What is the ‘refinancing gap’?
There are two main factors which have contributed to what is now known as the ‘refinancing gap’ in the UK and mainland Europe. The first is the collapse in commercial property valuations since 2019, becoming more evident in the second half of 2022 – this has led to higher loan to value ratios. The second is the increase in interest rates – the Bank of England has, in a bid to combat inflation, raised the interest rates in the United Kingdom in August to 5.25% and is now at its highest level since February 2008. The higher interest rates will now mean that a higher portion of rental income will need to be allocated to servicing interest payments.
The two main contributing factors mentioned above have created an ever-widening gap between the lending the commercial real estate sector needs to refinance debt coming due and the amount that lenders will be willing and able to refinance. It has been reported that around 45% of the outstanding commercial real estate loans in the UK are expected to mature in the next two years, rising to around 75% by 2026 (figures taken from Bayes CRE Lending Report MY 2022 (Oct 2022)), and some experts in the market estimate that the commercial real estate sector across Britain, France and Germany will face a debt funding gap of €51bn during 2023-2025, with one in five loans expected to face refinancing challenges.
Following the last global financial crisis in 2008 (“GFC”), there are also concerns that lenders are likely to be more risk averse in 2023 – this may be reflected in debt that is either higher cost, lower leverage, shorter term or a combination of the three and is expected to mean a more restricted supply of debt generally.
All of these factors mean that the market now faces a refinancing gap, which presents both challenges and opportunities for lenders and borrowers.
What are the challenges facing lenders in the current market?
It is likely that traditional bank lenders will remain restricted in the short-term in adapting to the ‘refinancing gap’ as it may take some time to evaluate risks across portfolios and assess the ever-changing market. Where possible, current lenders will need to work together with borrowers to reach suitable LTV and ICR levels for both parties.
However, the UK debt market is now more diverse than it was during the last financial crisis with more direct investors and debt funds playing active roles – there is therefore a degree of confidence that the debt markets are better structured, with a healthier variety of debt providers, to deal with the current refinancing gap. We expect to see alternative lenders taking advantage of the opportunities here and stepping in to bridge the gap. Alternative lenders who have traditionally focussed on the higher risk, higher return sector (e.g. mezzanine debt) are now moving into the senior lending space, which can now provide high rates of interest closer to what such lenders are used to and provide high returns at lower loan to value levels. It will be interesting to see whether this will in turn exacerbate the refinancing gap at the higher risk end of the capital stack.
What are the issues for borrowers in getting such loans refinanced?
Due to the increase in interest rates, debt is now significantly more expensive than it was in 2018/19 when a substantial amount of the current loans coming up for refinance in 2023/24 were originated. Certain well positioned borrowers will opt instead to refinance by way of contributing fresh equity. However, this will not be an option for the majority of borrowers who will instead require debt financing from the market. Borrowers who are not able to refinance with a traditional bank lender, due to the issues highlighted above, may therefore be turning to non-bank alternative lenders to meet their debt requirements. As noted above, with many alternative lenders now looking at assets and financing that would not have previously been part of their strategy, borrowers may find that whilst there is debt available to meet their refinancing requirements, this comes at a much higher pricing level than they are accustomed to.
We have also seen lenders and borrowers entering into extensions of existing debt facilities, with some borrowers preferring this approach in the expectation that interest rates will have fallen by the time their facilities mature. As a condition of such extensions, some lenders are requiring additional credit support such as money being placed on deposit or injections of further sponsor equity.
Conclusion
Whilst there will inevitably be some market turbulence caused by the refinancing gap, the commercial real estate sector is far better placed to weather this than it was at the time of the GFC. Lending has typically been at lower LTVs over the last few years than it was just prior to the GFC. In addition, traditional bank lenders are now subject to far greater regulation meaning that their balance sheets are much healthier than at the time of the GFC. The lending sector is therefore in a far better position to deal with any impending crisis. We will be watching the market with interest over the next few months to see how alternative lenders continue to take advantage of the opportunities here and the role they play in addressing the refinancing problem, as well as the approaches that borrowers take to deal with the challenges they face.
This article was written by banking and finance associate Stephanie Lynch.