Australia | Sep 18 2020
Download related file: Monthly_LIC_Report_September_2020_FINAL
A Listed Investment Company (LIC) is a listed investment vehicle that offers investors access to a diversified portfolio of shares in other companies also listed on the stock market.
Note: For comprehensive comparative data tables for LICs and ETFs please see attached. The story below is part of IIR's monthly update on Listed Managed Investments (LMIs) on the ASX which in its entirety is attached to this story.
Analyst Rodney Lay puts ASX-listed commercial real estate (CRE) private lending providers under scrutiny
Australian CRE Private Lending – State of Play
This is a lengthy thought piece but given the dislocation created by Covid-19 it is important that every identified material risk and opportunity for non-ADI alternative private debt lenders is given due discussion so that investors can make informed investment decisions.
With the possible exception of the industrial property sub-segment, no segment will be left unscathed by the ructions caused by Covid-19. But this does not mean there are not opportunities for astute, through cycle experienced and well-resourced private debt investment managers.
The larger alternative private debt managers that have focused on quality assets with non-cyclical cash flows, lent to strong asset-backed landlords and developers, and lent on conservative LVRs will do well. The market has already seen an increase in the interest rate premium for the same level of risk. Private lenders will undoubtedly gain market share with the further retreat of banks and foreign lenders to their respective home markets.
The key conclusion is risks and opportunities abound, but investment manager selection is key. As Warren Buffet famously said: “It’s only when the tide goes out that you learn who’s been swimming naked.”
In the current environment we believe there are a number of key qualities a manager must have to avoid the risks and capitalise on the opportunity set. In turn, for investors this relates to manager selection. IIR believes the important components are as follows:
1) track record of performance;
2) risk management capability and evidence of historical workout / corporate restructuring experience;
3) relationship management and borrower origination track record;
4) risk management / distribution and exit skills;
5) investor appropriate fund terms (risk, returns and liquidity), fees and costs of the investment product, scale and credit risk diversification;
6) size of team and breadth of market coverage; and,
7) investment in IT and portfolio risk management functions.
Investors are also seeking the manager to originate transactions and negotiate the appropriate fees and lending margins i.e., direct borrower relationships versus passive buy side bank ‘stuffee’. Therefore, if a manager has a small origination team or is reliant upon other originators or brokers for deal flow then the returns available to investors will be inferior.
Metrics, for example, often says that it seeks to bring investors closer to the point of origination. The benefit? The lender who originates the transaction charges the borrower 300bps fee, for example, and then sells down the risk to a new lender. The originating lender keeps 250bps points of the fee and shares or pays away 50bps to the secondary lender to participate in the transaction. Therefore, if a private lender can not originate transactions it incurs lower returns.
Finally, IIR believes that private credit is one of the few asset classes where the skillset of the manager can actually demonstrate the managers capacity to ‘preserve investor capital’. That is, when a manager originate a transaction and negotiate the terms, conditions, controls, covenants and security the manager is taking active steps to mitigate downside risk of loss of investor capital. Therefore, appropriate due diligence is undertaken to assess the risk to ensure appropriate lending terms are documented.
Each economic downturn creates opportunities and challenges in the credit markets for private credit and special situation investors. During and in the wake of Covid-19, the opportunity arises from the fact that lending in Australia has historically been driven, to a large extent, by banks and, as borrowers’ revenues plunge, a significant number of them will have to look to private credit to refinance their existing amortising bank debt.
Furthermore, banks are currently under significant workload stress and are likely to be for the next few years, which is likely to lead to deteriorating service levels and prolonged debt issuance time frames for existing and potential new borrowers.
Additionally, Over the last 10-year bull market banks have shed and reduced their workout capability internally quite drastically as well – there is likely to be an inability from a resourcing and skills perspective to work through deteriorating credits, opening up further deal flow to non bank lenders in potentially heavily discounted credits. In short, the private credit market will have a real role to play in ensuring that there is still liquidity in the system for some of those borrowers.
The ability of private credit investors to deliver greater flexibility than typically seen with financings from banks, with bespoke solutions and the ability to be more responsive will be a huge differentiator.
