by Jennie Dorsaint (London, United Kingdom)*
Nearly a year ago, the United Kingdom (UK) was fast approaching the referendum date which led in late June 2016 to the British voters opting for the UK to leave the European Union (Brexit). Prior to the vote, the volume of commercial real estate (CRE) financings was significantly affected by the uncertainties relating to the consequences of a Brexit. Many lenders and buyers were negotiating “Brexit” provisions, such as get-out clauses or agreeing terms that were subject to renegotiation in case of a vote in favour of Brexit.
The procedure for leaving the European Union is without a precedent and as a result, it brings its fair share of “known unknowns”. Pursuant to Article 50 of the Treaty of Lisbon, any EU member may leave the European Union by serving a notice triggering the exit process whereby such EU member has two years to negotiate an exit deal with the European Union. Article 50 was triggered by the United Kingdom on 29 March 2017 setting the date for Brexit to occur no later than April 2019. A UK general election has been called for 8 June 2017 and it is expected that the results will provide some level of stability to the financial markets with the government securing a strong mandate to negotiate the Brexit deal with the EU. It is further expected that any potential impacts of Brexit may only affect the CRE market once the Brexit terms with the EU become clearer.
Despite the vote to leave the European Union and the associated uncertainties it has brought to the financial markets, new lending for UK commercial properties remained steady in 2016 (1). With a weaker pound, foreign investors have seized the opportunity to make real estate investments in the UK, with several deals attracting Canadian investors. In December 2016, Brookfield Asset Management, the Toronto-based asset manager, completed its £560 million acquisition of the City Point building in London. With this outlook, the demand for CRE investments in the UK remains strong and various types of financing are available to investors, including senior loans, mezzanine loans, commercial mortgage-backed securities (CMBS) and loan-on-loan financing. Some of these options have been to some extent limited due to the current yields and the high investor demand for CRE assets.
Over the last couple of years, UK CRE has seen an increase in non-bank lenders, so-called “alternative lenders” (including private equity firms, insurance companies and pension funds) entering the market. This is partly due to the increased regulation being imposed on banks and the wide availability of capital investments for CRE. As a result, fewer deals are available for a wider range of CRE lenders. With borrowers being able to dictate the lending terms, covenants (in particular financial covenants) are heavily negotiated. Lenders are requiring that debt yield testing be inserted into facility agreement in addition to interest cover and debt service tests to monitor performance of loans. Borrowers will be keen to ensure that such financial covenants reflect the nature of their assets and are consistent with their business models.
Typically, senior loans are the preferred route for financing, particularly with banks. With the Loan Market Association forms of facility agreement and security agreement, senior loans can offer a speed of execution which allows parties to spend less time negotiating standard provisions. Senior loans will tend to be originated by a single lender with an option for syndication, in particular if the bank is relying on the “originate to syndicate” model. Larger loans will most likely have more than one original lender. Borrowers typically are keen for the syndicate to remain small in order to keep transaction costs down and ensure that their loans can be efficiently managed. With the recent increase in loan syndication and the shift in CRE financing negotiating power to the borrowers, a restricted list of lenders is often negotiated to ensure that the loan is not syndicated or transferred to a competitor of the borrower. Originators wishing to syndicate a loan and keep an on-going return can structure such loan with pari passu tranches and retain a tranche reflecting a “skim” interest in the loan.
With yields being compressed, adding leverage has become an important factor for lenders, in particular for alternative lenders looking to increase their returns. The mezzanine loan market has seen an increase in activity since 2014 and 2015 with higher margins reflecting the higher risk position taken by the mezzanine lenders. Mezzanine loans will require that an intercreditor agreement be negotiated between the lenders and often, the borrower. The security package will typically include a common security package structure whereby both senior and mezzanine lenders have an interest in the security with the senior lender(s) being the instructing party and with its interest ranking in priority to the interest of the mezzanine lender(s). Some senior lenders may require that the mezzanine lenders only take the benefit of a share security in respect of the mezzanine borrower. Since 2008, fewer deals provide for the tranching of a whole loan with a subordinated tranche, in particular, due to some of the issues that arose in legacy intercreditor agreements implemented prior to 2008.
Some CRE investors are unable to directly finance real estate loans due to internal compliance rules or are unable to secure CRE deals due to the significant amount of capital chasing a limited number of deals. CMBS have traditionally offered a transparent and liquid platform to such investors. The CMBS market in the EU has seen a slowdown since the beginning of 2016 due to, amongst other things, compressed yields. The appetite for CMBS amongst investors is still relatively strong, especially since CMBS 2.0 (2) addressed some of the issues encountered in legacy CMBS transactions, including correcting structural flaws in CMBS 1.0, simplifying the cash flow structure and making the transaction more transparent for the bondholders. CMBS is still an attractive option for investors, as it increases liquidity, transparency and comparability allowing for the CRE investment to be traded on a secondary market.
Whilst CMBS transactions in the EU have experienced a slowdown, more lenders are relying on loan-on-loan to finance their CRE investments. The loan-on-loan structure allows for a lender, generally an alternative lender, to fund a loan or a portfolio of loans and seek double digit returns, by adding leverage with the loan-on-loan facility. The loan-on-loan facility will often match the terms of the underlying loan. Warehouse facilities are also available and allow a lender to have financing in place at the outset thereby reducing the execution time for the completion of the financing to its underlying borrowers. Provided that the loans meet the agreed eligibility criteria, the lender can finance these loans through the warehouse facility and can also have the ability to add and remove loans throughout the term of the facility.
Despite the wider political uncertainties, the UK CRE market is still robust with investors remaining cautious of the potential impacts of Brexit on the CRE investments. The key challenges over the coming year will be the availability of assets, the compressed yields and the significant volume of available capital for CRE investments. CRE financings are expected to continue to be subject to heavy negotiation by borrowers whilst there is a wide range of capital available to them. Some investors will hope that CMBS in the EU will recover in order to provide access to assets which might not otherwise be available to them. Investors will also look to increase transparency in the CRE market and market participants and regulators are expected to focus on these areas over the coming years.
*Ms. Dorsaint is a partner at Paul Hastings (Europe) LLP.
(1) De Montfort University industry benchmark report, 2017.
(2) Market Principles for Issuing European CMBS 2.0, Commercial Real Estate Finance Council Europe, November 2012.
