How equity became toast

In September 2008 the whole real estate market was reeling from the fall out of the Lehman collapse, and for many this was the point where many investors first realised that their equity regardless of its size had become ‘toast’.

However, this sudden and stark realisation was not only bad news for clients. Banks too had the sudden realisation that the LTV covenants that they had imposed were now “underwater”. There was a sudden purge at reviewing loan and legal documents with a view to a quick fix enforcing revaluation clauses and endeavouring to quick LPA sales. 

Whilst the real estate fundamentals had not changed, investors overnight lost hundreds of millions through no fault of their own, just market conditions. The sudden lack of real-estate debt had a major impact on prices and caused a significant yield shift, prompting on some occasions a fire sale of assets. 

Valuers who had once been robust in their approach to Red Book reporting were suddenly in a very different market place. When considering updated valuations on a distressed or forced sale basis, and utilising market comparable that too are all distressed values were severely depressed. The exercise was not helped by the lack of very little open market comparable evidence (willing buyer, willing seller).

These sudden sales in an artificial market crystallised the until recently “Paper losses” became reality. Actual losses then frequently occurred when banks commenced the active process of document reviews s and covenants and enforced default scenarios across swathes of property backed facilities.  These actions were compounded further during this time when the banks allocation of capital was rebased by accountancy procedures, the effect of the Basel 1, 2, 3 agreements and the Bank of England imposing tighter controls.

The whole banking industry was obviously hit significantly hard over this period and we are all too aware of the Government intervention that was required to bail out and rescue lenders with large exposure to commercial real estate.  It must be said that the banks that were part government-owned were especially affected.

The problem is who you deal with at the bank, not the bank. Some panic, taking quick decisions to protect themselves without thinking through and acting on the long term benefits. Some asked for unreasonable equity injections at the worst time. The sudden shift in ownership of banks and the reorganisation of these institutions severely affected relationships. Many clients who had been highly respected borrowers suddenly found themselves exposed to lenders and bank officials whom they have history or track record. It was hard to deal with the likes of NAMA, IBRC or West register for example. These bodies were set up with the direct remit to shrink the loan books. There was no hope of rekindling a relationship with any sense of longevity.  

There were of course different types of clients affected by this action. Those who had stretched themselves by obtaining high LTV ratios and low end covenants were hit hardest.  With less equity in a transaction the clients were in the deepest mire. However, this did not necessarily mean they targets first. Quite often the banks would start on the easier targets where there was a great chance of receiving total or close to a full loan redemption. Banks would also look much harder for recovery where there was junior debt and personal guarantees. Traditionally private banks had relied upon client’s asset base to support personal guarantees. With the dwindling property values and equity markets retreating the net asset value of high net worth clients was significantly diminished. In the worst circumstances people were pursued under their obligation to personal recourse and were declared bankrupt.

These were deemed to be avenues where additional equity could be deployed to reduce LTV ratios.  

There were many conflicts between clients and banks as to the best possible outcome. Obviously banks wanted to sell and clients wanted to hold on the assets assuming that there would be a better time to sell.  These conflicts were often intensified further where banks in clubs or syndication agreements were placed in a capital stack. Those further down the stack would face a total loss and their attitude toward restructuring the loans would frequently differ from those at the top of the stack where the exit was much simpler. 

The banking market is improving however lenders predominantly are seeking to lend secured against the same product being prime property, secure income streams or properties in London. There is a significant problem in that there are major elements of the property market that are deemed ‘off limits’ by lenders, especially outside of major cities and strong sectors. 

Many other methods were tried with a view to reusing the equity in a transaction. New deals for equity, or recapitalise old deals. The risk in this instance is the wait for prices to return. Nobody knows how long it will take for the equity to return to a transaction. This is a dangerous waiting game.

Of our course there were many, many instances where things were so bad that investing new equity was simply an uneconomic option. Even large companies with deep pockets had to let go of some deals, as nobody has inexhaustible equity.

There were of course some banks who worked in parallel with the client to reach consensual and mutual solutions. The paper losses were very much aligned and the clients were quite often the best asset manager.  With a “share” in the equity position the bank would be able to take an upside in accordance with a long term business plan. 

We do see some light at the end of the tunnel. There are new and returning lenders to the market place which is increasing the demand to lend money.  However we don’t expect this to be a quick fix and it will be some time before return to the transactions levels that were being undertaken on the 2003-2007 era.

Raed Hanna is managing director of MFL Finance Limited