Mishcon Academy: Digital Sessions – Financing Real Estate Assets

Posted on 17 February 2021

The Mishcon Academy Digital Sessions.  Conversations on the legal topics affecting businesses and individuals today.   

Paul McLoughlin, Partner

Mishcon de Reya

In this episode, what does 2021 hold for the financing of real estate assets?  As Covid restrictions on landlords’ legal rights begin to subside, will there be a wave of enforcements and disputes or could there be other options to deal with problems in the real estate market?

Hello, and welcome to this Mishcon Academy Digital Sessions podcast.  I’m Paul McLoughlin, a Restructuring Partner at Mishcon de Reya and I’m joined remotely by Omega Poole, Head of Debt Advisory and a Partner in Mishcon’s Real Estate Finance team. 

Good morning, Omega.  Here we are, hopefully seeing some light at the end of the tunnel but before we look forward, let’s just spend a few minutes looking back.  2020 was an extremely challenging year for many real estate sectors but interestingly, not all.  How would you summarise the trends we’ve seen over the last year?

Omega Poole, Partner

Mishcon de Reya

Good morning Paul.  Well, about this time last year now seems like a very long time ago and when we were just entering into the first lockdown and at that time we saw many lenders, perhaps surprisingly to some, complete the deals that they had already committed to, with a few exceptions and obviously with some repricing and resizing going on.  There were a few lenders though that did have to pull out of the market because their own funding lines had been pulled so it wasn’t completely smooth sailing at the start and as you might expect, a lot of lenders rightly spent time managing their portfolios so, identifying potential problem positions and working with their borrowers.  There was also a particular focus, as in times of crisis and in this case, pandemic, of focussing particularly on existing loans and customers and when I was speaking to lenders actually about this time last year, there was certainly a sense that the pandemic was something out of all of our control and therefore there should be some kind of element of pain sharing between the parties.  The vast majority of lenders through the course of last year definitely were much more conservative than they had been in 2019 and they also refocussed a lot on their core strategies rather than peripheral strategies that they may have been developing over the last few years or so.  The market certainly won’t shut though so we did see a number of pretty sizeable deals, for example, the Allianz £400 million London office financing last year, so it’s not fair to say that there were no real estate finance transactions going on. 

The other main factor obviously that lenders are very concerned about is their borrower’s cashflow and in particular, rent shortfalls.  We saw, at the tenant level, that not everybody was playing by the rules, certainly there were a number of cases of can pay but won’t pay where for example, well capitalised retailers were open but not paying their landlords and we also had the somewhat perverse feedback that smaller tenants whose covenant, if you are a lender looking at a new potential facility, you wouldn’t have necessarily considered to be as robust as a big name covenant, were actually continuing to try and pay their rent and perhaps being more proactive with their landlords than say the larger tenants.  We saw in particular there was a huge rent shortfall at the end of last year and a number of industry bodies have commented on this.  One example is Remit Consulting who calculated that pension funds, insurance companies, REITs and other institutional investors in commercial real estate had a rent shortfall of about £4.2 billion in 2020 and overall rent collections for the last quarter are down by about 21%, so there’s certainly an element of tenants not paying when they possibly could do and I think this is particularly illustrated by the fact that roughly a quarter of commercial property leases had already been subject to rent concessions, rent holidays and/or renegotiated since the start of the pandemic but even a week after rent was due at the end of the last quarter, about 40% were still outstanding.  We also were speaking to lenders during the course of last year who had indicated to us that they were planning to, so to say, mark the card of tenants that perhaps they thought should be paying rent but hadn’t been but I suppose it’s to be seen whether the industry’s collective memory will be relatively short on that or whether they will actually continue to consider those to be less well behaving tenants. 

In terms of tackling potential issues, we saw a fair amount of communication between landlord and tenant, in fact some lenders were insisting to speak directly to the underlying tenants to understand how their businesses were fairing and also a fair of amount of forbearance with delayed covenant testing or short-term waivers and amortisation holidays in interest capitalisation.  And I’d be interested to hear your thoughts, Paul, on why you think lenders were taking such a sympathetic approach to distress situations during the course of last year. 

