Real estate debt has many attractions for insurers but as we progress through the market cycle, downside protection is taking centre stage, writes M&G's Duncan Batty
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Demand for European real estate debt remains buoyant as insurers and pension funds look for attractive cashflows backed by strong security over real estate assets. Yet without effective protections in place, lenders' capital may be more at risk in the changing market environment.
If central banks move to tighten policy, some borrowers may become stretched. The physical asset backing real estate debt still provides important support and value for investors, but investments can be strengthened further through the addition of carefully negotiated structural protections.
Early warning signals
There are a number of defensive tools in the workshop for investors in senior real estate debt to respond to a potential downturn in financial markets. The first is seniority, in the form of a first-ranking charge; the second is security over the underlying real estate asset, which typically includes a substantial equity cushion that should protect against potential falls in real estate values. What is often underrated, however, is the significant role that covenants can play.
Covenants enable a lender to closely monitor the performance of loans and provide early warning signals against deterioration in cashflow, the value of the property, and the credit status of the borrower. In an extreme situation, they can provide a mechanism for a lender to take early action and potentially obtain better recoveries in the case of a default.
When originating real estate loans, bespoke covenants on an asset by asset basis can be a key risk management tool. Incorporated in the contractual terms of each loan, they can typically be customised to protect investor capital. Asset managers such as M&G typically negotiate tailored covenants as part of a rigorous investment process, where the loan is underwritten to ensure that these safeguards are effective. Typically a lender can agree covenants on a real estate loan to protect against deterioration in income and value of the underlying real estate.
Covenant setting in action: scenario modelling
A hypothetical financing request might be for a five-year senior loan at 55% loan-to-value (LTV) secured against a London city office valued at £500 million. This equates to a senior loan (notional) of £275 million. The loan has an annual interest burden of £7.6 million, which, cashflow profiling shows, can be paid throughout the loan term from the existing rent roll with some additional headroom. The property has five tenants.
Scenario modelling can be used to produce a projected rent schedule for the asset over the five years of the loan term.
The day one interest coverage ratio would be 2.9x, but in one downside scenario it may fall to a low of 1.5x at a point where the model projects some vacancies in the property. To protect investors against the risk of interest non-payment, a cash sweep covenant could be set at 1.7x, which could be activated if this scenario materialises and would allow the lender to take control of cashflow from the property and use it to de-lever the loan.
A default covenant could be set at 1.4x, which would be breached if cashflow was lower than this level. A breach would give lenders the right to accelerate the loan by requesting repayment of the loan in full and ultimately take enforcement action to sell the property should this be necessary, before any further deterioration in cashflow is experienced.
Meanwhile, LTV covenants protect investors from property value deterioration and enable a lender to act in cases where real estate value declines to a point where the senior loan balance is higher than a pre-set percentage of the asset value.
Collateral and Solvency II considerations
Having the capability to set tailored covenants on an asset-by-asset basis is a key risk management tool when originating real estate loans. When we lend, covenants such as the above enable us to closely monitor the performance of loans and receive early signals of deterioration, which in turn should improve recoveries on these loans.
For insurers, European real estate debt offers stable cashflows, backed by the security of the underlying property, while the transparency of the tangible real estate collateral and the bespoke covenants can support favourable capital treatment under Solvency II. In addition, an asset manager that undertakes such scenario modelling can supply bespoke analysis to understand economic risks and assist insurance clients with their Own Risk and Solvency Assessment (ORSA).
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