As debt gets harder to come by and managers face the prospect of refinancing their loans, a multitude of factors may come into play - not least the state of your current banking relationship. Christine Senior reports
One indisputable fact about the real estate industry is that for the foreseeable future debt will be reduced. Loan finance will be harder to come by and more expensive, and lenders will impose stricter lending criteria on borrowers.
INREV's survey published in August highlighted industry views that in future debt would play a less important role in providing finance for real estate funds. Over the coming two years a majority - 88% of investors, 82% of fund of funds managers and 64% of fund managers - expect less reliance on debt. Investors are expected to seek funds with lower levels of debt than before the downturn.
Funds set up in the boom times of 2006-07 will be faced with having to renegotiate their loans from 2011 to 2013. But some of these renegotiations might have been brought forward if the fund has been hit by breaches of interest payment cover. The economic climate has suffered a sea change since the market peak and banks will inevitably want to impose much more stringent conditions on borrowers. Amounts advanced will be restricted to lower loan to value ratios, and higher fees and margins will also be part of the deal. Funds have suffered plummeting asset values, tenant bankruptcies, voids and downward pressure on rents, reducing their cash flows and hence their ability to service their loans.
Some managers are getting in shape now, ready to face the changed circumstances when they will need to refinance.
"It's fair to say some investment managers are still seeking to sell assets with a view to repaying part of the loan, reducing the principal that needs to be refinanced and thereby reducing refinancing risk," says David Skinner, investment strategy and research director at Aviva Investors. "Much of this risk is concentrated around 2011, 2012, or 2013, when a significant volume of current loans outstanding expire."
Many borrowers are being proactive in approaching banks well in advance of any refinancing date in order to work through any problems. Relationships count in this environment, and borrowers with long-standing and strong relationships with banks are better placed to get favourable treatment. A bank's view of the skills of the fund managers, its confidence in the management team's ability to deliver the fund's strategy and the quality of assets held all come into play when loans are up for renegotiation.
"For example, a bank's relationship with a borrower may well be bigger than just for real estate," says Skinner. "A lending bank's decision on whether to support a refinancing will certainly be based on quality of the management team and its ability to deliver on the strategy but it may be influenced by the wider corporate relationship which may go well beyond a particular fund or even beyond the real estate business."
The importance of established banking relationships is something that came out of INREV's survey, says Andrea Carpenter, INREV's director of research and market information.
"In our debt study what came through was the value of relationship banking, having a good track record in the relationship with your bank. If you want the loan as part of a wider strategy for the fund and you have a good relationship, the bank will understand that."
Also likely to count in a borrower's favour is keeping lines of communication open so the bank is up to speed with plans and potential difficulties. Maintaining a dialogue between bank and borrower, keeping the lender in touch with any issues arising goes some way to smoothing the way for further borrowing. Bankers in the INREV survey wanted investors to be more proactive in approaching them to deal with anticipated problems.
Cordea Savills' Italian business has acted early to secure its lending when its current loan matures in 2011. David Cunnington, executive director of finance, is involved in extending a bank loan to refinance an Italian mixed real estate fund. Under the terms of the agreement, the firm is making a repayment of €15m on the €70m principal of the loan. The cash will come from different sources, including from fresh equity. The bank asked for a 50% increase on the margin, which Cunnington considers reasonable in today's market. Cunnington says he is being cautious in renegotiating the loan early.
"I would much rather have certainty I don't have to repay that loan in 2011, then it gives my investors the opportunity to use their equity to make investments in this market," he says. "We think the market is attractive. In Italy we are starting to see good pricing. And pricing can deteriorate quickly."
Another development is that cross-border lending appears to be drying up, with banks preferring to lend in their domestic market. Some banks, especially those with significant taxpayer support, are feeling government pressure to lend domestically, and to focus more on lending to small business.
"There seems to be less cross-border lending," says Carpenter. "Borrowers are more likely to be restricted to banks in the country of the asset."
But some of the debt advanced in the good times presents more difficulties to refinance than a straightforward bank loan on a one-to-one basis. Many loans, especially for bigger projects, were split among a bank syndicate, so a refinancing means juggling the various interests of the lenders, first through negotiations with the lead bank, but potentially with individual members of the syndicate.
"If your lead bank isn't particularly helpful but others in the syndicate are more willing to consider a better solution, then borrowers can start having one-to-one discussions with other members of the syndicate," says Robin Hubbard, executive director of the real estate finance team at CB Richard Ellis. "Talking to the syndicate they will know which banks wish to refinance, so it might be easier to approach two or three of those that are willing to talk on the whole loan and refinance the others out. This has been challenging, though, as most banks are reluctant to refinance their peers, especially where the borrower may be in breach of covenants or not able to meet the current ‘market' terms."
