrower more headroom, and the lender comfort that cash isn’t being distributed to investors when value is under pressure. Setting the default LTV ratio with adequate headroom from the drawdown LTV ratio, potentially via the inclusion of a conditional amortisation trigger, should help a loan to weather some volatility in values without triggering a hard breach of covenant.

Clearly no amount of loan structuring will protect against value decline if borrowers are taking on very high LTV loans. This time round however it seems that, by and large, the real estate community is leveraging less. Coupled with both lenders and borrowers adopting a sensible approach to covenant structuring, the presence of debt should not be a catalyst for freefalling values if we are indeed heading towards a correction.

Richard Craddock is director of Wells Fargo Commercial Real Estate UK