As published in React News on 26 January 2023

Hollis’s Mark Hampson and Interpath’s David Pike discuss the mounting problems faced by borrowers and lenders

Rising finance costs and falling property values have created a testing environment for investors and lenders. The situation is further complicated by decarbonisation targets, capex events and pandemic-related forbearance agreement coming to an end.

AEW research predicts “significant refinancing problems for loan maturities in 2023-25” and estimates the funding gap to be plugged with new equity or borrowing at €24.2bn (£21.3bn) in Europe over three years. Meanwhile, data from The Bayes Business School predicts that about £40bn needs to refinanced in the UK in each of the next three years, with £5bn-7bn of fresh capital required annually.

React News caught up with Mark Hampson, Director at real estate consultancy Hollis, and David Pike, Managing Director at restructuring specialists at Interpath Advisory, to explore the pitfalls and opportunities when considering options for a distressed asset.

Is there an expectation 2023 will be a busy year for distressed asset sales?

Mark Hampson:
 Current macroeconomic headwinds are expected to lead to an increase in pressure on capital structures and ultimately distressed asset sales. Coupled with a ready pool of capital to purchase assets linked to maturing loans becoming too pricey to refinance, this could create fertile ground for fund managers anticipating opportunities to invest.

Hollis is already seeing distress coming through where sellers have no appetite to put costs aside for bigger refurbishments to meet occupier standards or to take on higher loans, so they’re off-loading assets – and it’s particularly pronounced with offices.

What’s behind much of that distress?

David Pike:
 There is little argument that 2020 and 2021 were brutal in many areas of operational real estate and that the recovery in 2022 was inconsistent. The impact on rent roll, inflation pressures on the cost base, as well as rapid increases in the cost of funds will continue to impact cashflows.

Wherever you sit in the capital structure (borrower, shareholder, lender or potential investor), having a robust and durable view on cashflow will be crucial to determining available holding, investment and financing options.

Mark Hampson: Downward pressure on valuations, combined with an increase in the cost of capital and new money requirements arising from liquidity challenges will continue to create significant pressure on structures facing overlapping lease, refinance and capex events.

Why is detailed asset knowledge more crucial than ever at this juncture?

Mark Hampson:
As such, debt service, operational cashflow and capex are key drivers which need to be understood, challenged and stress-tested. Having effective strategies to manage financial stakeholders through this is vital.

Each party in the asset management and transaction process will have various priorities to consider that are crucial to securing deals in a dislocated market that is bifurcating into a winners and losers universe of “the best and the rest”. Determining exactly where the fault lines emerge in these camps remains to be seen.

What do those reviewing a “cheap” distressed deal need to be mindful of?

Mark Hampson:
Current and prospective financial stakeholders and investors will need to look beyond initial savings in acquiring an asset at a reduced valuation and understand the capex required in the short to medium term. A wide range of non-discretionary capex areas is likely to drive real new money and funding requirements in structures.

One example being the 2023 MEES regulation changes that will apply to all existing commercial leases, making it unlawful for landlords to let commercial property with an Energy Performance Certificate (EPC) rating of F or G. Solutions for compliant and efficient energy management are all the more vital in the context of rising utility bills. A practical step is Solar PV technology, with operators in logistics premises reporting energy costs being halved via installing PV panels on roof space.

At Hollis, we have recently seen 57% more buyers – along with their lenders – asking for ESG/EPC advice and/or decarbonisation pathways. Ask your surveyor for an EPC improvement report as part of your TDD transaction and make sure it’s costed and practical – or get it ready ahead of a sale.

The cost of upgrading a property therefore to comply with legislation, or indeed wider ESG obligations, can be significant.

In your view, how’s that going to play out over the short to medium term?

David Pike:
 Higher leveraged structures and those with material new money requirements may see either a need for shareholders to make material equity injections; or experience potential refinance risk over the next year or two. Debt capacity, durable capital structure, tenor of facilities and the ability of shareholders to shore-up funding is likely to be important.

We have seen examples of situations where the existence of non-traditional lenders who are keen to exit has driven an acceleration of the consideration of enforcement options running alongside the borrower running their preferred refinance programme.

Where are the pressure points?

David Pike:
 Opportunistic investors have been biding their time and watching certain sectors closely. For instance, the office sector could begin to present opportunities once long-term leases begin to expire or reach a break option, with occupier trends such as downsizing and the flight to quality increasing vacancy rates. This creates downward pressure on values, triggering pressure in loan-to-value ratios as well as debt service tests.

The extent to which lenders take back such assets from borrowers will depend on both parties going beyond the initial forbearances of the Covid-19 pandemic – many of which will now be ending. For example, many shopping centres are now largely in some form of effective lender-control and there is a real balancing act between hold duration, capex programmes (and funding) and disposal strategy to prevent a glut of these assets being brought to market at the same time.

Where else could issues arise?

Mark Hampson:
 The valuation equation itself may have the capacity for further disruption. For example, calculations which employ DCF valuation methodologies will need to reflect material capex spend requirements around lease events. Tenants leaving bring forward capex events too, which will suppress valuations for such assets further.

When it comes to stakeholder management, the more moving parts and capacity for alternative positions that exist in the capital structure, the greater the need to have strategies to mitigate the risks arising from divergent approaches.

David Pike: An effective stakeholder management plan should build confidence and consensus around a jointly-owned Plan A, but which also has a robust defensive contingency plan in the event that this is not possible. If capital structure participants’ objectives do start to fragment, working through the game theory around the resultant impact of how parties coalesce, seek to disenfranchise others or go it alone, is an important part of a robust contingency plan.

Mark Hampson: Selling offices with no understanding of the costs required to put them into future compliance will lead to bigger price chips and drawn-out transactions.

In addition, occupier agents aren’t entertaining subletting terms past 2027 and 2030 to adhere to the potential future EPC C and B requirements without some of contribution/penalty for improvement work to guarantee its lettable – so the issue of buildings being stranded will hit us and market quicker than expected.

Will financial restructuring, enforcement and insolvency look any different this cycle?

David Pike:
 The resolution toolkit is different today compared with previous down-cycles. Part of this is that the restructuring plan has joined the CVA as a powerful borrower-friendly process, and we expect to see its use increase in real estate situations in 2023 and beyond.

In the event that lenders do want to take-control of assets, Interpath have undertaken a range of assignments and appointments where we have been able to preserve and generate additional value for tax attributes and mitigate SDLT exposures, beyond that which would be possible in a Fixed Charge Receiver led transaction.

How are investors trying to salvage value?

David Pike:
 Collaboration could lead to repurposing the asset in order to return it to profitability. Long term visions are seeing office blocks and shopping centres repurposed to residential-led mixed use schemes to meet demand. Likewise, underperforming retail and business park sites are being earmarked for logistics and industrial space.  Industrial, secondary logistics and some leisure are further sub sectors to watch.

Mark Hampson: Larger conversion and change of use projects can pay dividends but will typically require more detailed planning and analysis before contractors are on site, so that’s an important thing to bear in mind when considering desired timescales.

Effective asset management should be all about getting as much done as possible during the transition period and then – if the property is to be retained in its current use – minimising void periods by having a fit for purpose asset that will be quickly let.  Taking this kind of proactive, careful and hands-on approach to asset management and maintaining an engaged dialogue with tenants can yield results when done right.

Mark Hampson

Head of Commercial and Clients
Management Board

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