The amount of defaulted debt in the market is likely to increase, providing opportunities for investors to make returns through a variety of strategies including loan-to-own, debt-for-equity swaps, negotiated distressed sales (no formal insolvency process), negotiated sales through a pre-packaged insolvency procedure and purchases out of an insolvency process. While these types of higher risk-return deals are not overly relevant to ((QRI)) and ((MXT)), it is relevant to the ((MOT)) and Metrics Credit Trust Strategy mandates.
Of course, the challenge stems from the exact same circumstances, namely, that the virus has had (and will continue to have for some time) a dramatic adverse impact on the creditworthiness and viability of some existing portfolio companies of private credit investors. Addressing this challenge requires private debt managers to be highly selective with respect to new investments and for existing holdings comprehensive review of each company’s situation in terms of its business performance, obligations under its financing agreements and options for moving forward.
While there are a host of economic risks stemming from the disruptions created by Covid-19 and these will ultimately impact the debt markets investors should be aware that from this dislocation event come a host of opportunities for well positioned private debt lenders in the Australian market.
IIR believes there are five key opportunities for astute private debt fund managers and, in turn, investors: Specifically:
1) an increased private debt premia;
2) more lender friendly loan structures;
3) increased deal flow/market share, and;
4) strong vintage year performance.
However, whether these opportunities can be realised in sum total across an entire loan book portfolio will be impacted by how a manager addresses what IIR sees as four key risks:
1) property sector exposures and long-term structural changes in certain sectors;
2) valuation risk;
3) liquidity, particularly payment holidays, covenant waivers and ability for borrowers to tip in additional equity; and,
4) defaults and recoveries.
Examining each of the opportunities noted above
Private Debt Premia
Private debt has always earned a premia and that premia has invariably been greater in Australian private debt versus the larger US and European market This premia consists of three key components:
1) a complexity premium;
2) a supply and demand impacted premium; and,
3) and illiquidity premium.
Often, these three factors are encapsulated in the overall term ‘illiquidity premium’ but in IIR’s view, that term gives too much weight to the illiquidity component and not enough weight to the two other factors.
In Australia, a key determinant of private debt pricing is ultimately the actions of the banks – i.e. supply and demand. That is, if the banks (domestic and foreign lenders) are chasing assets then competition will drive down the price. If there is a withdrawal of bank participant liquidity then the market price will go higher. That is what happens in LBO and property related lending markets – the bank withdraw and there is a funding gap so market prices go higher. This is also because Australia has a very immature debt capital market ie., most borrowers are unrated and therefore reliant on banks for finance.
Notwithstanding the growth of private alternative lenders, Australia remains a bank dominated market, as noted below, and pricing in the market is largely determined by the liquidity of the banks and their risk appetite, which compensates an investor for the added uncertainty of tying up capital for longer periods of time and the risk that the illiquid asset cannot be sold quickly enough (within a reasonable time period) to prevent or minimise a loss. In short, it is ‘market’ not ‘asset’ liquidity that will determine the price.
The complexity premium relates to the origination skillset of the manager. Deals with greater complexity are often less competed for as not all managers have comparable skillset in origination, loan management and workout skills. Adept, well-resourced managers may gain comfort with certain deals where less adept managers may not. Additionally, direct lends typically price at a premium over club or broadly syndicated loan deals (more relevant to the corporate lending market, however the same dynamics apply to CRE lending).
Examining the illiquidity risk premium in isolation, this is in part based on three sub-components:
1) it rests on a reliable estimate of expected return, which requires a significant amount of judgement;
2) expected cash rates and public debt risk premia (bond yields and/or bank loan pricing);
3) expected credit losses, which can arise due to defaults on the payments; and,
4) further risk aversion around credit risk. In addition to these expected credit losses, risk-averse investors will demand an extra premium to compensate for the uncertainty of those losses, and the lefttailed nature of credit as an asset class (lots of modest positive returns, but the potential for large negative returns).
In aggregate, the pressures on the private debt premia is likely to continue to be higher for some time, reflecting the amalgamation of these three forces.
The private debt premia is not constant, changing over time primarily in relation to supply-and-demand, which also often feeds into the execution premium by way of OID fees, and high operational barriers to entry.
Prior to Covid-19, the private debt premia in relation to private debt was undoubtedly contracting globally and in Australia as a result of increased competition and greater capital inflows into the non-ADI private debt segment. From prior conversations with certain CRE lenders, we estimate premiums had contracted circa 50-75 bps in first lien secured CRE and corporate debt over a two year period due to these dynamics. That said, other managers, such as Metrics, report there evidenced no real compression as the market growth (from the retreat of the banks) accommodated the increasing competition.
