Lenders are generally happy to tolerate LTV breaches as long as interest payments are being serviced. But refinancing negotiations are turning out to be far from uniform or straightforward. Lynn Strongin Dodds reports

As the financial crisis continues to wreak havoc, it is no surprise there is a rising number of loan-to-value (LTV) ratio covenant breaches. What is reassuring for property investors, perhaps, is that banks are adopting a more measured tone in developing solutions. The restraint is welcome in the already fragile property markets, but a tougher stance might be required if conditions deteriorate further.

As David Skinner, director of real estate strategy and research at Aviva Investors, puts it: "To date, banks have shown a great degree of tolerance, although there have been isolated cases where they have pulled the plug. Typically, there are two loan covenants that borrowers must meet - the LTV ratio and the interest cover ratio - and while to date we have seen many breaches of LTVs in the market, interest continues to be covered by rental income in the vast majority of cases."

He adds: "It is this latter covenant that is key for banks. Although the outlook on the economy is poor and there could be an increase in tenant failure over the next 12 months, many borrowers still have quite a bit of fat in rental income received relative to their interest payment obligations."

Timo Tschammler, managing director of international investment at property adviser DTZ, adds: "Although LTVs may be breached, banks do not often, as we expect, take control of the underlying properties. It is not in the bank's interest to put struggling clients into further financial difficulty and it is more important to cooperate and maintain established client relationships.

"They are instead focusing on the underlying quality of the property and the occupier fundamentals rather than falling values. Banks are looking at the ability of the owner to meet the interest rate and amortisation payments. If they do not have the cash flow, then it will impact a bank's flexibility."

Mark Creamer, head of CB Richard Ellis' loan and corporate recovery service, echoes these sentiments. "The big issue rolling forward is what happens if occupational tenants are not able to pay their rents and hence not able to cover the interest," he says. "The banks then may have to call in their loans. However, they are not keen to let that happen and would rather renegotiate if they can."

Investors were not fully aware of the severity of the problem until last summer when Dawnaday, the UK-based property investment group and Martinsa-Fadesa, one of Spain's biggest developers, went into administration. More recently, UK-based Songbird Estates, which owns 61% of Canary Wharf Group, warned there was a "material risk" that it would breach its key debt agreement in the next 12 months after the value of its properties slid from £6.7bn (€7.54bn) to £4.9bn last year. The firm has hired investment bank Rothschild to oversee the refinancing of its £880m loan with Citigroup that is due in May 2010.

In addition, Summit Germany, which invests in German commercial real estate, announced it was in breach of its LTV covenant of 85% on a €96m debt facility. The company said it approached the lender for talks and believes a "suitable outcome can be achieved".

"Until one or two years ago, neither investors nor lenders - especially in the US and the UK - were concerned about LTV ratios, as falling values in commercial property were unheard of," Tschammler comments. "An LTV ratio of 100% was not unusual in the markets. Even banks and managers were relying on the rising prices, which is one of the original reasons why we are currently in this deep economic crisis. No one expected values to fall."

The general consensus is that deals burdened with LTVs of over 70% are probably now heading for default. The US, as well as Spain and the UK, have been the hardest hit, while the rest of continental Europe is unlikely to suffer as much. This is a result of the conservative banking lending practices in many countries. For example, Tschammler points out that several European financial institutions enforced a maximum LTV ratio of 66% for the financing of property, while German open-ended public funds were not allowed to exceed LTV ratios of 50%. This is in sharp contrast to the UK, which over the past two years had seen some firms reach 100% LTV, with the average LTV being 80%.

Figures from De Montfort University's latest bi-annual survey on the UK commercial property lending market reveal that over £76bn of the total commercial property debt (almost £208bn), will have to be refinanced before the end of 2010. In total, the report says an estimated £600m of loans defaulted during the first six months of 2008. This represented about 3.3 % of the total loan book by the end of June (almost £7bn when applied to total debt) and more than treble that reported at the end of 2007. The most common reasons cited for default was tenant failure and the inability to re-let the units.

Breaking it down further, the study reported that the number of organisations holding loans in breach of financial covenant in the UK almost doubled by mid-year 2008 to 78%, from 45% at the end of 2007. Roughly 43% put loans into administration, up from 33% during the whole of 2007.

"At the moment, there are several refinancing and renegotiation discussions taking place where LTV covenants have been breached," says Mike Clarke, head of property distribution at Schroders. "We are not, though, seeing a significant increase in foreclosures. The techniques will vary depending on whether the institution is dealing with a single bank or a syndicate, such as in a commercial mortgage-backed securities (CMBS) transaction. Banks can be more flexible and less formal if it involves a one-on-one relationship, but it does become more difficult when there are several parties, such as bondholders, involved."

