With all the uncertainty that the world is currently facing, questions have been raised about potential distress in the debt market, particularly when it comes to commercial real estate lending.
However, the outlook for borrowers across Europe is not quite as bleak as some believe – while there is no guarantee that the debt market will be distress-free, it is much more resilient than during the Global Financial Crisis, and conditions are ripe for a period of sustainable innovation.
Debt market resiliency
Before the onset of the GFC, the loan market was largely dominated by retail banks which accounted for around 60 percent of new loan originations.
By contrast, retail banks accounted for only 43 percent of new loan originations in the first half of 2020. This is followed by international lenders and non-bank lenders, which, as a lender type, didn’t even exist in this context in 2007.
In addition to the wider range of lenders in the market today, leverage is at historic lows. Prior to the GFC, senior lenders provided loans at around 80 percent loan to value. Conversely, in 2020, the average loan to value for commercial real estate was closer to 55 percent.
With this in mind, a repeat of the GFC is doubtful. The combination of low leverage and a wider range of debt providers has created a more resilient debt landscape which has the ability to weather the current storm.
Polarised reaction from lenders
Although there are reasons to be optimistic, the debt market will not be distress-free, with lender appetite increasingly polarised. At one end, debt finance is readily available for both the logistics and residential sectors and this abundance of supply has ensured that debt pricing has been maintained at very competitive levels.
At the opposite end of the spectrum, lender appetite for retail and hospitality assets has contracted. Despite assertions that this is a short-term dip, we have already started to see transactions which have in part been instigated due to the high levels of debt secured against hospitality portfolios. Another potential indicator of distress is the amount of bad debts lenders are beginning to provide for.
Lenders across Europe have increased loan loss provisions in Q1 and Q2 of 2020, and while changes in the way that UK banks have to provision for loan losses will have driven an increase in bad debt provisions, the underlying numbers are still far higher than in 2019.
Lenders began to deal with an influx of covenant waiver requests as the effects of covid were felt across Europe in Q1 2020. At this stage, lenders were encouraged to demonstrate forbearance to help maintain financial stability, with covenant testing holidays granted for up to 12 months in some cases.
Taking these factors into consideration, we are predicting that from March this year we will begin to see increased activity being driven by lenders looking for borrowers to restructure and recapitalise their facilities.
Uncertainty accelerates positive change
Despite the possibility of increased distress for the debt market, uncertainty has the added benefit of accelerating change, forcing the sector to think differently.
The recent development of the “sustainability linked loan” – one which includes a downward margin adjustment if the borrower achieves specific sustainability or ESG linked targets – will certainly be one to watch.
With Europe’s ageing and energy-inefficient building stock responsible for approximately 40 percent of energy consumption and 36 percent of C02 emissions in the EU, reductions will need to be achieved to help meet net zero 2050 climate targets.
Despite this, Europe continues to lead the way in sustainable finance, with borrowers accounting for 63 percent of overall sustainable lending in the first of 2020. It is becoming increasingly important for tenants to occupy sustainable buildings and similarly, it is equally crucial for lenders to provide tailored financing solutions to fund those same sustainable buildings – therefore, this area of the market is expected to continue to grow.
Last year was filled with unexpected events, and while there is still some way to go before we fully understand what the new normal will look like, debt providers across Europe have demonstrated resilience as well as a growing consideration for the impact that they have on the environment. While troubled times may still lie ahead, there is much reason for optimism over the coming year – at least where the European debt market is concerned.
Lisa Attenborough is head of debt advisory at Knight Frank.