Paul McLoughlin, Partner

Mishcon de Reya

Sure.  Well, look, last year was a very strange year and I think lenders have probably recognised that real estate investors, sponsors and landlords have been under pressure from all sides during 2020 and therefore lenders themselves have limited options but just looking at the position of landlords, I mean firstly there was another wave of CVAs by tenants to force rent reductions and other compromises to vary lease agreements, we had legal restrictions on landlords enforcing against defaulting tenants, particularly the use of winding up petitions and also the restrictions on rights of forfeiture or the ability to terminate defaulting leases but also, thirdly, just in terms of valuations, given the impact of people working from home and lower footfall in towns and cities, there has inevitably been an issue for the valuation of some real estate assets.  Looking back, we certainly had a lot of tenant retail CVAs and insolvencies but not very much in the landlord space.  I think the only one that’s caught the news was Intu back in April of 2020 but that was certainly a landlord which had problems that pre-dated the Covid crisis, they were suffering under a £4.5 billion debt burden for many years and in fact the administration of Intu was triggered not by the lenders but by the directors who presumably felt that they had no option but to call in the administrators after an emergency cash pool was rejected by investors.  So, I think in summary, we haven’t seen a huge amount of action, or enforcement action, against landlords but that’s mainly due to legal restrictions and that certainly impacted the appetite of lenders for any aggressive action to landlords.  But looking ahead, Omega, how do you think lenders are feeling as we look forward to 2021 and hopefully some degree of market normalisation?

Omega Poole, Partner

Mishcon de Reya

So I’d say that across the market there’s a sense of cautious optimism that the Government has now some kind of a plan to get the economy back to a new normal, hopefully sometime this year.  There’s also, interestingly, a sense that 2021 is a great year to originate new debt so we’ve seen a number of pretty substantial funders come in with new debt strategies.  Some important examples, October last year, Lasalle raised 435 million euros for its fourth mezz fund, in Q3 Blackstone raised $8 billion for a real estate debt fund, I think that’s probably one of the largest real estate debt funds we’ve seen and we’ve also seen other institutions like Invesco and Brookfield refocussing their credit strategies so obviously these funders who also have, for most part, equity businesses, have seen the advantages of having a debt strategy when they can have the protection from having an equity buffer and asset level security whilst potentially generating higher returns on the debt side than they might have been able to do in previous years.  We’ve also seen lenders change their strategies so a number of lenders are specifically allocating capital to short-term distress opportunities expecting that these will start to come through in the next year but I also think it’s fair to say that not all asset classes are created equal and we’ve certainly seen a polarisation in the market between those asset classes which are considered hot and those which are not and I think that will certainly continue.  Retail, for example, well it was out of favour Covid but I think will continue to have a very cautious approach from lenders and a limited financing appetite, unless potentially we are talking about a repositioning play to a different asset class such as residential.  On the flip side, residential, build-to-rent, logistics, life sciences, healthcare and data centres, I think will all continue to be popular from a financing perspective and other asset classes like hotels which have historically been great performers but obviously have suffered through lockdowns and been forced to be closed, I think they’ll come back, particularly those subsectors which are well placed to offer Covid-secure accommodation such as serviced apartments. 

The other interesting anomaly I suppose, is that development financing still seems to be relatively popular and I think that’s because lenders can see the lead type of projects coming to market and hope that that will tie in quite nicely with the ramping up of the market as we come out of this crisis.  At the end of the day, prime assets I think will continue to attract good financing and secondary assets may struggle. 

One of the other questions that we often see debated in the market is whether debt funds will save the day.  After the last crisis, there was a proliferation of debt funds entering into the market to address at the time, the so-called funding gap and so a number of commentators and market participants are asking whether they might be able to do the same this time.  That said, I think actually what we are seeing is these alternative lenders accessing deals which would typically have gone to institutional lenders and clearing banks and able to generate better returns at lower risk profiles and I think there’s some debate still whether the alternative lenders will be able to bridge the funding gap for higher risk financings and we may find that there is still a gap in the market.  A number of commentators have tried to calculate what that might be looking at how much banks and other lenders have retrenched and what sort of appetite there seems to be and there is some estimates that there could be a circa 30 billion sterling funding gap in the market which would be about 17% of outstanding loans. 

But one thing I’d be interested to hear your thoughts on, Paul, is whether we think there might be more loan sale transactions which obviously did characterise a lot of the activity after the financial crisis last time round.  So do you think we’ll see this time a lot of activity in the secondary debt market?