Reduced loan to value (LTV) ratios mean fund managers face a gap in funding between what the bank is willing to advance now compared with the previous loan. Other forms of borrowing could fill the breach but this is likely to be expensive.
"Typically in a refinancing situation in an asset by asset level the fund manager would talk to the existing lender first or potentially other lenders," says Ville Raitio, investment manager at ATP Real Estate. "But if it proved to be difficult they would go for higher return seeking capital sources, which is expensive."
Failing this, fund managers start to involve the investors, asking for further injections of equity capital to solve the problem. A major consideration is how any rights issue is managed, so that terms suit all investors whether or not they choose to participate. Some may not wish or be able to pour in more money, though if all investors take part no one's shareholding is particularly diluted. Setting terms and setting the right price is tricky.
"Investors would require an independent third party to come in and say ‘this is what these assets are worth at this point in time'," says Hubbard. "If there is secondary trading it tends to be at a level below the manager's quoted NAV due to the lack of liquidity and transparency in the market. A manager will get a view from external auditors every three or six months. Unfortunately somebody has to come in and put a real-time value on the underlying assets."
This is where advisers like PwC can come in with an independent view and the expertise to navigate the difficult task of pleasing all parties.
"A key role we have played is in setting the appropriate price at which to raise the equity, so that it is fair to investors willing to put more money in and fair to those who aren't," says Simon Boadle, corporate finance partner at PwC. "The pricing is set at a level so investors who are writing cheques get a fair return whilst not unfairly diluting those who can't or won't invest."
If offers to put more money into the vehicle are not forthcoming from existing investors, a more drastic option is to involve new partners. In a closed-end vehicle existing investors have to agree to any injection of new equity, which they are not likely to view favourably. New investors have the clout to demand more attractive terms, which puts existing investors at a disadvantage. But it could be a make or break situation.
"If the alternative is losing what they have already, existing investors may agree to a new investor coming in. In practice, the existing investors may come up with the money when faced with this, but both situations have occurred," says John Forbes, real estate industry leader at PwC.
A more dramatic change may involve a restructuring of the fund using different instruments to the existing fund.
"The simplest way is for investors to come into ordinary units on the same basis as existing unit holders," says Boadle. "Other instruments can be used - convertible preference shares or convertible loan notes. In a situation where the fund was for sale or on a winding up it would give those investors priority of capital return against other unit holders. There are various forms of fund raising that can achieve slightly different structuring."
New injections of cash are opportunities for new terms to be agreed between limited partners and managers. On the manager's side there may be a desire to rebase the fee based on what appear to be more achievable targets, since the assets have fallen in value and the original target now looks unrealistic. With 40% drops in value in the UK market prospects for managers to get their carry are reduced.
"New investors want to put the minimum amount of equity in to keep the banks happy and enable the asset manager to create more value," says Hubbard. "If a general partner thinks he's going to work his magic but not make much money, he's not going to be particularly motivated. It means adjusting the terms under which the general partner is remunerated so he is incentivised to do a good job."
Raitio says he has seen little evidence of fund managers approaching investors to top up their investments in unlisted funds. But the company's property investment managers have not in most cases faced difficulties refinancing loans due for renewal. This may be because of the specific circumstances of the value added portfolios the managers are running. Three or four years ago managers might have bought an empty building, which they have since been working on, improving and adding value, so now it is producing income.
"The managers have created more value, and if you look at the LTV ratio for the type of asset it is not as bad as you might think because of the additional income that has been added," says Raitio. "So in those cases the loan amount can be the same as before, as managers have been able to maintain the value of the asset and have therefore been more successful in refinancing this type of assets."
If ATP were approached for more capital injections by its investment managers, these would to be treated as a new investment. Raitio says: "If managers were to ask for additional equity we would always look at it as a new investment, which has to make sense on its own and compete with the other investment opportunities we see in today's market."
It is certain that the conditions for refinancing have improved over the past few months, driven by a few months of rising valuations. Drops of 40% from peak to trough in the property markets, and the subsequent rise in transactions, give some confidence that valuations will continue to rise over the next few months. Bankers, feeling that the downside risk to their business has reduced, are able to participate in a more profitable lending business through higher margin charges than for the past two years.
"The experience of the past few months suggests the availability of credit will continue to ease unless we have a major setback in financial market and confidence is reduced again," says Skinner. "But I wouldn't expect the volume of lending to return to the levels of the 2003-06 period."