LeBruin Quarterly Update
October 7, 2020
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LeBruin CRE Funding Update

The LeBruin Group is active and open for business in the CRE funding market with our subsidiary, Origin Capital, negotiating €50 million worth of new loans in September and October. If you have a funding requirement in the CRE market, please contact tombrowne@lebruinprivate.com or cathalfitzgerald@lebruinprivate.com or call us on (01) 281 5250.

Welcome to the first edition of our funding update which will focus on the state of play in the Irish Commercial Real Estate (CRE) funding market. This edition will focus on alternative lending platforms funding investment loans (as distinct from development loans).

Background and a Brief History

Immediately post financial crash, the number of banks offering funding for CRE fell from 12 to zero and for a couple of years there was essentially no funding available for Irish CRE. The first entrants post-crash to the Irish market were credit and private equity funds out of the USA primarily focused on individual large transactions with borrowers who had large borrowing with Irish banks (later NAMA) and departing UK banks. While some transactions were completed, most attempts failed due to unrealistic expectations on the part of the credit funds and owners of the loans.

Banks and NAMA began to favour the sale of loan portfolios as the most efficient and profitable way of selling loans. In addition to the funds, a new group of players entered the market, private equity funds that sought to buy portfolios of loans, usually non-performing loans, at significant discounts to the par value of the loans. The objective was to earn a return on the loans acquired by pressuring the borrowers to repay from personal resources, selling the underlying assets held as security or refinancing the loan with another lender.

Where borrowers were offered the opportunity to refinance the loan by the private equity fund, usually at less than par, there was a requirement by the borrower for fresh funding. The local pillar banks were not an option as they were still dealing with the aftermath of the financial crisis and there were no other local sources of funding.

Some credit funds now focused on establishing alternative lending platforms to take advantage of the emerging lending opportunities. The returns on those loans in Ireland were very attractive compared to other jurisdictions but importantly, leverage was required by the credit fund to get the target returns and to get leverage, scale is required. The drive to achieve scale to get leverage became a key issue.

Several alternative platforms did get established and the drive for scale resulted in interest margins falling from 8% at the peak to sub 5% immediately before C19.

Pre Covid-19

Immediately pre C19, there were eight alternative lenders (the banks were never really active) all with broadly the same terms for an interest paying CRE project. All alternative lenders shared one important feature; the way in which they finance the loans. In simple terms, a  loan at an interest rate of 6% p.a. must make a return on equity of at least 13% p.a. to hit the fund’s return target. The way to do this is that another lender (the ‘balance sheet lender’ or ‘senior lender’) lends or advances to the fund 70% of the loan at an interest rate of 3% and the credit fund puts up the remaining 30%.

Thus a €1m loan provided by the alternative lender is funded €300k by the credit fund and €700k by a loan from the balance sheet lender at a cost of 3% (€21k). Hence the annual return to the fund is €39k (€60k less €21k) on its outlay of €300k .i.e. a return on equity of 13%. Magic!

Thus, the continued willingness of the balance sheet lender to provide funding is critical to the ability of the credit fund (via the alternative lender) to make new loans or extend existing loans that mature. Of greater importance is that in return for providing the low-cost funding the ‘balance sheet lender’ is in the driving seat when it comes to dealing with loans that go wrong.

Finally, in addition to the credit policies of the fund, the parameters of balance sheet lender are also very important as they may not fund all the loans the fund and alternative lender favours.

Covid-19 Hits

When C19 hit, it was the actions of the ‘balance sheet lenders’ that had the greatest and most immediate impact. The message from the balance sheet lenders to the alternative lenders was that no new funding would be provided. Overnight the CRE funding market closed although most alternative lenders said that they were still active.

Another feature of this arrangement between the alternative lenders and the balance sheet lenders is that the balance sheet lender has the right to withdraw from the arrangement in the event a loan goes into default. Practically this means that the credit fund must repay the money it has borrowed from the balance sheet lender. In the above example, the fund must come up with the €700k it borrowed from the balance sheet funder. In addition to being a drain on precious capital, it also depresses the return on equity for the fund. A double hit. Hence, there was an immediate focus on the loans in terms of their ability to remain within terms.

However, due to the global nature of the pandemic (as distinct from just being a local problem) and the extent of government interventions and supports, the effect on economies and responses from funds has been muted.

Thus, for the most part, from a borrower’s perspective, nothing has happened but behind the scenes there are intensive discussions and negotiations between the credit funds and the balance sheet lenders. The question is when and how this will impact borrowers.

Current State of Play

In practice, the main impacts to date can be split into new funding and existing loans. With regard to new funding, most alternative lenders are effectively closed and those that are open have much tighter credit parameters primarily due to the unwillingness of the balance sheet lender to advance funds on anything but the safest of loans; essentially residential with private tenants, HAP tenants or leased directly to some state (national or local) covenant. Office and industrial can be funded but covenant quality and length of tenure are very important.

Retail is interesting in that foreign funders tend not take account of local market dynamics. The narrative is that the structural move to online retail has been accelerated by the pandemic and repeated lockdowns of retail increases the risk of healthy retail, not exposed to online competition, getting into financial difficulties. Hospitality for obvious reasons is a non-runner and the view is that those business models may be permanently damaged.

Also, in addition to tighter loan parameters, interest rates have increased by the order of two percentage points and back-end fees are higher by one to two percentage points due to the higher risk.

Regarding existing loans, action is suspended but the pressure will build mainly because the credit funds will come under increasing pressure from the balance sheet lender to repay the portion of the loan funded by them. Thus, loans that get into trouble will be a key focus. Also, it will be increasingly difficult to get loan extensions for maturating loans even where the borrower has been performing.

Health warning for borrowers whose loans mature in the next six to nine months. Don’t plan on an automatic extension to the term at maturity from the current lender (bank or alternative lender) and it may not be easy to refinance the loan with another alternative lender and definitely not a bank. Also, it is highly likely that the interest rate will be one to two percentage points higher than the existing rate and more equity may be required.

Thus we think it is important to plan well ahead as the existing alternative lender may not have the option of extending the maturity unless a refinancing is clearly visible.

We will cover residential development loans in the next update, but the current situation is that unless a development is presold or preleased, it is near impossible to fund right now. There is a lot of talk about takeouts by Approved Housing Bodies (AHB) and prelets with Councils. However, our experience is that the requirements and process of these bodies are very onerous and slow. Furthermore, the nature of the commitment to purchase or prelet provided by the AHB or Council usually falls far short of what alternative lenders now require to provide funding.