With the Covid-19 market dislocation, we are universally hearing from private debt managers IIR that current premiums have effectively reversed that decline, increasing in the vicinity of 100-150 bps.
Why has this occurred and is it likely to persist. In IIR’s view there are three key reasons:
1) the ongoing retreat of banks from CRE and corporate lending;
2) reduced non-ADI lending competition;
3) less non-ADI lending capacity, and;
4) a reflection of higher public debt credit spreads, less earnings visibility, and greater caution regarding default rates.
The Retreat of Banks, Foreign Lenders and Market Consolidation
In the Australian market, IIR believes the trend of lending flow away from banks to non-bank lenders in the mid-market corporate lending sector is likely to accelerate. Additionally, as quality businesses look for loans in a credit-strained market, lenders will demand higher pricing. These views are based on a range of factors, the primary ones being noted above in the opening paragraphs.
The Australian CRE lending market is still very much controlled by the banks, which control approximately 90% of all CRE debt in Australia. This figure is very different to the US and Europe, where banks tend to represent 40-50% of the market, with the residual being funded by alternative financiers.
As such, the growth potential of the alternative private debt market in Australia is very much dictated by the behaviour of the banks and their appetite through a cycle. As noted above, it appears that the banks are more inward focused currently, looking to do less things, and more focused on absolute prime borrowers at this point of time. We expect that bank-led financing will continue to be selectively available from the Banks to tier one Australian REITS and other real estate borrowers at the top end of the credit spectrum. Others are likely to face a tighter lending environment for a significant period.
Similarly, foreign private lenders, which had increased their presence materially over the last one to two years, are likely to retreat to their respective domestic markets to focus on opportunities present there or, in some cases, deal with issues in existing portfolios.
The upshot is there is likely to be more demand for financing from alternative lenders in the Australian market over the next 12-months, or so, just has been the case in the past six months. For borrowers who are unable to access bank-led financing, the Private Credit markets, and in particular the private debt funds, remain open and many have plenty of committed capital to deploy.
Finally, its IIR’s sense is that there are a number of non-ADI lenders that either do not have the desire to extend new loans or, alternatively, are not capable of doing so, potentially managing distressed portfolios that were built over the last few years.
It is conceivable the Australian direct lending market may be left with fewer players as certain managers fall away due to performance and liquidity issues in their portfolios. We would speculate that this is likely to be in the form of some international private credit managers not returning to the Australian market, or at least not any time soon.
Lenders that created a portfolio full of loans to good-quality borrowers at responsible levels of leverage and full covenant protections will not be hindered by severe illiquidity resulting from distressed portfolios. Instead, they will be able to deploy dry powder in a disrupted market that will be very attractive for lenders.
Short Dated Maturity Profile
The illiquidity premium is not earned until principal is repaid or the asset is sold. Actively Creating liquidity can be a compelling form of exit strategy. One example of this is short maturity corporate and CRE loans, designed to bridge events and then be refinanced into more vanilla syndicated term loans.
We note that the likes of QRI and MOT all have short to very short weighted average loan maturities, specifically 8 months and 1.7 years, respectively (MXT less so at 2.5 years) overall but 1.1 years regarding its CRE lending portfolio component). This enables rapid recycling of capital, mitigating both risks should the outlook for a borrower deteriorate in addition to maximising the potential to capitalise on opportunities when they arise.
Vintage is an important determinant of performance in private markets. CRE lending and Mid-market corporate credit is partly a vintage business. And particularly when the weighted average duration of a loan book is short, as it is with the likes of QRI and MOT.
Taking the GFC as an example, while applicable to private corporate debt we suspect is equally applicable to CRE lending. Leverage multiples peaked in 2007, and in the wake of the GFC, the 2009-11 period produced excellent vintages. The 2019 vintage, with average debt to EBITDA of 5.5x for mid-market leveraged buyouts, was remarkably similar in terms of leverage to the 2007 vintage, where debt to EBITDA was 5.6x. The 2009 and 2010 vintages had debt to EBITDA of 3.3x and 4.2 for mid-market LBOs, respectively, both of which turned out to be attractive vintages.
