Close Brothers, one of Europe's leading independent corporate finance advisers, is urging banks and investors in the UK property sector to devise alternative financing solutions in the face of a potential £140 billion (approx. 142 bln.) price fall and a £125 billion debt refinancing bill over the next four years.
Going into 2009, it has been calculated that banks are exposed to approximately £250 billion of UK commercial property debt, of which 50% needs to be refinanced in the next four years. Close Brothers believes the scale of this issue has not been fully appreciated and is likely to trigger further write-downs and, combined with the impact of a worsening wider economy, a second credit crunch in due course.
Gareth Davies, Managing Director in Close Brothers' European Restructuring and Debt Advisory Group, comments, "The commercial property world has not seen a significant downturn since the early 1990s when the financing structures deployed were much simpler and less aggressive. Banks adopted a strategy of selling assets into a distressed market however; this caused a death spiral with ever decreasing prices. Therefore, alternative solutions to restructure the indebted sector are required this time round, for example debt conversions, new third party investment or partial asset sales.
"There will be significant risk and difficulty of implementing a consensual funding strategy between the multiple stakeholders in these complex structures. For instance, there will be many differing agendas to align. In addition to enhancing the risk of a restructuring or refinancing failing, secondary market investors will increasingly take advantage by acquiring ransom strips with the aim of exploiting their nuisance value to be refinanced or bought out at a profit further amplifying the problem."
Today, appetite among banks to write new loans has evaporated, with a corresponding drop in acquisition activity and price depreciation. Close Brothers predicts that by the time the market has bottomed in late 2009 / early 2010, pricing will have fallen by 50% to 60% (which is more than most other commentators). Close Brothers believes the combined factors of no available debt finance and a limited number of investors with equity to fund acquisitions means that any property which needs to be sold will only realise distressed values.
Based on the assumptions of an average 70% LTV, a 50% price fall from peak to trough, Close Brothers anticipates there will be £140 billion total unrealised losses on commercial property, split equally between debt and equity.
With such a rapid fall off in valuations, most LTV covenants across the sector have been breached already rendering equity investments now worthless. Close Brothers believes, given the number of cases involved, the banks are unlikely to take action on an LTV breach, preferring to either waive the breach or re-set the covenant. However, in 2009 and 2010 there will be more interest and capital payment defaults across the sector as tenants seek to lower costs or go out of business. This will escalate the issue for borrowers because banks will start to take a much more pro-active stance.
Borrowers needing to refinance over the next four years (approximately £125 billion worth of debt) face a tough environment in which to do so as in most cases there is nowhere to go other than the existing syndicate. Typical issues they will face in trying to negotiate an extension include significantly higher interest rates, higher upfront fees plus, particularly where leverage is high or the property has underperformed, the risk of significant or total equity dilution unless new funding is injected by the shareholders.
Gareth Davies concludes, "Whilst in the 1990s banks took possession and sold assets when investments hit difficulties, past experience shows this is not always the optimal strategy. Selling property into a distressed market causes a death spiral of falling prices and ever widening losses on the remaining portfolio. Quite often, however, banks do not want to cons