The nature of the UK’s departure from the European Union is still defined by uncertainty, leaving businesses precariously positioned in no-man’s land. What might come next is preoccupying the domestic real estate debt market, including private equity investors.Uncertainty and the potential for an economic contraction are the fundamental risks posed and threatens the sector in three specific ways.
- Reduced lending appetite
Conventional sources of capital – clearing banks – are increasingly reluctant to lend against projects outside the London prime real estate market or beyond hot sub-sectors like the private rented sector, student accommodation and logistics. This applies even to borrowers with which they enjoy longstanding relationships. Liquidity is tight. Banks are re-evaluating their lending and the risk they are willing to take, and not just for new deals. Refinancing is not easy; borrowers are being asked to accept higher pricing and/or to inject further equity to reduce lenders’ exposure to assets.
The solution for private equity investors is to seek out alternative lenders that may have more lax risk appetite, including challenger banks, insurance companies and private debt funds that offer the additional benefit of being generally much speedier in gaining credit approval and ultimately executing a transaction. Choice presents a further test to borrowers: how to access and assess this large pool of sometimes unknown players that offer a variety of unfamiliar financing solutions. Getting it wrong might not be obvious at the outset, but is a high risk further down the line. To mitigate this risk, borrowers need to be crystal clear on their business plan for the asset and their borrowing objectives, including flexibility, timeline and key assumptions in order to devise a well thought-through debt structure. Then their task is to match this to a provider’s offering.
- Rising FX risk
Since sterling plummeted in the wake of the Brexit referendum in June 2016, currency exposure has posed a risk to any real estate investor with exposure to pound sterling, including the numerous private equity real estate funds that invest cross-border. The risk for those that acquired sterling-denominated assets is currency depreciation and its impact on asset valuations, irrespective of the performance of the underlying portfolio. This is a high priority concern. The private equity debt funds that have stepped into the real estate lending market to fill the gap left by banks are particularly sensitive to FX risk. They promise returns to investors that will not tolerate a negative impact from a currency move.
The answer for borrowers, and debt funds, is to define an FX management strategy. There is a range of hedging tools available: FX forwards, swaps/rollovers, options and collars. Sometimes the best outcome is to retain an unhedged position, but this can only be judged in hindsight. The key is to validate this decision through detailed analysis. In our experience, investors are increasingly asking asset managers to justify their approach to managing FX risk. Asset managers need to be prepared to substantiate their position.
- Interest rate unknowns
Should crashing out of the EU or the prospect of extended negotiations precipitate a recession, how will the Bank of England respond? Or, conversely, if the economy ‘bounces,’ would that mean interest rates are more likely to increase? Anticipation of rising interest rates prompted a wave of refinancing in 2018, when we saw our clients either seek to extend their debt or enter a new hedging to take advantage of current rates, and so future proof their financing on a five-year time horizon.
While these risks are very real, they can also offer opportunity. Future-proofing debt costs via active refinancing and smart interest rate hedging provides certainty on a five-year horizon, leaving asset managers to focus on their portfolio management and originating new investments. Often, FX hedging can result in enhanced returns instead of being a cost, due to the interest rate differential between different markets; euros vs US dollars, for example.
The doomsday commentary about Brexit chaos and a slowing global economy is only one side of the story. The weight of capital investing into European real estate remains positive, and debt liquidity for well-positioned investments is high. There are many bright spots, and you don’t need to look too hard to find them.