Property Investor Outlook

Until recently, property investors with UK investment portfolios were being rewarded by the market for committing to a longer fixed-rate facility term. But this is no longer the case. James Thomlinson, senior broker at boutique firm Red Chilli Structured Finance, looks at a recent trend in the swaps market and comments on key issues for investors in 2009.

A market on its head - the impact of a newly inverted UK money market

“In the current difficult funding climate more than ever, Relationship Managers working for active lenders are being more favourably received by their credit committees where their client is prepared to hedge some or all of the proposed debt. Hedging debt has always been a good way of simplifying a property transaction. The cost of funds and the lender’s margin are both fixed on day one and for the duration of the facility term both the lender and the borrower are able to accurately budget for their overall finance costs. In some cases (typically commercial transactions) the rental income also adheres to a known profile – for example where a commercial lease includes pre-arranged uplifts at a fixed percentage – and in this case rental surplus can also be calculated on day one. In other cases (typically residential transactions) an assumed level of rental growth will be deemed achievable by the lender and a likely surplus can be estimated.

In addition to the increased simplicity, the willingness to hedge debt creates opportunities for a lender’s treasury function to put a structure in place that financially benefits both the borrower and the lender. For both these reasons most lenders will reward the borrower that is willing to hedge their debt with a lower interest cover ratio (ICR) requirement – perhaps 110% ICR rather than the typical 135% ICR where a variable cost of funds is used. This allows the borrower’s rental income to stretch further and service a greater level of debt interest – in short increasing their achievable loan to value (LTV) percentage. Lenders have differing preferences relating to term length (historical criteria, varied opinions on risk, business model) but their margin is typically the same whatever the duration of the facility. So, and I am assuming throughout that the debt facility term and the hedging term are the same (nearly always the case), lenders have consistently rewarded borrowers that commit to fixed-rate structures – regardless of term length. However term length has been a crucial factor in the prices provided by the market.

Throughout 2007 and the first three quarters of 2008 the money market showed a broadly proportional relationship between the cost of funds (or ‘swap rates’) and the length of term. Committing to fixed-rate money for 3 years was more expensive than 10 years; 10 years was more expensive than 20 years; and so on. Whilst the current trend is not the exact opposite (30 year money is still cheaper than 10 and 15 year money) – a very sudden inversion has taken place within the last quarter. The following were the rates (with illustration) on 1 September 2008 (All Interbank, reflecting the offered side of the market. Also note that the periods are not at regular intervals – the charts are only for illustrative purposes. Source: www.swapratesonline.com):

Sterling Swap Rates / Years

This happens to show a clear reward - to the borrower by the market - for borrowing over a longer term. The team and I were able to create a number of pioneering products that took advantage of this opportunity. The following are today’s rates (again, all Interbank, reflecting the offered side of the market) and tell a different story – a mere two and a half months later:

Sterling Swap Rates / Years

The above chart reveals a reversal in the curve’s shape when compared to before. The upshot of this is that for the price-sensitive borrower it is currently better value to borrow for a shorter term than a longer term.

The reason for qualifying my statement that short term funding currently benefits the price-sensitive borrower is that not all investors are driven by rate and margin. At a time where we have seen improbably large and well established banks falter, many borrowers would rather pay a slightly higher rate in exchange for perceived comfort that their lender will not fall over. Many borrowers are happy to shelve an investment for many years in the knowledge that its income comfortably services its debt interest. The portfolio can then be left to appreciate in value over time with very little extra effort needed to manage its financing.

It should finally be noted that we are in a somewhat unprecedented funding market. This has created many anomalous trends in the funding market that are all interesting and significant. However, for a borrower with a long term outlook – and being mindful of the potentially high costs of unlocking a long term structure – few decisions are as important as choosing the length of a facility’s term. Over the next two quarters in particular investors must ensure that the structure they are looking to put in place really suits their key objectives first and foremost. Whether the priority is competitiveness of rate, time and effort required keeping the portfolio funded, or working with a lender that is perceived as solid - borrowers are rightly weighing up all their options and seeking out the best advice available”.

Red Chilli Structured Finance is an independent property finance advisory firm specialising in arranging funding for property projects in the UK and all over Europe.

Call us on 0845 210 5000 to discuss your funding requirements.

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