Van Stults, founding partner of property investor Orion Capital, agrees, adding that "banks are looking at different options to reduce the debt and take the pressure off LTVs breaching their covenants". He says: "Part of the problem today is the size of the problem, and the banks are trying not to create an even larger one. However, they will charge more money, and we have seen margins increase to 250-300 basis points from 100 a couple of years ago."

Banks are also becoming more selective about who they do business with and, as in any time of crisis, the relationship suddenly comes to the fore. As Mark Evans, senior director, real estate finance  at CB Richard Ellis, notes: "Banks are now assessing their borrowers and who they want a relationship with. It is not in their interest to end up with a large chunk of property on their balance sheet, although some will be willing to take the assets on and wait for the market recovery."

In terms of the solutions being developed, there are different scenarios being played out on the renegotiating table. These range from injecting more equity into a deal, to debt for equity swaps, or striking a similar deal to the one seen in the Dawnay Day case, according to Creamer.

In March, Dawnay Day sold its portfolio of 221 properties to F&C REIT Asset Management and AREA Property Partners (formerly Apollo Real Estate Advisors) for over £600m in one of the biggest property deals since the credit crisis began. Norwich Union, Dawnay Day's main creditor, is continuing to provide between £500m and £550m of debt to F&C REIT through a new loan agreement with an LTV of less than 80%.

Market participants expect that this could be the first of many deals where lenders, trying to avoid large-scale property losses on portfolios owned by insolvent companies, provide debt to the purchasers for large transactions.

Metrovacesa, Spain's third largest property group and one of the most highly leveraged, on the other hand, took the debt-to-equity-swap route. The majority family-owned firm had breached conditions of a syndicated loan of €2.8bn, but the banks were keen to avoid a replay of Martinsa-Fadesa, which went into administration last summer. In what has been described as one of the most complex debt restructurings since Spain's last recession in the early 1990s, six of the country's biggest banks exchanged the €2.8bn syndicated loan for a near 54.8 % stake in Metrovacesa.

The terms also included a cash payment to cover the shortfall between the loan value and the stake's perceived market value of €57 per share. This was also the price paid to a group of institutional shareholders - mainly savings banks - for their 10.77% stake. Amid all this, the company also sold the HSBC Tower in London, for which it had paid a record £1.1bn in the summer of 2007, back to the bank at a loss. It was unable to pay off a bridging loan on the original purchase.

While the Metrovacesa deal was complicated, market participants believe that restructuring CMBS transactions, which helped fuel the property market in many countries, will prove even more challenging. The Four Seasons Healthcare, the care home operator that breached covenants on its £1.5bn debt last June, is a case in point.

Three years ago, £600m of bonds were issued as part of the CMBS programme, originated by Credit Suisse, called Titan Europe. It was included in the £1.5bn debt package arranged for the buyout of Four Seasons by Three Delta, a Qatari-backed fund.

Restructuring has not been an easy task as the transaction has more than 10 tranches, with investors holding positions in different parts of the capital structure. The healthcare group is looking to sell its business, while its creditors, which include Royal Bank of Scotland, Marathon Asset Management, Cheyne Capital and Morgan Stanley, have been trying to agree terms for a debt-for-equity swap. This would hand ownership over to them and reduce the debt to £1bn, rather than a sale, which would crystallise losses on their debt claims. The parties have been in discussions since last summer when it became apparent the firm would not be able to meet the repayments on part of its debt. In the meantime, the creditors have agreed to a ‘standstill arrangement', whereby they will not enforce their debt claims (until May) while talks continue.

Uncertainty also hangs over the REC Plantation Place deal. The £435m single-property CMBS, which was put together by NM Rothschild, was the first to breach its LTV covenants in early 2008. Late last year, the consortium of borrowers put forward a proposal to redeem a portion of the loan and remove the LTV covenant, but bondholders could not agree. This is because holders of the £300m senior class are receiving a mere 23bp margin over LIBOR and would rather be repaid in full upon enforcement. Junior bondholders led by Fortress, however, face being wiped out and would rather sit out the property downturn while they are still receiving interest. Formal restructuring proposals can be blocked by 25% of the senior note holders. Informal discussions are currently taking place.

Whatever the outcome of these two deals, many more are tottering on the precipice.
Research from Barclays Capital shows three-quarters of European CMBS deals they monitor (80 CMBS transactions, representing 60% of the market) are either in default, have breached lending terms, or have other "credit issues". Last year, credit rating agency Fitch said that 35 of the 67 CMBS issues it covers (263 loans worth £32.8bn) could be at risk of default if the downturn is as bad as that in the early 1990s.

Despite the relative gloom, Tony Edgley, head of corporate finance at Jones LaSalle Lang, says: "There are reasons to be cheerful. We are in a low interest rate environment and all pricing of fixed assets is coming off a very low base. The Asset Protection Scheme also probably draws a dotted line for the bottom of the market and banks will be encouraged to fix their problem loans rather than sell them."