Paul McLoughlin, Partner

Mishcon de Reya

Yes, I do.  It’s likely that banks will start to trade some of their real estate exposures, if not already then sometime soon.  I think when we look at the market overall, clearly a lot of these distressed investors, hedge funds, credit funds have built up huge amounts of dry powder over the last twelve months and coupled with the inability or the unwillingness of lenders to take aggressive enforcement action, I think that those two things are likely to turbocharge the secondary debt market in the months and the years ahead.  And thinking about it from the lenders perspective, it’s a very simple and easy way for lenders to resolve problems, it’s certainly a lot quicker than restructuring and it’s certainly a lot easier than enforcing so I think that option will be certainly within the list of remedies for most lenders.  I think conversely for landlords and sponsors, it is more problematic.  We know that real estate funds are much more likely to take aggressive action and they are much more likely to want to try and take control of real estate assets rather than simply sit on term debt and wait for it to be repaid over a period of time.  So, I’m sure there will be action in the secondary debt market. 

Omega Poole, Partner

Mishcon de Reya

I suppose we could say 2020 saw many real estate loans in a type of stasis, waiting to see what the future holds and from discussions with clients and contacts in the market, there seems to be a sense that in 2021, we’ll start to see the consequences of the economic impact of the pandemic feed through.  How do you see that playing out?

Paul McLoughlin, Partner

Mishcon de Reya

I think the starting point is that landlords were under significant restrictions throughout 2020, as we’ve discussed previously.  They were supposed to come to an end on 31 December 2020 but very late in the day the Government extended those restrictions through to 31 March 2021 and the Government did say at the time that that would be the absolute last time that those restrictions would be extended.  Just looking back slightly, between the end of December and now, we’ve had clearly the introduction of a new Tier 5 regime, another lockdown, we’ve had closure of air corridors, we’ve had different variants of the virus that have been identified and so it’s not difficult to imagine that when we get to end of March 2021, the Government may say that a further extension of those restrictions is justified but I don’t think we’ll find that out until very near to that deadline.  I think the other thing that’s relevant is Government concern, clearly the Government has been very preoccupied with the real estate sector and it’s provided significant assistance, something like 330 billion of guaranteed loans by the Government, that have been, as we’ve said, laws to impose moratoria on forfeitures and winding up petitions, we’ve had business rates relief for hospitality and retail and leisure, and VAT deferrals, more recently we’ve had the new Corporate Insolvency Act which provides various other schemes of support for businesses and tenants and so the Government has taken enormous steps to try and ease the pain in the real estate market but how that unwinds in 2021 is going to be a real concern and it’s certainly a concern that has been addressed by the Government.  In June 2020 they published a paper called the Code of Practice for Commercial Property Relationships during the Covid-19 Pandemic and that paper introduced a set of principles to try and guide negotiations between landlords and tenants and lenders involved in commercial real estate and those principles, in a nutshell, suggest that parties renegotiating leases and real estate loans should act transparently and they should collaborate and try and take a unified approach, that they should act in good faith and importantly, they should consider the Government support that may have been given to try and preserve relationships and interests in real estate.  And so that code is endorsed by numerous trade associations in the real estate sector, including the British Property Federation, RICS, Commercial Real Estate Council and various others.  But despite that, it is a voluntary code, it’s not binding in any way and landlords and lenders are free to ignore that if they please and so I do think we’ve got to step back slightly and look at what the position of those different parties or stakeholders may be and certainly for landlords, I think a lot of landlords and lenders in certain sectors will have little patience left for any further tenant delays to payment of rent and I do think as restrictions on winding up petitions and forfeiture expire, some landlords will move quickly to try and take action against defaulting tenants and particularly those which are high profile and, as you say, probably could have afforded to pay but have used this regime to their advantage.  I think the other thing that’s worth bearing in mind is you touched on, is that it is relevant to certain sectors but not all, so certainly retail, hotels, leisure, events venues are those which are most under pressure.  In comparison to, for example, logistics and warehousing and industrial real estate which is probably less pressured as a consequence of the events of the last twelve months.  As far as lenders go, as we’ve said already, it’s much more likely that they’ll be willing to trade real estate debt where they have exposure and there will be plenty of buyers for that, I’m sure.  The buyers generally being hedge funds who tend to be more aggressive and I’m sure that they will look to take enforcement action where they think they can get their hands on valuable real estate.  So, overall I think that there will be much more action in 2021.  I think there’s a lot of pent up pressure, a lot of distortions and I think that is very likely to unwind over the course of the next twelve months and beyond. 