The conclusion is that we would expect to see income distributions from well managed Australian private debt vehicles, whether engaged in CRE lending or corporate low to mid-market debt lending, to increase over the foreseeable future. Of course, this is subject to how well a manager manages existing and new loans with respect to defaults.
More Lender Friendly Loan Structures
The Australian private debt market never witnessed the deterioration in lender safeguards like the European and North American markets, particularly in the corporate debt segment. Notably, this included ‘cov-lite’ provisions, lower equity headroom / higher LVRs, EBITDA addbacks, and less reporting transparency from borrowers. In short, credits were being underwritten with weaker overall credit profiles.
Nevertheless, CRE and corporate debt lenders we have spoken to are invariably issuing loans on lower LVRs (based on arguably conservative valuations factoring in the limited economic visibility), generally to borrowers with strong balance sheet backing (i.e., have the ability to utilize equity for interest and principal payments and potentially inject equity capital should the LVR creep up) and in CRE lending, require a greater degree of pre-sales commitments.
The conclusion is not only higher pricing, but arguably (said in a rather tentative way) lower risk. And this is in the Australian private debt market, which has always both benefited lenders with a higher premium and better protections than both the US and European markets, and partly due to a lesser degree of competition and institutional capital flows into the sector.
Of the major property segments, it is highly likely that no segment will be left unscathed by the implications of Covid-19, with the possible exception of the industrial segment. In IIR’s view, the key relevant dynamics that are likely to impact landlords and developers include the following:
1) The eviction moratoria will have ups and downs, with tenants seeing a cash-flow benefit, but at the cost of landlords and their financiers. Inner city residential is broadly expected to be the segment hardest hit (disproportionate concentration of students, renters in hard hit sectors such as retail and hospitality)
2) Construction of some new projects has seen some disturbance as a result of supply chain issues and more recently in Victoria workplace restrictions, which may impact timetables and budgets in construction facilities. Risks appear to be greatest with mid-tier property developers with projects coming out of the ground. Many were operating of very thin margins per Covid-19. Settlement risk and extended time lines augment risks. We expect insolvency rates (when insolvency laws are re-established) to be not immaterial.
3) Updates to valuations for purposes of existing debt covenant compliance is likely to be met with significant uncertainty – this might see a need for amendments/waivers of covenants.
4) Additional liquidity might be difficult to generate for those outside the top of the credit spectrum, but more flexible private credit lenders and possibly also “in one line” sales of development stock to private investors remain clear options.
5) The retail, student accommodation and office sectors, the former of which was already undergoing a structural move to on-line (exacerbated by unsustainably high rents), may have permanently changed.
6) Cash payment terms, which have contracted materially, are likely to revert to more standard 60 days and when they do many midtier developers may well face a cash crunch. The reinstatement of insolvency laws is likely to be no small risk, and may see many smaller developers/trades people go to the wall.
Some sectors of the property market have been affected by Covid-19 more than others – and lenders and borrowers dealing with assets in these particular sectors may suffer greater ramifications as a result.
For example, property assets with an exposure to discretionary retail, tourism, hospitality and fitness business are likely to be impacted more than assets with an exposure to non-discretionary retail and medical assets. With an increase in the use of e-commerce, industrial assets with a focus on warehousing and logistics may also be sheltered from some of the impact of Covid-19 as online shopping continues to maintain demand.
More generally, business may look to decrease fixed costs – and with the majority of the workforce working remotely, reducing office space is a way to do this. This may lead to a short term reduction in demand for office space, and potentially on a more long term basis as business embrace the use of remote working on a more permanent basis.
Clearly, stay-at-home orders will impact the ability (or willingness) of tenants to pay rent. Lack of rent would squeeze the cashflows of real estate owners, which (under a worst case scenario) would lead to potential breaches of fixed-charge cover ratios within lending agreements.
However, the swift response of the Australian Government, and those around the world, with payments supporting wages and small businesses has to date ensured rents have largely continued to flow. For example, looking at overseas markets, outside of retail, most US REITs have reported mid 90% cash rent collection in May 2020 (with May collections generally better than April for apartments, healthcare and malls). Most of the rents not yet paid are on deferral agreements. Only slightly worse cash rent numbers were reported from Europe/UK
We would caution investors drawing too much optimism from the below chart. First, IIR has not done a deep dive on the Australian REIT sector to determine the above. Secondly, IIR believes the worst is yet to come, with 2021 shaping up likely to be a crunch year. As Qualitas described it, we are currently in the eye of the storm, with a lot of false economies out there.
