min read

The dominoes may slowly fall as we head towards a distressed commercial market

Commercial Proeprty

The UK’s commercial real estate sector is currently encountering various challenges - such as high interest rates, inflation, declining property values, and liquidity problems for lenders and borrowers.

These factors have been accumulating over time like a row of dominoes, and they could be ready to topple? If one falls, it triggers a chain reaction, reflecting the mounting pressures in the commercial property market.

Initially slow-moving, this situation can easily escalate rapidly. Failure to act in response to this environment could result in severe consequences for lenders, borrowers, and other stakeholders. 

This article delves into the factors contributing to this crisis and explores potential strategies for addressing them.

The Domino Effect 

Over the past five years, various issues like Brexit, Covid, political uncertainty, material shortages, and the cost of living crisis have unfolded, piling on the pressure on those operating in the commercial real estate sector. 

Then there’s the rising interest rates as the Bank of England attempts to grapple with inflation - a fight that is expected to rumble on.

Borrowers continue to face pressure despite easing interest costs, maintaining a high burden compared to the last 15 years. The days of a 1.25% rate seen in Summer 2022 are unlikely to return, adding stress to borrowers seeking refinancing or struggling with current obligations. This leads to falling property values, exacerbating affordability concerns for occupiers and putting investors and owners in a tight spot with reduced equity and rising debt.

Liquidity problems for lenders will only worsen the situation. As borrowers default and property values decline, lenders are left with a shrinking pool of assets, limiting their ability to offer new credit or refinance troubled loans. Finding equity is particularly challenging, as investors now prefer subordinated debt over traditional equity in a low-interest environment.

The Consequences of Inactivity

The slow-motion descent into distress poses severe consequences for all stakeholders involved. For lenders, the inability to refinance loans or recover their investments can greatly impact their financial stability, and in some cases, their ability to fund deals at all.

If refinancing becomes unattainable, disposing of assets may be the only viable course of action. However, acting too late risks flooding the market with similar assets, causing a price correction that further erodes their value. Caught in a precarious situation, lenders are facing the challenge of calling the bottom of an unpredictable market.

Borrowers, too, face difficult decisions ahead. Stuck in an unfavourable borrowing environment, they are finding it increasingly challenging to secure refinancing or restructure their existing loans. Naturally, lenders are being very selective regarding their lending criteria and valuations, constricting approval of deals. Without a proactive approach to address these issues, borrowers risk defaulting on their obligations, potentially leading to enforcement and the loss of their properties.

Inaction, therefore, is simply not an option.

What can be done?

It’s important to remain proactive with such matters, and there are several recommended steps that should be considered to ensure the pitfalls are effectively negotiated;

Assessment: Lenders ought to be closely examining the loans in their portfolios to spot possible trouble spots. They must be transparent in their communication with borrowers and consider options including prepayments, adding more borrower equity, delaying repayment terms, and securing more security. Lenders should also be cautious when evaluating new loan prospects and keep a careful eye on market trends. It is crucial now more than ever to take the time to do appropriate due diligence, which includes legal reporting.

It is vital that borrowers evaluate their financial situation in-depth. Owners of operating assets ought to look for ways to improve cash flow, such extending the lease or cutting expenses. Mid-scheme developers are more susceptible to increased expenses and decreased demand. It's critical to handle contractors well.

Communication: It will be more important than ever for borrowers and lenders to communicate with one another as soon as possible in order to address any potential problems. Many times, if the borrower had been more forthright and honest about their difficulties, additional funds could have been made accessible. However, by waiting it out, the lender will not have the chance to offer its support or assist in finding a solution, which could have disastrous consequences for the borrower.

But, a lender's decision to support a faltering loan or development depends on the borrower's performance history, conduct, and capacity to meet obligations. This also applies to the reliability of the group of advisors a borrower has chosen to surround themselves with. 

Lenders ultimately want to establish relationships with borrowers who are honest and open in their communications, and who are ready and able to address problems when they come up. This way, when the lender gets repaid, they will be more likely to work together again. A lender who feels aggrieved is more likely to enforce guarantees.

Alternative Financing: Alternative financing solutions should be taken into account by both lenders and borrowers. Adopting creative financing makes it feasible to customise funding to meet the unique requirements of the current project. Because these options are more flexible than traditional methods—which have tight criteria and rigid terms—they will present investment opportunities that traditional lenders might pass up or think are too risky.

