UK Commercial Property Finance - a year on from Lehman’s collapse

On the anniversary of the collapse of Lehman, arguably one of the most devastating economic events in generations, Bernard Frazer, a Partner at Red Chilli Structured Finance, reflects on the state of the commercial real estate market.

£43 billion of commercial property refinance and no lenders

15 September 2008 undeniably marked the nadir of the credit crunch when the air was sucked out of the market pretty much overnight and money markets froze, depriving the financial markets of whatever little liquidity was left after a gruelling year long drought. Finding itself in uncharted territory, the property industry struggled to come to terms with the brutality of the situation it was finding itself in and to fully fathom the implications for a sector already on its knees. Once the shock was over, the one conclusion everyone seemed to agree on was that the lack of liquidity would have one clear unavoidable effect: Distress with a capital D for investors who had secured aggressively geared loans in the heyday of CMBS and cheap credit. The rapid drop in capital values would lead to an epidemic of covenant breaches, the deterioration in the general economy and the resulting strain on tenants would exert increasing pressure on debt servicing and all this would culminate in a flurry of distressed sales by investors and mortgagees in possession. By some accounts, £43 billion worth of commercial property loans were due to mature in 2009, many relating to properties now worth less than the debt secured on them and most in serious breach of their loan to value covenants. One thing was for sure: there was going to be a bloodbath. Property old hands had of course been there before and there was some undisguised glee in a few corners and much hand-rubbing from those institutions that had in their infinite wisdom (or mere luck) cashed out before the wheels came off the property wagon. Hedge funds and equity funds alike were preparing for what was surely going to be best buyer’s market in decades. Talk of vulture funds were rife.

Commercial property transactions: the big chill

It will be one of the defining quirks of this crisis that, despite the collective wisdom and the industry’s consensus of expectations, this has yet to materialise. A year on, with the exception of a few sporadic deals (some publicised, others quietly done), the number of transactions has been disappointingly low for those that had built up war chests for the greatest buying spree of all time. Distress or no distress, the market has remained seized up and frustration has been mounting.

The reasons behind this most unexpected turn of events are likely to be more political than down to economics. Furthermore, the severity of the crisis has stifled the usual balancing mechanisms we have come to expect from our modern capitalist systems. The suddenness, brutality and universality of this crisis are clearly the fundamental reasons behind the current market sclerosis. The industry (and the broader economy) have suffered from such dislocation that the old rules no longer applied and the market was simply unable to digest or adjust to problems of such epic proportions. The problem transcended the market like never before and instantly became a national problem that required the government to step in. The property industry debacle like the broader economic malaise became everybody’s problem and, at the same time, ironically, it was no longer anyone’s problem, at least in the sense that no one could do anything about it. Cue the government stepping in as the saviour of last resort.

Property lenders’ heads in the sand

As it became clear that a radical solution on a national/international scale was needed to address the crisis and in the expectation of a government rescue plan, financial institutions were reluctant to rush to make any moves to try and protect their positions. A government solution was always going to be a protracted affair and even though Messrs. Brown and Darling acted bravely and decisively, policy implementation would be nothing if not a slow and arduous process.

In the meantime, in an unprecedented but self-preserving bout of pragmatism, lenders resigned themselves to the fact that in the absence of a clear solution but with debts being serviced in most cases, they would turn a blind eye on breached covenants and simply continue collecting their dues without asking any questions – the answers they knew they would not like. This pragmatism was further forced on them by the knowledge that the whole world was in the same predicament and by the fear that covenant repairs were most unlikely to be on the cards. They knew full well that forcing borrowers to sell distressed assets would only feed the infernal downward spiral, achieving nothing, simply aggravating the crisis and further impairing their already sick balance sheets for no gain. Time for heads in the sand then.

This is of course assuming that lending institutions were still operating semi-normally. This was however far from the reality as lived by thousands of bank employees fearing for their jobs, assuming they still had them. Unsurprisingly, in the face of such seism, banks quickly became dysfunctional. Beyond the anxiety induced by a most uncertain future and impending Armageddon, the sudden realisation that they did not fully understand the risks they had taken on (but then who really did?), the ugly legal ramifications of poorly executed contracts in the urgent days of easy credit and the resulting uncertainty of the outcome of any possible litigations created the worst possible environment for anyone to operate in, let alone address such critical issues effectively.

Plan B: gaining exposure to commercial property in a transaction-starved market

A year on, as the banking industry is still trying to recapitalise its balance sheets and negotiate with the government which toxic assets they can offload or buy guarantees for, little has changed. Those Funds that had prepared themselves for the deals of a lifetime have been feeding over too few deals, competing with all too many other opportunists. Three quarters of the way through 2009 and the long awaited flow of disposals forced by the absence of refinance options has still not materialised.

And yet, expectations remain high that some time in the next 12 to 18 months the taps will be turned back on. Interestingly though, weary of a long and frustrating period of inaction, those Funds sitting on piles of cash are now considering alternative strategies that will allow them to take positions in the desired assets without waiting for those assets to reach the market. Additionally, they are hoping that those strategies will allow them to keep their efforts under the radar and avoid the gruelling competition that such a scarce market fosters.

Red Chilli has been working with such Funds who are now aggressively seeking to take positions in income producing assets by entering into joint ventures with either mortgagees in possession or borrowers who are in need of liquidity. By offering to inject capital into investment portfolios, those Funds are able to gain the exposure they have been so actively pursuing and generate similar returns to those they would achieve as principal investors. They would get involved in any one of a number of typical situations:

• New investments where the principal does not have enough capital to top up the senior facilities offered by timid lending institutions.
• Investments where an existing long term senior facility has reached its term and whose exit gearing cannot be matched in the current climate
• Ongoing investments where breached covenants cannot be repaired by cash poor principals
• Ongoing investments where, given current swap rates, it would be beneficial to lock in at a new lower rate, but doing so means losing a highly geared facility and replacing it with a lower geared loan and/or breaking the swap at a cost the principal cannot afford.

In all these cases, the Funds the Red Chilli team is working with can bring the capital that is missing allowing the principals to acquire or retain their assets while enabling the Funds to gain exposure to the assets they have not been able to buy in such a tight market. Those Funds can be flexible in the way they structure their involvement, whether they act as a mezz provider or a JV partner, require a high fixed coupon or a smaller coupon with additional look back IRR, no coupon but an equity stake, convertible loans etc… They will look at most asset classes and also consider quirky opportunities where the real value of the deal may be in a planning play.

Interestingly and to conclude on a positive note, these Funds are likely to become increasingly critical agents in the property and lending industries as they bring the much needed liquidity back into the market exactly where it is needed. That will lead indirectly but equally effectively to helping banks recapitalise their balance sheets while assisting investors in distressed situations to avoid the loss of their assets. Whilst by no means a painless solution as it will inevitably lead to dilution of capital for those assisted, such capital injections could be just what the doctor ordered.

Bernard Frazer is a Partner at Red Chilli Structured Finance, an independent property finance advisory firm specialising in arranging funding for property projects in the UK and Europe.

He can be contacted on 0845 210 5000
www.redchilli.com

Red Chilli Structured Finance
Minories House
2-5 Minories
London EC3N 1BJ

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