Market review September 2022

22 September 2022

It’s fair to say that the UK Economy is being buffeted by a wide range of headwinds. The UK has benefitted from a long period of record low interest rates and more recently substantial financial support for individuals and businesses during the COVID pandemic however we are now seeing rapidly rising inflation rates coupled with material increases in the Bank of England Base Rate and SONIA (Sterling Overnight Average), which is the rate banks borrow from one another at.

Inflation is being driven by (amongst other things) supply shortages post COVID and the ongoing war in Ukraine which is driving energy prices ever higher and which is also feeding in to rising food costs, fuel costs and many other aspects of people lives.

This, coupled with the increase in the cost of money is also driving up borrowing costs which impacts homeowners (especially those on variable rates) leading to an acute cost of living crisis. Corporate borrowers and property investors are similarly affected.

To give some context to these points, the table below show the change in the SONIA floating and swap rates over 1 day, 1 month and 12 months. Swap rates are the fixed rate of interest a borrower can secure in the market with the 5 year swap being a ‘benchmark’ for borrowers looking to secure a 5 year fixed rate.

 

 

The interest cost of borrowing is made up of two key components:

1. The lender reference rate – typically one of Bank of England Base Rate, Gilts or SONIA
2. The Margin – this is the cost a bank charges their borrower and it is an assessment of the banks risk and the level of return they require.

 So, using the table above and looking at the change in costs:

  

So, if you had borrowed £10m in 2021 from a Sonia based lender, by 2022, your interest burden would have increased by £361k pa or £1.8m over a 5 year term (assuming interest only borrowing).

The increased interest cost is putting pressure on interest cover ratios and lenders are stress testing off higher rates still to ensure rental income is capable of servicing the facility in the event of an even higher interest rate environment at facility expiry and to allow for a loss of income over the term should some tenants cease trading. Lenders are reducing leverage as a result. Whereas year you might have seen 60% interest only on prime assets 55% is the new normal. Several lenders have already indicated that they won’t consider facilities beyond 50% as a general rule. So borrowers are facing a double hit of reduced leverage and higher borrowing costs. It seems inevitable that this will feed through to property yields – indeed we are already seeing it – and while inflation may come through in the rental market it is unlikely to be to levels sufficient to offset yield shift. Values will be under pressure. 

This material rise in the cost of debt isn’t limited to specific asset classes – we are seeing increased margins across the board and the increase in SONIA is universal. It is also feeding through to development finance where loans are typically floating and unhedged. For example, we are now seeing the cost of development debt for residential developments on a stretch senior basis increase to between 7%-8% (excluding arrangement and exit fees) over SONIA (floating). The graph below shows the forward curve for SONIA – the expectation for the SONIA floating rate at various points in the future. The market is suggesting that this could reach 5.53% by October 23 – so this could lead to development finance costing say 12.5% over certain periods of the development, which will mean a larger percentage of the total facility will go to servicing interest and will put further pressure on developer profits.

So, what does this all mean to real estate finance? 

Certainly, in the short term, and as we are already seeing, the cost of debt is going to increase materially and leverage reduce.  This should have an impact on property yields and you would expect property prices to fall as yields move outward. In addition, the increased cost of debt for development will lead to developers needing more equity as profit margins are shrunk.

But, in addition, this will mean new opportunities present themselves as prices and yields correct to the new costs of borrowing.  We may also see an increase in distressed assets come to market and land values for sites with planning should see some price reduction too.

The key point is to ensure you seek advice for your real estate debt requirements as having an experienced property professional to help you navigate these choppy waters could be the difference of getting a great deal or no deal.

The Peritus Corporate Finance Team brings together decades of experience across all asset classes with a team who have seen and understand complex property markets and investment cycles be it expansion or recession.