It is important for investors to appreciate that different sectors and subsegments and different classes of borrowers face very different risks. We believe that the larger alternative financiers with through economic cycle experience (went through the GFC) and strong teams will be left relatively unscathed and, in fact, may perform better during this period.
For example, Qualitas have yet to receive one borrower request for a deferral on interest as well as principle payments. This is partly due to strong asset selection in addition to larger borrowers that have very strong asset backing (the ability to tip additional equity in should valuations decline / LVRs increase).
Similarly, Metrics, in terms of its CRE lending, have seen six of its existing borrowers complete projects since March and all have settled pre-sales without any significant uptick in settlement defaults. A number of Metrics’ existing projects have seen continuing strong sales (particularly for land sub-divisions) and reported sales have been at price points exceeding valuations.
All assets are monitored carefully by such lenders. Additionally, both QRI and MOT have relative short weighted average loan durations. This is important as it means the managers are better placed should heightened risks emerge, in addition to take advantage of opportunities through the recycling of capital.
Qualitas is also not seeing evidence of forced selling of property assets at the large end of town. This suggests that currently it is not just the quality of the Qualitas portfolios, rather a sector wide phenomenon. Of course, the situation may change.
Businesses are facing increasingly tough conditions as governments respond to the Covid-19 threat by imposing restrictions on the general population’s movements. We have already seen various businesses close their shop fronts (voluntarily, or as a result of insolvency) and many are unable to pay rent.
Borrowers who rely on tenants’ rent to service their debt will face the loss of this income stream – and this will almost certainly have a flow on effect in their financing arrangements, for example breaching covenants in their loan documents which require a level of rental income and ultimately being unable to meet their scheduled interest and principal payments to their lenders.
Recent government announcements such as the proposal for a six month moratorium on tenant evictions may also have an effect on borrowers who will find themselves without an income stream, but are in a position where they cannot replace a tenant.
Covid-19 is having an impact on the various worldwide supply chains, and this will likely have a flow on effect on the construction industry as materials become harder to source or there are delays in delivery. Additionally, in Victoria the sector has been significantly impacted by the second lock down, shedding 13,000 jobs between early July and early August.
The job loss numbers do not cover the period of strict stage four restrictions. As such, it is inevitable that the trend will worsen, driven by workplace restrictions, where the number of workers for larger construction sites is restricted to 25% of pre-Covid-19 numbers, combined with the closure of hardware stores. For smaller residential construction sites, numbers have been limited to five workers at a time, with specialist contractors allowed to visit a maximum of three construction sites a week. We note the National Australia Bank has forecast a 20% decline in dwelling construction for 2021 and subdued demand to continue through to September 2022, with lower overseas net migration being just one factor expected to drag on the sector.
Factors such as these will have a flow on effect to time lines for completion of construction and will also result in increasing costs. Construction financing arrangements often contain sunset dates by which construction is to be completed, and any delays in completion could lead to review events or events of default in the absence of consent from lenders. Financings also often require certification as to costs to complete, or contain obligations as to cost overruns (including requiring additional equity) – each of which will need to be considered as the effects of Covid-19 make their way through the economy and the construction industry in particular.
Builder insolvencies will also have an impact on construction financings as some borrowers may find themselves without a builder. A focus on the terms of builder tripartites will invariably follow.
The silver lining is that strong, well balance sheet backed developers are still being funded, both through banks and second-tier alternative lenders. We note that such lenders are being extremely cautious – LVRs have dropped, pre-sale requirements have increased and lenders wanting very solid assets.
In contrast, middle tier developments and developers are finding financing difficult. Some of these developers were already facing pricing pressures. There does not need to be lot to go wrong for such developers to face serious financial difficulties. To the extent these borrowers can get finance, additional finance, or re-finance (the capacity / desire to lend of second tier lenders has declined), these developers are likely to have to pay a large premium for that funding. The middle quality suburban build type developer, for example, may struggle to get a project away.