These might include joint ventures, partnerships, seller financing, lease options, private lenders, or obtaining funds from other sources that can offer more flexibility and liquidity. Seeking stock investors or investigating finance options catered to particular situations could be part of this. 

Note that secondary sources of liquidity cannot simply be turned into cash without affecting a company's operations. Yet, in order to satisfy their financial obligations, a borrower who is short on cash or near-cash assets could have to sell off assets like machinery, plants, and inventory.

Still, there are alternatives. Reworking loan conditions and repayment schedules, extending loan terms, or reorganising a site to sell off more land are among options that debtors may want to explore in order to get more liquidity. However, there will probably be a cost associated with each of these options, such as exit and arrangement costs or modified rates from the lender. 

In the current economy, bridging loans may also be very helpful. On the other hand, if the borrower's exit strategy is not secured or does not have the credibility to persuade a buyer or refinancing lender (be it development, refinancing, sales, or rental), a lot of borrowers and lenders will find themselves in a difficult situation in 2024.

The majority of respectable lenders will not provide a bridging loan without a clear repayment plan, and they will really give confirmation and clarity to an escape strategy before credit history. 

If a borrower has liquidity concerns, they should work with their lender to develop and approve a reasonable exit strategy. While there may be additional costs and covenants associated with this technique, the alternative of defaulting on the loan and incurring default interest rates and penalties is far worse. Going much beyond the loan period might harm the borrower's credit history, lead to repossession, and result in severe financial losses because bridging loans have higher interest rates. It is preferable for all parties to reach a consensus.

When additional funding cannot be found

The current economic situation differs significantly from that of 2008, when property values plummeted by 15% within a few months, triggering substantial repossession activity. Presently, we observe more modest declines in property prices, yet these are adequate to induce considerable financial strain on already stretched budgets. The real estate sector is experiencing a notable decrease in demand, both in residential and commercial properties, leading to enforcement measures across the market.

Large-scale development projects have been severely impacted by this chain reaction. Consequently, numerous promising sites are now facing challenges purely due to evolving circumstances. While resorting to administration and receivership is typically considered a final option due to concerns about devaluing assets through formal insolvency procedures, the current hope is to sustain more projects by absorbing losses privately, given the diverse and extensive funding sources available.

When salvaging a project becomes unfeasible, lenders are left with two primary choices: appointing a receiver to manage the asset or selling the debt to an investor. Choosing between these options hinges on the level of certainty and the ability to manage the workout process effectively.

Opting to sell the debt guarantees a definite loss for the lender, contrasting with the potential uncertainties associated with attempting to restructure the loan for a more favourable outcome. However, debt restructuring is a specialised field, and not all lenders possess the requisite expertise to navigate such scenarios. Consequently, lenders may lean towards selling the debt to distressed debt investors, potentially exposing borrowers to more assertive creditors than their original lenders.

In recent years, the prevalence of receiverships has shifted towards alternative lenders rather than major banking institutions, largely due to increased exposure and pricing differences. New market entrants may lack the necessary skill set to handle workout situations effectively, leading to decision-making challenges.

Receivership stands out as the simplest enforcement method, particularly effective for single assets or property-centric cases. In contrast, more complex property scenarios may benefit from administrator involvement.

An administrator can be appointed where the security has a qualifying floating charge.  In addition to being tasked with realising all assets—not just property—the administrator also has a duty to all creditors. When a lender believes they won't be paid back solely from the property asset and can recoup costs from other assets, that arrangement can appeal to them.

Given that administrators typically have more authority than receivers (depending on the security documents), they are usually preferable when dealing with assets that involve active businesses, such as care homes, as their powers tend to be greater.  

Get support

Lenders and borrowers alike need to take the initiative to address the issues at hand and seek professional guidance in order to minimise any potential damage in the face of these challenges. 

By retaining skilled legal counsel, all parties will be able to independently and collaboratively make educated decisions to protect their interests. The important thing here is to respond quickly and not put off taking corrective action in favour of waiting for the previously described dominoes to fall. In our industry, time is of the essence. Although there isn't a magic bullet to solve the current economic problems, acting wisely when it matters most should improve everyone's chances of surviving. 

About the Author: James Dakin is a finance expert who acts for a number of big banks and institutional borrowers, and more recently has worked with private firms and start-ups involved in commercial property and its funding.

About Newmanor Law: Newmanor Law is a specialist real estate law firm, combining fresh technology with legal insight, working with property professionals on acquisitions and sales, construction matters, development, property disputes, landlord and tenant matters, along with debt finance and tax matters relating to property.


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