Omega Poole, Partner

Mishcon de Reya

Because there was a lot of discussion wasn’t there last year that the market as a whole was in a better position in terms of average leverage and underwriting standards, as well as the breadth and depth of finance providers compared to, for example, before the global financial crisis and I still think that this will have helped and continued to help stabilise the whole market but obviously that’s just a market average position, isn’t it, it doesn’t translate directly to individual loans. 

Paul McLoughlin, Partner

Mishcon de Reya

Yes, exactly and as I said, I think some sectors are much more at risk than others so, it is going to be the retail space, the office space, hotels which are much more vulnerable to upheavals.  I think the other interesting one is student accommodation.  There have been some fairly significant impact on students and universities as a consequence of the pandemic with students not being able to attend universities and also there are some structural changes in the market for students, particularly the impact of Brexit on oversees students and also Covid inspired changes as to how education is delivered so it can be done online through lectures and seminars over the internet and so on but also significant Government changes in policy which are now favouring apprenticeships and non-university education and I think we’re likely to see more investment in that which will take away some of the financial support for the education sector. 

Omega Poole, Partner

Mishcon de Reya

And the other point that’s probably very important for lenders and always is of course, is the calibre of the sponsor so I think in this ongoing period of uncertainty, the lender will be looking at the sponsor team and trying to work out whether they’ve got the credential and wherewithal actually not just to deliver the agreed asset management plan but given there is still a fair amount of uncertainty, whether they would be able to adapt to changing circumstances to maintain the value of the underlying assets and I expect there’s a real opportunity for many borrowers and lenders to work together to reach consensual resolutions to some problem loans and I suppose that brings me on to another question for you, Paul and you touched upon the new Corporate Insolvency and Governance Act that was brought in last year and that’s brought in a slightly different toolkit from a restructuring perspective compared to after the financial crisis so, do you think there’ll be a different emphasis in approach across the market going forward?

Paul McLoughlin, Partner

Mishcon de Reya

There are certainly more tools in the kit than previously as a consequence of the Corporate Insolvency Act but again, it’s worth standing back and just looking at the market from the perspective of different stakeholders and so looking at lenders for example, I know that we’ve seen previously, after the 2008 financial crash, that some lenders tried to set up warehousing structures for real estate debt and that proved to be controversial, not least because of valuations of the underlying real estate so I don’t think we are likely to see that and also debt equity swaps which formed a fairly prominent feature of previous phases of restructuring.  I think it’s much more unlikely that certainly retail banks, commercial banks, would want to hold equity in most businesses, certainly real estate and so, whilst debt equity could work and some lenders will be inclined to work out problems in that way, I don’t think it’s going to form a significant part of the restructuring landscape going forwards.  So I think for lenders, we do come back again to the secondary debt market where they are much more likely to look at offloading their real estate exposures to other distressed investors.  From the perspective of landlords and sponsors, I guess the most obvious solution is always to try and dispose of assets either through some kind of distressed M&A process if necessary or in the ordinary course but, again, we come back to the issue of value for certain sectors where values are likely to remain depressed and I think anybody selling in that market will be very much a distressed seller and therefore to avoid that, much more likely to seek new investment and access to working capital to try and get through this current market cycle.  The other thing that is potentially open to landlords and sponsors is to use some of the more non-consensual restructuring schemes of arrangement or restructuring plans under the new Insolvency Act but really that would only be relevant to landlords with quite complex capital structures.  Tenants remain to be interesting, clearly we’ve had a lot of CVAs from retailers.  Tenants also can use the new moratorium that was introduced under the new Corporate Insolvency Act and that’s fairly easy to put in place and it gives a limited amount of breathing space but I think it’s much more likely to be used to try and buy time to negotiate a CVA for tenants.  So, CVAs likely to be of interest for tenants and indeed landlords who are affected by them but it’s also worth noting that as of December last year, HMRC will now be a preferential creditor in CVAs and as you might remember, a CVA can bind unsecured creditors but it can’t affect the rights of secured or preferential creditors and so for any business that has unpaid VAT or PAYE or National Insurance contributions, the position of the Revenue is likely to be fairly important in planning any CVA and it’s worth bearing in mind there’s not cap and no time limit on the arrears that can be claimed or be subject to preferential claims by HMRC.  I think what we would say is that we’d expect HMRC to be fairly flexible given the host of other Government support measures, financially, legally, with VAT and rates relief and so on but there’s certainly no certainty around that and HMRC is likely to look at each case individually. 