Residential real estate financings often rely on pre-sales – either as a hurdle to drawdown or otherwise as an ongoing obligation. In the current climate, in addition to finalising new pre-sales becoming more difficult, we may see an increase in pre-sale contracts being rescinded or otherwise falling over due to the impact of Covid-19 on purchasers. There will be a degree of overseas buyers that are not going to want to complete and some domestic borrowers just simply not in a position to do so given potential job losses, in addition to other potential issues. Additionally, Borrowers may face the situation where they are unable to draw on facilities as they are unable to evidence the relevant level of presales or find themselves in breach of their undertakings.
Where low pre-sales levels make debt financing very difficult to secure, there may be increased appetite from private equity investors to acquire “in one line” development stock from residential developers, providing them with much needed liquidity.
Segments of the residential and apartment sectors are likely to be hard hit in 2021 as government support is wound back, loan holidays expire, businesses / ‘zombie’ companies simply go to the wall. Inner city investment property and SME borrowers segments are likely to be hard hit. Some Middle tier property developers, already operating on thin margins, will likely not come out the other side should buyer settlement and elongated sales cycle risks transpire, creating issues for developments already underway.
Many corporates will be anxious not to commit to big capex projects or make any firm employee headcount forecasts, which will strengthen demand for preconfigured space on flexible terms.
Furthermore, the forced mass experiment in home working will reinforce the need for corporates to adopt agile portfolios and adapt the physical office to deliver collaboration. The trajectory of the office market will be shaped not only by the ability of governments and financial institutions to manage the ongoing crisis, but also the potential emergence of structural changes to how space is used and incorporation of lower employee density and deployment of remote-working options.
While some corporates might look to remote working in order to compress their real estate footprint, most are already looking at ways to future-proof their portfolios. Risk mitigation strategies will include greater investment in ‘business continuity planning’ space and remote-working facilities. De-densification is also likely as the appeal of highly dense, large, open-plan offices is now clearly up for debate. The co-working office sector, which had been a contributor to net absorption in Melbourne and Sydney, has fallen flat as a direct result of the Covid-19 outbreak. This will likely force significant consolidation across the sector. In the medium to long term, although the sector is likely to be a beneficiary.
Landlords have acted swiftly to remain competitive in a softening market. Rental declines for new leases have been practically universal, either through face rent adjustments or increased incentives. Sydney saw the sharpest decline in the Q2 2020 across the entire Asia-Pacific region at 8.6%. Although there was an initial rush from some tenants to secure rent abatements or waivers, unless mandated by enacted Government policy, their success in doing so has been patchy. That’s not to say landlords have not been amenable to working with tenants in financial difficulty, but that rental write-offs have not been common. Most tenants continue to occupy their space and pay their rent, resulting in only modest market level rental declines in the face of weak sentiment.
However, There is likely to be a glut of sub-lease space on the market as corporates pursue similar rationalisation strategies – available sublease space in Sydney has reached levels last seen during the GFC – and so achievable rents are likely to be well below former market levels.
Broadly speaking, we expect property markets to become more tenant friendly and landlord friendly markets position. We expect total rental declines for the year to average 5% but ranging up to 15% for markets that were already encountering headwinds prior to the pandemic.
The vacancy outlook though is much more nuanced, reflective of the wide range of conditions between markets (Figure 7; Figure 8). Space needs are evolving, driven by cost reduction and greater employee flexibility. The speed at which these workplace strategies can be deployed is dependent on several factors, but ultimately require the alignment of financial goals with corporate real estate strategy, HR policies and change management practices. Expect this to continue to play out over 2021 and beyond.
For retailers, the primary focus in the short term remains on preserving cash. A rising number of retailers operators are assessing options to offset the loss of revenue from their physical store portfolios. The operative word is omni-channel sales distribution – gyms providing online workout sessions, restaurants are offering meals for delivery or collection, shops moving to more online sales.
Looking further ahead, many retailers will rethink their operations, with greater emphasis placed on the shift toward a flexible omni-channel retail model. In addition, existing store networks will be reassessed. Landlords will take some pain, with potential ramifications for lenders.
Covid-19 has presented an acceleration of pre-existing structural changes in the retail market. Clearly this trend, and associated pain, will be greatest in the discretionary sector. Owners and debt holders in the neighbourhood retail sub-segment, anchored by large supermarket chains and a host of other non-discretionary shops, may well emerge relatively unscathed.
