Who benefits from mortgage market volatility?

UK bridge lenders are able to show their strength in periods of stress, maintains Steven Kelly of Whitehall Capital.

Steven Kelly

It’s a truism to say that when public credit markets experience volatility, commercial conditions improve for alternative lenders – as bank risk appetite reduces, private debt investors fill the gap and capitalise on improved pricing power. This dynamic is particularly evident in UK real estate bridge lending. The industry has grown dramatically over the past 10 years as slow mortgage underwriting increasingly offers a source of senior secured positions with equity-like returns. But the sector always performs best in an environment of broader market stress, as tighter financing conditions divert high-quality dealflow from traditional lenders to alternative credit.

In October 2022, following fiscal policy errors by the UK government, several buy-to-let mortgage providers pulled their products entirely as the market repriced to a higher risk-free rate. This event, and the resulting application backlog, has created a sizeable opportunity for private debt investors to capture enhanced risk-adjusted returns.

So how does the UK bridge lending market work? Property investors need capital quickly to fund opportunistic acquisitions, and they’re happy to pay high interest rates in order to secure their investment. Bridge lenders offer terms ranging between three and 24 months, and senior pricing in normal times is around 12 percent annualised. Loan-to-value ratios are set comfortably inside the value of the property (around 70 percent) to absorb any deterioration in pricing that would hinder refinancing.

Unregulated products, whereby the property being financed is not the borrower’s main residence, make up the majority of the market. For these kinds of transactions, England and Wales is among the best jurisdictions in the world to take security, as enforcement and sale of the collateral can be completed in as little as four weeks (with longer timescales in Scotland).

The usual protections expected of senior debt are available, with personal and corporate guarantees and debentures being commonplace, with very little covenant-lite lending. While a vanilla bridge financing deal doesn’t usually involve construction or development costs, bridge lenders often offer separate development loans to fund renovations. But supply-chain issues are now a material risk due to the increased costs of materials and labour, as well as delayed construction. As a result, appetite for development risk is reducing across the industry.

For the residential market, the downside is limited by the key fundamental characteristic of the UK housing market – constrained supply. In the 2008 financial crisis, prices fell by only 15 percent, which is modest considering that bank underwriting appetite effectively vanished (and the alternative credit space was less developed than it is today). In comparably financialised economies, price deterioration was much more severe (20 percent in the US and 50 percent in Ireland).

Post-crisis, UK banks are extremely well capitalised and so there is not yet reason to expect the same conditions to materialise. There have been several more volatile events since the GFC (most notably the period surrounding covid-19), but overall market activity recovered strongly following each of these and lenders did not experience lagged losses relative to public markets. In fact, many bridge lenders recorded their best performance during these quarters.

According to the UBS Global Real Estate Bubble Index, UK cities are not yet in bubble territory. Prices in Paris, Amsterdam and Frankfurt are more overvalued than the UK, which implies relative stability of collateral. Still, there are some areas of the UK real estate market that bear material risks.

Liquidity is often the primary risk to consider in terms of collateral quality – in the residential market, it is unlikely a lender would fund 70 percent LTV on a large country house or a central London mansion apartment. In the commercial property market, prices are generally falling due to reduced tenant demand, which is reflected in yields that are often close to or sometimes even below the risk-free rate. Additionally, many commercial landlords have rent arrears from the covid lockdown period which reduces the credit quality of borrowers. As a result, most lenders have significantly less appetite for commercial real estate, if they participate at all.

Meanwhile, the risks in the residential market are much more manageable – while landlords are facing rising buy-to-let mortgage rates, they have so far been able to pass on increased costs to tenants with rental prices increasing as vacancies continue to fall.

Despite mortgage market volatility (and also because of it), UK residential bridge lending remains an attractive flight-to-quality due to high returns and a very manageable downside. Increased capital flows are pouring into the sector, particularly from US and European credit funds, which is a sign of its maturation. Several alternative lenders have entered the space in recent years, with many using debt-funding models in order to offer cheaper loans and thereby capture market share. But margin compression is inevitable for these lenders in an environment of rising wholesale rates, and their relationships with funders will undoubtedly be tested as broader credit conditions deteriorate.

So how can investors participate? Deal-by-deal financing via family offices is an option, which usually allows influence over each transaction structure, but the work involved limits scalability. At Whitehall Capital, investors have earned 10 percent p.a. net of fees with quarterly liquidity and extremely low volatility of returns. This is equity-funded and so not directly affected by rising rates. So far, bridge lending has proven to be an attractive alternative credit allocation, and through whichever channel investors gain exposure, they should target double-digit returns and select managers that have performed through the cycle.

Steven Kelly is a vice-president at fund manager Whitehall Capital in London