Real estate debt: how to target better outcomes from private debt investment

Written by M&G’s Real Estate Debt Finance director Duncan Batty

03/12/2018

Subdued inflation and low interest rates created a relatively benign environment for real estate lenders, but is this set to change? As we progress through the market cycle, with uncertainty around rate rises ahead, the importance of building in protections for lenders in the European commercial real estate debt market is coming into focus.

Typically, senior real estate lenders receive a first-ranking charge and security over the underlying property, but other risk management tools such as covenants are often overlooked. Built into a loan contract, covenants can give early warning signs of borrowers struggling to repay, or deterioration in the value of the property or credit status of the borrower.

To assess new loans, lenders such as M&G undertake analysis of the real estate asset’s cashflow sustainability. This includes the tenants’ capacity to meet their rental obligations, which support the interest payments on the loan, and the capacity of the borrower to repay or refinance the principal at the end of the loan term.

“What if…” scenarios

Scenario modelling can be used to project an asset’s expected cashflow profile. For example, in an property, the expected rent for each tenant in the building can be forecast and modelled to create a total expected rental profile for each quarter of a loan term, incorporating factors such as tenant entry and exit dates, rent reviews and potential void periods if space in the property becomes vacant.

Modelling can also be used not only for stress-testing the loan under a range of conditions, but to enable insurers to evidence to their regulators how these loans could perform in different market scenarios.

In addition, the real estate asset associated with a particular loan is typically held in a ‘special purpose vehicle’, to ensure that it is legally separated from other assets and liabilities in the wider borrower group, while giving lenders direct access to the property in downside scenarios.

Built in protections

Bespoke covenants can be set by the lender for each asset. These typically include value-related metrics such as loan to value (LTV), income-related metrics such as interest coverage ratios (ICRs), as well as property specific covenants.

These covenants are then continuously monitored throughout the loan term and tested for compliance, typically by annual revaluations of the properties and quarterly cashflow statements.

LTV covenants protect investors from property value deterioration and enable a lender to act in cases where real estate value declines to a point where the senior loan balance is higher than a pre-set percentage of the asset value.

Interest coverage covenants are based on how many times the interest due on the loan is covered by the projected income from the property. They are set with a degree of headroom and enable a lender to act if the income from the real estate asset falls below the prescribed level, such as in the event of a tenant breaking their lease obligations.

Default covenants are set at the outset and a breach will occur if the property value or rental income declines beyond the permitted levels. This gives the lender early warning signals and, potentially, the ability to act before the property value falls below the loan value and/or cashflow is insufficient to support ongoing payments on the loan. The borrower usually has the right to repay enough of the loan to cure the covenant breach, but if they are unable to do this, the lender has the right to assert more control over the property’s operations, control cashflow or even force a sale for repayment.

Collateral and Solvency II considerations

Having the capability to set tailored covenants on an asset-by-asset basis is a key risk management tool when originating real estate loans. When we lend, covenants such as the above enable us to closely monitor the performance of loans and receive early signals of deterioration, which in turn should improve recoveries on these loans.

For insurers, European real estate debt offers stable cashflows, backed by the security of the underlying property, while the transparency of the tangible real estate collateral and the bespoke covenants can support favourable capital treatment under Solvency II. In addition, an asset manager that undertakes such scenario modelling can supply bespoke analysis to understand economic risks and assist insurance clients with their Own Risk and Solvency Assessment (ORSA).

For Investment Professionals only

This document reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. Past performance is not a guide to future performance. The distribution of this document does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any security, strategy or investment product. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents.

The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority’s Handbook.

M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority.

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