Another consideration for borrowers and lenders is the valuation of property assets being financed, especially as financial ratios are often tied to the relevant asset’s value. There is an obvious concern as to the impact of Covid-19 on the value of all types of property. Lenders often have a right to ask for updated valuations in circumstances where they think the value of the property the subject of the financing may have fallen. Financing arrangements may also contain covenants tied to the value of the particular property. Should the value of the property in question have fallen, then this could result in the right of a financier to review a particular facility or a borrower may find itself in default of its loan-to-value ratio.
Practically, there may be difficulties in obtaining valuations as site inspections are more difficult to complete where restrictions have been placed on people’s movements for nonessential matters and because the slowdown in transactions may make it difficult to assess comparable sales. In addition, the Australian Property Institute has also released a new valuation protocol to deal with significant valuation uncertainty (including clauses specifically dealing with uncertainty limitations in relation to Covid-19).
The uncertain economic outlook and lack of clarity of the short- and medium-term impacts of Covid-19 on have made valuing assets substantially more difficult. In turn, IIR suspects this has led to some private debt managers adopting a cautious approach and sitting on the sidelines with regards to new lends, while for those more actively looking to trade there is an increasing divide between vendor and purchaser pricing expectations.
According to Qualitas, the market did experience a decline in valuations beginning from March. As a generalisation, declines ranged from 5% to 15%. These declines largely reflected a deteriorating cash flow outlook, with the hotel, retail, and office sectors hardest hit. However, to date there has been little change in capitalisation rates so far, though this is likely in part due to the limited number of assets trading as many owners are reluctant to sell and lock in potential losses.
Moving forward there is likely to be a tug of war between the discount / capitalisation rates (the low interest rate environment provides something of a floor) and cash flow expectations.
Moving forward, hospitality and retail asset values will come under even greater scrutiny and the loss of income from lower occupancy and sales will inevitably be reflected in any valuation. The office sector to an extent and industrial sector should be more resilient, though average lease expiry and tenant covenants will influence pricing.
Ultimately, how far capital values fall in 2020-21 will largely depend on whether government measures to keep businesses afloat through the lockdowns are successful. If they succeed then the fall in capital values should be limited and a slow recovery occur as and when business activity picks up and investor sentiment revives. However, if there is a wave of insolvencies, then a lot of space could be left vacant and the recovery in rents and capital values is likely to be delayed.
Similarly, there is little evidence of true distress in the market at the current time, but this may become more apparent if the outlook worsens or banks become more conservative on lending policies.
Where valuation declines occur LVRs increase, potentially to levels either the lender is uncomfortable with or alternatively in breach of agreed covenants. In either case, a financier has a number of options: have the borrower injecting additional equity; the borrower may cut costs to improve principal repayments; the borrower may drawdown existing facilities (notwithstanding the increased interest cost of doing so) and/ or incurring new debt subordinate to the lenders; sell assets; refinancing with a different lender; stretching the loan term through payment deferrals – this approach typically is likely to be only a very short-term fix; or; as a last option the financier can take possession and divest the asset (and where the sale price exceeds the level of principal recover 100% of funds).
The ability for a borrower to tip in additional equity is subject to their balance sheet backing. And it is this area where the larger alternative lenders are at a distinct advantage as many of their borrowers run larger entities and have typically done so for some time (more recession resistant). Additionally, larger borrowers have often had longer term relationships with certain borrowers (these investment managers have been around for some time) and have a strong information advantage regarding the cash flows of a lender. In this Covid-19 period, it will undoubtedly be the SME borrowing segment hardest hit, none of which the ASX-listed private debt manager participate in.
With respect to payment deferrals, in addition to deferrals to trade creditors, a borrower may choose to select the maximum length of interest periods and requesting amendments to change cash pay interest to payment in kind (or deferred interest that accrues but is not capitalised). Where there is amortising debt, a borrower may also request relief from repayment obligations.
Similarly, some borrowers are concerned that their accountants will not be able to complete the audit in the time specified in the facilities agreement for delivery of audited financial statements, which in turn may impact the ability to calculate excess cashflow and make any required mandatory prepayment from such excess cashflow within the prescribed time. In such cases, borrowers are also seeking relief of such mandatory prepayments from excess cashflow (a number of borrowers that do not have an issue with the timing or calculation of excess cashflow but project liquidity issues arising from Covid-19 are also seeking relief from such mandatory prepayment obligations).
In the context of incurring additional debt should a loan facility have undrawn committed facilities, the question of whether a default is continuing is extremely pertinent as the lender can refuse to fund new advances if a default is continuing or the repeating representations are not true (sometimes qualified by materiality).
