Our emergence from a global pandemic, coupled with the war in Ukraine, as well as socioeconomic and political upheaval in the UK, is creating an environment that borrowers are finding challenging due to the steep increase in global interest rates.
Earlier this month, inflation hit a multi-year high of 10.1% and predictions are that this could reach 18% before long. Consumers are paying the price for higher wages and material costs in the current cost-push inflationary environment and, while global monetary policy is attempting to control inflation, commercial and consumer borrowers are beginning to feel the pinch.
In order to close out interest rate risk for commercial real estate loans, many borrowers are acquiring caps at a substantial upfront cost - which must now be built into upfront transaction cost analysis. Alternative hedging solutions, such as interest rate swaps or fixed rate loans, are now also carrying the burden of higher all-in rates, as five-year EURIBOR and SONIA swaps have increased by 45bps and 96bps respectively over the last month (at the time of writing this article).
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The effects of higher debt costs are not solely impacting investor returns; borrowers are also being forced to renegotiate positions on previously agreed covenants to ensure sufficient headroom is available in interest cover and debt service ratios.
This does not mean that borrowers are out of options. On the contrary, the debt market has undergone a significant transformation over the last ten years. A wave of new alternative lenders and debt funds has provided much-needed liquidity. In addition, lenders' attitude to financing has become more collaborative. We have witnessed several debt providers being open to the suggestion of restructuring terms and covenants to accommodate the increase in swap rates.
As we move through this period of uncertainty, lender appetite is expected to remain fluid.
We have started to see some lenders, who have already exceeded their annual lending targets, confirm that they are content to sit tight in the short term. For these lenders, they will be highly selective in deciding which borrowers and which lending opportunities to back in the closing months of 2022. However, with such a wide range of debt strategies and debt providers currently active in the market, it is expected that, overall, appetite will remain strong. We must remember that the market is robust enough that it can afford for a handful of lenders to temporarily pull back.
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With interest rates predicted to continue their upward trajectory before peaking in 2023, volatility will remain in the swap market. With regard to margins, ‘price discovery' will continue as lenders seek to price risk relative to other investments available to them - particularly in the case of funds that price debt based on the concept of relative value.
Looking ahead
It is time for borrowers to take a dual approach. My advice is to stay close to those relationship lenders who have been supportive throughout previously challenging times. Long-standing lender relationships will prove beneficial and should never be overlooked or underestimated.
My second recommendation, which is slightly contradictory to the first, is do not get complacent. While staying close to tried-and-tested lenders is important, also seek out new connections to ensure that terms received are competitive. There are many lenders who are still active and seeking to deploy funds, despite fears that the debt market is contracting.
We have enjoyed a prolonged period of being able to obtain debt at incredibly low rates over the last ten years. A painful period of rebasing will take place in the short term, but in the long term the debt market will continue to demonstrate resilience. There is no need to panic - there is light at the end of the tunnel, which could be reached sooner than you think.
Lisa Attenborough is a partner and head of debt advisory at Knight Frank