The dominoes slowly fall as we head towards a distressed UK Real Estate market
The UK’s commercial real estate sector is currently facing a variety of challenges – increased interest rates, stubborn inflation, falling property values, and liquidity issues for lenders and borrowers.
All these elements have been lining-up for some time like a series of interconnected dominoes. As each one falls, it knocks into the other and so on as the continuing downward pressures come to bear on the market.
All of this is happening in slow motion but, while the pace is gradual, inactivity surrounding this impending crisis will lead to dire consequences for lenders, borrowers, and other stakeholders.
In this article, we will explore the factors contributing to this crisis and discuss how they might be navigated.
The Domino Effect
Like a delicate equilibrium disrupted, the UK commercial real estate market finds itself grappling with a multitude of challenges.
The first domino to fall was rising interest rates as the Bank of England attempted to grapple with inflation and it still continues to do so. At the time of writing, the MPC have most recently caught out most commentators by holding the base rate at 5.25% in September.
As borrowing remains expensive, with the market accepting we are not returning to the historically low rates we saw in Summer 2022 any time soon, this puts pressure on borrowers, who are either struggling to meet their current obligations or seeking refinance at this critical time.
This is when the second domino starts to topple — falling property values. The conventional wisdom is that the market is ripe for a correction, leaving investors and owners with diminished equity whilst facing increasing levels of debt.
The third domino, liquidity issues for lenders, exacerbates the situation further. With borrowers defaulting on their payments and property values declining, lenders find themselves holding a shrinking pool of valuable assets or difficulties in finding suitable deals that they can fund.
This lack of liquidity limits their ability to extend credit and refinance troubled loans. Eventually, the falling dominoes will threaten the entire UK commercial real estate landscape.
The Consequences of Inactivity
The slow-motion descent into distress poses grave consequences for all stakeholders involved. For lenders, the inability to refinance loans or recover their investments can severely impact their financial stability, and in some cases, their ability to fund deals at all.
If refinancing becomes unattainable, disposing of assets may be the only viable course of action. However, acting too late risks flooding the market with similar assets, causing a price correction that further erodes their value.
Caught in a precarious situation, lenders are facing the challenge of calling the bottom of an unpredictable market.
Borrowers, too, face difficult decisions ahead. Stuck in an unfavourable borrowing environment, they are finding it increasingly difficult to secure refinancing or restructure their existing loans.
Naturally, lenders are being very selective regarding their lending criteria and valuations which is constricting approval of deals.
Without a proactive approach to address these issues, borrowers risk defaulting on their obligations, potentially leading to enforcement and the loss of their properties.
Inaction, therefore, has far-reaching consequences that can spell disaster for lenders and borrowers alike.
What can be done?
Waiting for the dominoes to finish falling is not a viable option and action needs to be taken now by both lenders and borrowers alike.
- Assessment: Lenders should be carefully assessing their loan portfolios and identifying potential problem loans. It is crucial for them to communicate openly with borrowers and explore options such as pre-payments, injection of additional borrower equity, extending repayment dates and negotiating additional security. Also, lenders should closely monitor market trends and exercise prudence when considering new lending opportunities – taking the time to complete proper due diligence (including legal reporting) is now more important than ever.
For borrowers, it is essential to conduct a thorough assessment of their financial position. Those with operational assets should explore measures to enhance cash flow, such as renegotiating lease terms or reducing running costs.
- Communication: Now, more than ever, it will be crucial for lenders and borrowers to engage with each other as early as possible to resolve any impending issues. All too often, extra funds could have been made available if the borrower had been more upfront and honest about their challenges, but in waiting it out, the lender will not have the opportunity to lend its support or help secure a solution and that could be catastrophic for the borrower.
However, whether a lender will allow a struggling loan or development to continue is reliant on the credibility of the borrower and their ability to deliver. This extends to the credibility of the team of advisors that a borrower has surrounded themselves with.
These advisors should act as a fresh pair of eyes to help come up with a viable plan when the borrower may not see a way through.
Ultimately, lenders want to build relationships with borrowers who are willing and able to proactively tackle issues, but who are forthright in their communications. This way, when the lender gets repaid, they will more than likely be willing to work together again.