So, I think in summary, what we’d say is the combined effect of the Covid pandemic on values in certain sectors, combined with legal restrictions on landlords and legal protections for tenants, it does mean that the landscape is going to continue to look challenging for landlords, lenders and investors going forwards and therefore there’s likely to be a fair amount of turmoil in 2021 but Omega, I suppose in this environment, people will look for other options and solutions around asset value preservation and attempts to reach compromises and consensus with all stakeholders to avoid crystalising losses or provoking asset fire sales so, presumably on the real estate side, you’ve been giving some thought to this and how this might play out over the months and years ahead. 

Omega Poole, Partner

Mishcon de Reya

That’s right so, although it will only be applicable in certain situations, we do think the new moratorium process could allow a constructive dialogue between different stakeholders and potentially provide some breathing space for a new business plan to be developed and as you suggested, we’ve been giving some thought to how best to support our clients in the coming months and year in terms of working out particularly challenging situations whether the client be investor or lender side and on that basis, we recently launched our rebuild proposition.  The concept is quite simple, so rebuild brings together a number of our specialisms, particularly technical restructuring and real estate finances advice as well as debt advisory and capital sourcing and our asset management legal execution expertise, with the aim also of leveraging our wide network of contacts to help provide a platform for a consensual turnaround plan to be developed for certain distress loans and assets, as we’ve talked about every situation will be different and in some cases the plan may involve new debtor equity replacing the existing capital or it may require bringing in addition asset management expertise, for example, to reposition an asset.  So, we’re hoping that we’ll be able to continue to support our clients through the challenging months and years ahead.

Paul McLoughlin, Partner

Mishcon de Reya

And just on the rebuild initiative, Omega, presumably you’ve been having conversations with your contacts in the market about that and how has that been received so far?

Omega Poole, Partner

Mishcon de Reya

So, across the board, I think there’s a huge willingness to address different distress situations from a consensual perspective.  When I speak to my contacts in the lending and finance space, there’s a huge volume of capital that is really looking to come in and be the white knight or the rescue capital for particular situations and when we speak to our contacts in the asset management space, many of them have lined themselves up to really help clients to reposition assets so, a good example may be where a client has owned an asset that is no longer fit for purpose in the new environment that we see ourselves in and they need to bring in external asset management expertise to reposition that asset to help maintain its value but the network is there to help our clients to address these challenging situations and loans. 

Paul McLoughlin, Partner

Mishcon de Reya

Okay, that’s really interesting.  I guess, you know, as we mentioned, some of the challenges in 2021, it’s always helpful to have different options out there so, I’m sure that’s one that people will be very interested in, in looking at as things unfold.

Well, for now, let’s end it there.  I’d like to say thanks very much to Omega Poole for joining me for this Mishcon Academy Digital Sessions podcast.  I’m Paul McLoughlin and in the next episode my colleague Charlie Sosna will be in conversation with Emma Woollcott and Claire Yorke who’ll be talking about managing reputation in the context of a relationship breakdown.  They’ll also discuss privacy rights of children and the considerations that may arise where a parent seeks to include children in their social media footprint. 

The Digital Sessions are a series of online events, videos and podcasts, all available at mishcon.com and if you have any questions you would like answered or suggestions of what you would like us to cover, do let us know at digitalsessions@mishcon.com.  Until next time, take care.

The Mishcon Academy Digital Sessions.  To access advice for businesses that is regularly updated, please visit mishcon.com.

Join Partners Paul McLoughlin and Omega Poole as they discuss what 2021 might hold for the financing of Real Estate assets, as COVID-19 restrictions on landlord's legal rights begin to subside. Will there be a wave of enforcements and disputes or could there be other options to deal with problems in the Real Estate market?

Mishcon Academy: Digital Sessions are a series of online events, videos and podcasts looking at the biggest issues faced by businesses and individuals today.

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