Late stage, but few red flags

The benign credit cycle appears to have almost run its course, but there are few signs of structural concerns. Martin Wheeler and David Mortimer of ICG Longbow examine some of the market’s key characteristics.

Where are we in the credit cycle? What evidence is there?

MW: At ICG-Longbow, we think that where we are in the property cycle is of greater relevance to commercial real estate debt risks than the position in the credit cycle. That said, in the lead-up to the peak of the market in 2007, the property and CRE credit cycle were moving in tandem, as each was fuelling the other. This time around both property and credit markets are nine years into their cycles, but we are seeing more differentiated performance caused by the weight of equity driving the property cycle but with banking regulation having a braking influencing on the CRE credit cycle.

DM: Lenders have not generally been chasing asset growth and as a result, CRE debt as a percentage of UK banks’ total loan books has fallen year-on-year from 12 percent in 2009 to 6.8 percent today.

Martin Wheeler, ICG-Longbow

The recent Cass report [formerly De Montfort] showed there has been almost no recent growth in CRE debt books with total debt outstanding of around £165 billion since 2014,  whereas exposures grew by nearly 50 percent between 2005 and 2008. Also, terms are holding up, with LTVs coming down since 2016 and no real signs of the ‘covenant- lite’ structures that are creeping into corporate deals.  Finally, we continue to see pricing discipline – lending margins on our senior debt programme have been broadly consistent for the past four years now.

MW: Where we are seeing some later cycle behaviour is on trophy assets or “mega-portfolios”, with lenders from across the globe competing aggressively on pricing for both senior and mezzanine. In a similar way, we are seeing a greater range of listed borrowers gaining access to unsecured financing or private placements, which would have been restricted to top tier names until recently.

How fully valued is the property market? What are the historical precedents?

MW: When thinking about property values, we start with the health of the occupational market, which overall is in not a bad place with record employment following a number of years of strong growth which has created the all important demand for real estate. When coupled with levels of new construction activity in pretty much all markets other than central London offices and the lower levels of debt in the market overall, this has left most property owners well placed to weather any bumps in the road ahead. But it would be very easy to be complacent and miss the potential danger zones of fully rented London offices and a weak retail sector.

DM: From a capital values perspective, the MSCI UK All Property Index is still about 20 percent below where it was in 2007. The index has risen about 45 percent since its trough in 2009, compared to over 90 percent in the six years between 2001 and 2007.  We also track UK property initial yield versus 10-year redemption yield and  that’s been about 3.5-4 percent since 2012 and that’s roughly double the long-run average. This shows there is room for upward movement in interest rates without property yield pulling the market down.

MW: There is a general consensus that rental and capital value growth will be flat over the next few years on average, but this masks some real polarisation between different parts of the market.  Some sectors, notably London offices, are at record values but on the other hand many regional markets still offer value. It’s important to be close to the market and base your decisions on property fundamentals as well as consideration of the macro environment.

Given the stage of the cycle, which types of investment make most sense, especially in higher returning strategies?

MW: We have three strategies – our Senior Debt Programme which aims to create investment grade loans; a residential development fund to finance the construction of new apartments for sale; and our higher yield whole loan focused Partnership Capital funds. Across each of these strategies, the deeper you get into the cycle, the more important your investment selection becomes as the market won’t bail you out for poor decisions that you make now. So it’s more important than ever to stick to our core investment philosophy of investing on property level fundamentals – essentially will the property attract tenants and will there be liquidity on exit in good markets and bad? – and to lend to borrowers with a proven track record through the cycle.

David Mortimer, ICG-Longbow

DM: Across all of our strategies we are looking to minimise risk by seeking diversification of the tenant income underpinning each loan,  coupled with property and sponsors that can deliver improvements to cashflow and value outside of market cycles.

MW: In the higher yielding strategies this could come from refurbishment and capital expenditure, the planning process or just more hands-on management.  Experience through the cycles has shown us that these value-add initiatives reduce risk as they increase the value of the security and reduce the lender’s exposure to the market.

What factors do you need to consider when investing in senior debt in this kind of environment?

DM:  Ensuring preservation of our investors’ capital is key. As well as underwriting the income, you need to know what the exit looks like – who will be the next buyer of the asset?  Will it be financeable?  That’s why we like diverse income with tenants coming and going, there is generally more stability than on a single-let building with a wasting lease. In our senior debt programme we have put this philosophy into practice – we have invested around £1 billion over the last four years, with security over around 500 properties leased to over 2,000 tenants.  Also, it’s important to maximise the controls available to the lender – you want to be able to take early action in the event of trouble. For that reason, we don’t syndicate loans and we don’t allow junior debt behind us in the structure.

MW: In downturns we have seen a number of syndicates where an asset is in distress and you get divergent opinions from syndicate members, leading to huge inertia and the controls available to lenders are rarely used. If there is only one lender, it can use all the controls to protect its position.

What are the current priorities for ICG Longbow?

MW: The current priority is to invest the capital under management while sticking to the  fundamentals. When we get to the end of a fund we rely on the quality of those investments acting as the shop window for the next fund. We just have to make sure we don’t miss good opportunities as a result of being overly cautious. For example, in retail there are still some good opportunities in some sub-sectors and you can’t afford to be intellectually lazy and call everything off limits.

How do you see the real estate debt market panning out over the next year or two?

MW: There is a growing trend already seen in direct lending where bigger and bigger funds are being raised and investor capital is being concentrated in the hands of fewer managers. There will be a consolidation of managers and there will also be a hunt for new niche strategies. Banks will continue to mark time but we also think insurers will play a bigger role. More of them will invest themselves while others will invest alongside managers in segregated accounts. Potentially the most sophisticated will run a mix of an internal platform supplemented by backing more targeted strategies through external managers.

Martin Wheeler is a managing director and co-head and David Mortimer is head of senior debt, real estate at ICG Longbow, the London-based real estate debt manager

This article is sponsored by ICG Longbow