- Alternative Financing: Both lenders and borrowers should consider alternative financing options. By embracing creative financing, it is possible to tailor funding to suit the specific needs of the project at hand. Unlike traditional methods, which come with inflexible terms and strict qualifications, these alternatives allow for greater flexibility, and this will open up opportunities for investment that conventional lenders might overlook or consider too risky.
Such options for consideration may include partnerships, joint ventures, seller financing, lease options, private money lenders, or accessing alternative funding sources that can provide additional liquidity and flexibility. This may involve seeking equity investors or exploring financing structures tailored to specific circumstances.
When it comes to secondary sources of liquidity, be mindful that these cannot be easily converted into cash without impacting a company’s operations. But where a borrower is running low on cash and near-cash assets, they may need to liquidate assets like inventory, plant, and equipment to meet their financial obligations.
There are other options though. To increase liquidity, borrowers could consider reworking the terms of their debt obligations, such as repayment schedules, and adjusting the term of the loan, or reorganising a site to sell off additional plots of land. However, all of these options will likely come at a cost, eg, the lender charging adjusted rates, or arrangement and exit fees.
Bridging loans can also provide a valuable lifeline in the current economic climate. However, extra caution is required because many borrowers and lenders are going to get caught out in the next 6 to 18 months if the borrower’s exit strategy is not secured or has a prospect of success to convince a purchaser or refinancing lender (be that refinancing, sales or completion of development, etc).
Most reputable lenders will require a clear repayment plan before providing a bridging loan and will actually prioritise a confirmed and concise exit strategy over credit history.
The failure to implement a realistic exit strategy or non-repayment by the agreed date will leads to increased interest rates and penalties.
Given the higher interest rates incurred on bridging loans, going significantly over the loan term can damage the borrower’s credit history, result in repossession, and cause significant financial losses.
When additional funding cannot be found
We are unlikely to see the same level of enforcement action in relation to development sites as we did back in 2008 when there was a lot of repossession action; however, there is the expectation that we will see more enforcement action across the market.
Focussing on development, there has been an increase in decent sites being dragged down by underperforming ones, however, administration and receivership remain a last resort because of damage to the value of the asset.
The hope now is that more projects will be kept alive with the hit being taken privately because the sources of funding are so varied and deep.
Where a project cannot be salvaged, whether a lender chooses to appoint a receiver or sells the debt is a question of certainty and work-out capability.
Selling the debt gives the lender a definite loss as opposed to the potential uncertainty of trying to work out the loan for a better outcome. But lenders may be more willing to sell the debt to other lenders, which may mean that borrower finds themselves in front of a more aggressive lender than they started with.
In the last few years, receiverships have tended to be more with alternative lenders rather than big clearing banks because they have more exposure and higher pricing.
Lenders that have entered the market in recent years may not have the requisite skill set to do the workouts, which will inevitably lead to indecision on their next course of action.
Receivers are the simplest enforcement method and often work best with single assets, or where the main asset is property. However, if the property is more complex, an administrator may be preferred.
Ensuring that you have a real estate professional either dealing directly with the asset as a receiver or working alongside an administrator, is paramount as they will have the skills to deal with the property.
Where the asset involves an operating business (e.g., a care home) a receiver’s powers may be more limited than those of an administrator (subject to what the security documents say).
Where the security has a qualifying floating charge then the lender can appoint an administrator, whose duty is to all of the creditors, but they can realise all of the assets (not just the property).
This may be attractive to a lender where they do not think they will be repaid from the property asset alone and they can benefit from some recovery from the prescribed part under the floating charge.
In the face of these challenges, lenders and borrowers must be proactive in addressing the problems at hand and seeking expert advice to mitigate the potential damage.
Engaging experienced legal support will allow both parties to make informed decisions to safeguard their interests, mutually and independently.
The key to this is to move swiftly, and not to delay taking redemptive action rather than wait for the aforementioned dominoes to fall.
Time can be costly in this sector, and whilst there is no silver bullet fix to the economic challenges at hand, taking the appropriate advice, at the crucial time, should increase the chance of survival for all involved.
Alex Pelopidas is a finance specialist at Newmanor Law, who has over ten years of experience in real estate finance transactions. He has a broad practice involving loan origination, restructuring and enforcement as well as loan book transfers and work relating to loan servicing. He acts for a variety of lenders and borrowers, developers, loan servicers, insolvency practitioners, and receivers