Extend and Pretend

‘An extended loan gathers no loss’ – Bloomberg Article

I would like to discuss the topic of commercial property debt in both New Zealand and the global market. I believe that it is a crucial piece of the economic puzzle that perhaps is being missed a little bit by mainstream media and could have some significant impacts to policy decisions going forward.

To begin, let's explore how commercial property finance works and how it differs from residential property finance. Commercial property debt, particularly that of a larger scale, is significantly different to your standard residential home loan. Most of the debt is on a 3 – 5 year loan term with large balloon payments due upon the expiration of the loan as opposed to your traditional 30 year residential mortgage. A lot of it is also priced on what are effectively floating interest rates opposed to fixed terms and, due to the nature of the lending, attracts a higher capital allocation than residential lending which leads to higher rates.

Lastly, let's discuss the concept of "Interest Coverage Ratio (ICR)" in commercial property financing, the primary servicing metric utilised by lenders. This is the ratio of NET Income relative to the interest expense. To understand the ICR, we need to clarify what NET Income means. Net Income is the gross rent on the property less any expenses incurred by the landlord. This may include rates, insurance, maintenance, management fees etc. Various commercial leases are structured in different ways with some (or all) of those costs borne by the tenant and thus it is important to understand the lease as not all are created equal. Once you have your Net Income figure you simply divide this by the expected annual interest expense.

For example, if you have a $10,000,000.00 property with a 4% Net Yield that would mean you have $400,000.00 of net income off that property. If you then have a $5,000,000.00 loan at 4% then the interest cost if $200,000.00. Your ICR is 2.0x ($400,000.00 / $200,000.00).

Banks have typically sought the ICR to exceed 2.0x on the debt on their books. This is changing….

This ratio reveals the current underlying market issues. The above was a fairly typical example 18 – 24 months ago when the OCR was at its lowest and property was a hot commodity. What has happened since is a severely sharp increase in borrowing costs for commercial property owners. In some instances, interest rates have tripled from 3% to 9% over the course of less than 2 years. Meanwhile, the landlord may be locked into fixed rents or minor increases meaning that their income isn’t close to keeping pace with the rate hikes.

The cost of funds for most banks at the moment is sitting close to 6%. Above this they typically add a margin of 2 – 3% onto a loan meaning overall interest rates are sitting at about 8 – 9%. If we look at the example earlier, the landlord is likely still only attracting $400,000.00 of net income, however, their interest cost will have at least doubled to roughly $400,000.00 in itself. Therefore, every dollar of income is just covering the interest expense, not to mention the possible principal requirements. ICR has fallen to 1.0x.

In response to this we have seen some easing of credit criteria at the banks around commercial property with acceptable ICR ratios falling to 1.5x or lower with some institutions. A number of existing clients are being asked, where possible, to top up their loans (reduce the debt) so that they can meet their ICR requirements and some were even asked to refinance.

Many commercial property owners are facing challenges when it comes to reducing (topping up) their loans as they do not have significant cash reserves. Refinancing is also not a straightforward option, primarily because all banks are facing similar circumstances and constraints. We are seeing an uptick in activity around refinancing some of these positions to Non-Bank lenders who are on friendly enough terms to bridge some stakeholders through to a more buoyant market or better rate environment.

People are reluctant to sell, and it is easy to see why.

If we take it as read that leverage, as with most property transactions, is an important tool then a significant change to the availability and cost of that leverage must see a similar change in value. If banks require 1.5x interest cover on commercial property with rates of 8%+ then a $400,000.00 net rent roll would support debt of $3,333,333.33 as opposed to the $5,000,000.00 a few years ago. That is a 33% drop in leverage.

There are also alternative places to put your capital that are arguably lower risk but attracting good returns. Some primary lender deposit rates are approaching 6%, this must dictate that commercial properties have higher yields again affecting price.

At a 4% cap rate a $400,000.00 rent roll equates to a $10,000,000.00 property value. At 6% it falls to $6,666,666.66 (again 33% less…).

And this isn’t just a New Zealand problem. This is a global issue, particularly in the US and Europe. In San Francisco alone there have been the keys ‘handed back’ on 3 commercial assets just this year with debts totalling almost USD$2 Billion. There is an estimated USD$1.4 Trillion (yes Trillion…) of debt expiring in the next 12 – 18 months. There is a view that this could be the catalyst to another GFC type event. Large property syndicators are already halting withdrawals and selling down strategic assets.

As a consequence of these circumstances, it appears that the main banks are showing restraint in their actions or not exerting significant pressure at the moment. They are politely looking to get their borrowers to recapitalise, however, are unwilling to really push sales. As stated above, ‘A rolling loan gathers no loss’. If the lenders are forced to take properties to market and accept such significant drops in value it could cascade through the financial system. Commercial Loans are often looked at annually relative to values and if these fall LVR restrictions will quickly be breached and these must be fixed.

How long can this last? Unsure. What will it all mean? Also, don’t really know.

We do think, however, that there could be some turbulence on the horizon which will present opportunity and possibly some easing of credit. Governments and those on the tills have shown a real willingness in the recent past to kick that can down the road and we could be heading that way again.

Stay tuned