While many headaches after the global financial crisis were caused by defaulting loan-to-value ratios on the debt behind properties, today’s crisis is expected to provoke greater focus on a different ratio.

“The problem is not going to be LTVs,” comments Charles Baigler, head of acquisitions, private equity real estate at Geneva-based manager Pictet Group. “It’s about ICRs.”

Interest coverage ratios, or debt service coverage ratios – which also consider amortization – are measures used by creditors to determine whether a company’s revenues are sufficient to pay interest on outstanding debt obligations. As today’s negative macroeconomic conditions push down real estate asset values, lenders are increasingly focused on a borrower’s expected rental income as an important barometer to make decisions. “Bank’s concerns are all about income falling away,” says Baigler.

At the heart of any assessment will be more forensic analysis of the occupier base of an institutional property portfolio. In a white paper published last month, Fritz Louw, senior associate at research firm MSCI, warned how cyclical and secular threats are directly impacting tenants. “Rising inflation is also leading to increasing interest rates, further reducing the free cashflow from the portfolios of levered real estate investors. Against this backdrop, understanding tenant-default risk is more important than ever.”

For managers to avoid triggering ICR/DSCR defaults, looking through to the vitality of their entire tenant bases will be important. “We have found many do not go beyond analysis of only their largest tenants,” remarks Louw, adding his paper reveals analysis of only the top 10 tenants by rental income as inadequate because this income often represents less than half of portfolio. “It is easy to miss significant risks with such a narrow focus.”

Alive to the issue is Rob Wilkinson, chief executive officer for Europe at Boston-based manager AEW. He said the firm appointed ratings giant S&P Global Ratings this summer to conduct a portfolio-wide rating of its tenant base. “The occupier side is pretty robust,” he said. “Will we see credits weaken within the tenant base? So far, we aren’t seeing anything bite. But I can’t rule out tenants will default in certain circumstances.”

When that happens, the fallout for ICR/DSCRs is expected to lead to tough decisions for lenders. Dallas-based manager Invesco Real Estate, one manager seeking to bridge a widening hole in the real estate credit markets left by traditional bank lenders with its debt funds, is among those with an eye on borrower vitality. Andy Rofe, head of Europe at Dallas-based manager Invesco Real Estate, said: “We always say credit over yield. The real estate has to work and the sponsor has to work.”