Ask any lending banker to describe the metrics of a loan transaction and, invariably, one of the first elements to be mentioned is the loan-to-value ratio (LTV).

This is hardly surprising; knowing whether a transaction is a 40% or an 80% LTV loan provides an instant picture of the risk being taken by the lender.

Ask any lender what the debt yield (DY) on a loan is and it is possible there may be some pause for consideration. The DY is a simple metric dividing the (net) rental income from the property security by the amount of the debt. So, if a loan of £50 is under consideration for a property yielding rental at 5% (£5) and valued at £100, the LTV is 50% and the debt yield is 10%. This DY on a transaction is known at the outset and, with the length of leases known, can be estimated with some confidence at maturity of the loan and beyond.

The issue with the emphasis on LTV, as compared with other metrics such as DY, is that the LTV is one of the key metrics of a transaction over which neither the lender nor borrower has any control. As we have all recently both happily and painfully experienced, valuation can fluctuate, often quite significantly, as a result of external changes to the market environment. The identity of the borrower, the term of the loan, the quality of the rental income — these are all elements that can be analysed and risks assessed. And while we all have a view on the current state of the market, I have yet to meet anybody who is able to predict with much certainty what stage the market cycle will have reached by the time a seven-year loan reaches maturity.

So why could DY be given greater consideration? For a start, one of the key elements in many banks’ internal risk models that judge the credit quality of a loan is LTV. While DY is an element, it is given less consideration.

If we pause to consider, we could ask ourselves whether this approach could be subject to greater scrutiny. Greater emphasis on DY — and its sustainability — could help lenders take a better informed view as to the ability of a borrower to ride through any temporary depression in market values that may coincide with the maturity of his loan. Because the DY is a good indication of the ability of real estate to service interest expense on the loan.

One additional interesting piece of analysis could be to review a DY on any given loan against the peak and trough yields against which similar assets to the type being financed have traded over a long period. To take City offices, research from analysts show ‘prime’ yields to have fluctuated between a low of around 4.5% and a peak of around 6.5% over at least the last 20 years. So if at the maturity of any loan, it demonstrates metrics that anticipate a DY in excess of 6.5%, this should give the lender additional confidence that even in a severely distressed market, they should be able to exit their position without distress, based upon long term market evidence.

While most term sheets contain LTV and Interest Cover (I/C) covenants, few if any that I have seen make reference to DY. It is certainly possible to create an argument that this concept should have greater air time in the discussion of loan terms. Market forces are such, however, that — particularly in a highly competitive lending environment such as the one we are currently experiencing — borrowers may resist any attempts to introduce such a new and untested concept.

On an entirely unrelated matter, it was good to read that the UK banks have all satisfied the ‘stress tests’ as implemented by the European Banking Authority and announced last week. There was a further boost when the UK regulator announced slightly lower leverage requirements for domestic institutions in respect of their risk assets, to be phased in by 2019. Moreover, the UK regulator will publish its own ‘stress test’ results in the week before Christmas; these additional tests are considered to be more rigorous than those of the EBA.

While the net result of all of the above may well be a conclusion that more capital is required in the UK banking system, the real news is that slowly but surely regulatory uncertainty is being removed — and that should be welcomed by all!

Max Sinclair is head of the UK division, commercial real estate, at Wells Fargo Bank International’s London branch.

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