Where a default is continuing, the lenders will then be faced with a judgement as to whether the borrower will meaningfully benefit from additional liquidity or if it is preferable to simply refuse to fund. Outside of this, the scope for the borrower to incur additional debt in most traditional facilities in Australia is very limited (even more so where such debt is to be secured, even on a junior basis). An exception to this might be in the context of nonrecourse receivables financing, but this will be subject to a cap. The borrower may also consider selling material assets (including by sale and leaseback), the proceeds from any such sale will be subject to mandatory prepayment requirements and so may have limited value from a liquidity perspective absent a waiver.
The banks have enormous balance sheets and the way they fund it is very different to a second tier alternative private debt managers. The banks can ultimately decide to hold onto these under performing debts for some time.
In contrast, alternative lenders do not have that same ability. These lenders ultimately still have a liability on their balance sheet that they need to pay income from to investors. They will ultimately move on assets far more proactively than the banks, if deemed necessary to recoup principal and outstanding interest.
Default & Recoveries
The chart (in the attachment) illustrates historic default rates in the Australian CRE lending market. Investors should note, however, that during the GFC even a greater share of total loans were financed by the banks. IIR believes the adept alternative private debt managers have more determined workout and recovery teams. Take Qualitas as an example, which has GFC experience. While Qualitas has recorded defaults, it has never lost a dollar of principal and interest outstanding.
Loan impairment in Australia’s commercial real estate finance market
The Australian commercial first mortgage lending market has historically sustained low impairment rates and losses, including during the GFC. For Australian ADIs, commercial real estate loan impairments as a percentage of overall commercial real estate loan exposures peaked at 4.5% during 2011 and have averaged circa 1.0% for the four years ended 31 March 2020.
Default takes place once a company fails to meet its debt obligations in accordance with the terms of the loan agreement. Failure to repay could be the result of short-term liquidity difficulties or more fundamental business issues that may threaten the company’s solvency. In case of liquidity issues, there is usually a reasonable chance that the company may return to performing and generate sufficient cash flows to cover loan losses and remain as a going concern, a situation which is called default resolution or loan curing.
Loss given default of cured loans is usually confined to the opportunity cost of late repayments, forgiven debt obligations or implicit costs associated with working out the loan, which are, in general, very small. In the Australian context, these peaked at 0.67% in March 2010.
On the other hand, if the company is suffering from insolvency problems, lengthier operations would only lead to a reduction in the company’s asset values and higher losses. In this case, liquidation of pledged assets is the preferred workout strategy by the bank. Loss given default in the liquidation case depending on the option value of the assets could be substantial, noting that when the option value of the assets is low, the business owners or guarantors have little incentive to save the company.
A default on interest and, in the case of amortising debt, principal does not automatically lead to a recovery situation. But should it do so, all dedicated private debt managers IIR has dealt with (Metrics, Qualitas, Revolution AM, 360 Capital and Moelis) all have dedicated experienced workout expertise within their respective teams.
Again, the experience and track record of managers will be of increased importance in investor decisions, and this will benefit established managers throughout and beyond the current market turbulence.
Two main conclusions emerge from studying the relationship between LGD and its underlying determinants. First, soft information about the business borrower acquired through long-term relationship over the life of the loan is an important factor in predicting LGD. Thus, relationship building with commercial borrowers, which is specific to bank lending, plays a central role in bank’s appraisal of the expected losses and thereby risk management.
Second, there is a U-shaped relationship between the size of the loan and expected LGD, which could be attributed to the interaction between two opposing factors: increasing returns to scale in the process of distressed loan workout and the bank’s strategic workout policy that takes into account spillover effects of default of large borrowers. On the one hand, increasing returns to information implies that workout of larger loans should be more effective and yield lower LGD. Larger firms with greater bargaining power tend to renegotiate terms of the loan after default and avoid costly liquidation. In addition, larger firms can take advantage of diversification benefits and accordingly avoid default.
Studies have shown that the probability of default shows the highest correlation to four factors, and in order of significance:
1) soft information used in private debt financiers rating of borrowers for predicting LGD;
2) variables capturing macro-financial conditions ranked next;
3) security of the loan (collateral and guarantee) exhibited substantial effects on LGD.;
4) the size of the loan.
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