In this latest Scope Ratings interview, Florent Albert, Director in Structured Finance, and Philipp Wass, Executive Director in Corporates, explain why in conversation with Dierk Brandenburg, head of credit and ESG research.

Dierk Brandenburg: The big issue these days for the real estate sector is that rates have risen and are likely to keep rising. How is this affecting asset values and project risk?

Florent Albert: Real estate valuations in structured-finance deals have increased to all-time highs across all types of properties except retail. So recent acquisitions have been expensive while rental growth is lagging, compressing cashflow yields.

Most commercial real estate direct lending is financed on a floating basis with generally a cap as interest-rate hedge protection. Plenty of competition among lenders and low interest rates had led to a relaxation of hedging terms with high strike rate and/or partial debt hedging in certain transactions. Rising rates squeeze debt servicing ratio metrics for these deals.

We expect yields to widen some more as risk-free rates continue to rise which will ultimately impact property values and leverage. Real estate assets are not mark-to-market assets; it will take time for values to adjust but the signs are already here, with some secondary assets with flat rental growth dropping 30% in value since Covid.

Some borrowers may struggle to refinance their assets with the same quantum of debt if rates continue to rise and rents remain flat, though we remain optimistic for the sector: it is a good hedge against inflation, resisted the pandemic well and exhibits generally healthy underwriting standards.

DB: What options do borrowers have to reaction to rising rates?

FA: On the leasing side, borrowers negotiate more inflation indexed leases and try to pass on costs to tenants. In the retail sector, we see more short-term leases with a turnover component, which is beneficial for both sides in an upturn but of course bears more downside for lenders in a downturn.

On the financing side, borrowers are keen to close out refinancing plans to lock-in interest rates before they rise further. We see more commercial discussions between lenders and borrowers on hedging terms and conditions, strike rates, and hedging limited to a quantum of the debt.

For underperforming and soon-to-refinance transactions, some borrowers are looking for short-term loan extensions until market conditions get better and Covid-related risk is clearly off the table before securing longer-term financing.

DB: What about credit risk on tenants' side an issue?

FA: Much has been said about credit risks in the retail sector especially for UK shopping centres and high streets. Many have filed for insolvency, sought rent deferrals or rent reductions after years of decreasing footfall and revenues. Our recent research on securitised loans since 2017 shows that median retail rents are 20% down. However, rents for niche retail warehouses anchored to essential business-like grocery shops are holding up.

Industrial tenants continue to surf the e-commerce wave and accept paying higher rents – 6% up for recently securitised loans. Nevertheless, over-supply concerns are appearing not least after Amazon said it had too much warehouse capacity.

In the office market, we see a K-shaped outlook, with prime properties fetching higher rates while secondary sites struggle to keep up rents and maintain occupancy despite longer rent-free periods.

DB: What about the impact or rising rates on property companies?

Philipp Wass: Generally, most property companies – with some exceptions like homebuilders - are well protected (see chart and table above). They used ample market liquidity to extend debt maturities, reduce weighted average cost of debt and cap interest-rate exposure. We see little debt service risk for now.

However, faced with the rising cost of capital, companies are shifting strategy. For those with on-balance-sheet developments for which yields might not live up to previous expectations, companies are cutting back capex or are switching to “develop-to-sell” to get access to institutional investors through co-financing, while retaining management of the assets. Another option is to offload performing assets, perhaps into JVs, to reduce debt and strengthen capital recycling to upgrade and diversify portfolios.

DB: Do you see financing/deal-structure disadvantages for structured finance vs property companies?

FA: More than the type of financing, it is the quality of asset that matters. A good asset can be financed with fixed rate debt or floating-rate loans. Many investors will favour floating-rate financing to hedge interest-rate risks. However, deep-pocketed lenders like insurers will continue lending on a fixed-rate basis to match their liability profile. Above all, sponsors need flexible financing solutions to cope with the fast-evolving macro environment characterised by rising rates and inflation, structural changes, and the active management needed for real estate.

PW: Squeezed profit margins amid weaker economic growth, supply-chain disruptions and increasing interest rates are all big risks for property developers. Rising costs, delays in time-to-deliver and declining purchasing power of customers will also force developers to finance projects for an extended period, levelling up finance costs especially as floating-rate debt constitutes much of their borrowing.

FA: This is particularly true in Germany, where, without a property crisis for a long time, complacency has led to some covenant-lite lending. Some top-notch commercial real estate development projects face problems, not just on the cost front but also on time-to-deliver.

PW: Falling asset values will negatively affect credit quality through higher LTVs, though the reliability and stability of valuations depends on the location and type of property as investors are likely to continue to focus on safe-haven assets, accepting stable/low yields for low-risk prime properties. Correspondingly, yields will widen on second-tier assets. 

While asset values may be inflated, real estate companies have been tying dividends to cashflow rather than unrealised gains, with some regulatory exceptions for REITs. Rising rates will impact distributions as we expect companies to maintain stable pay-out ratios.

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Contributing writer: Matthew Curtin