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Domino dancing

James explores how the dominoes are slowly falling as we head towards a distressed UK real estate sector.

THE UK’s commercial real estate sector is currently facing a variety of challenges – increased interest rates, stubborn inflation, falling property values, and liquidity issues for lenders and borrowers. All these elements have been stacking up for some time like a line of dominoes standing on end. As each one falls, it knocks into the other and so on, like the mounting pressures stacking up in the property market.

The domino effect
Over the past five years, the UK real estate has faced significant hurdles. Brexit, the Covid-19 pandemic, political instability, supply chain disruptions in building materials, and the current cost of living crisis have all created challenging conditions.

Currently, the property market is grappling with heightened interest rates set by the Bank of England, which, as of January 2024, holds the base rate at 5.25% to combat inflation. Despite lenders reducing mortgage rates, borrowers still experience substantial pressure owing to the rising costs of borrowing instigated by the Truss administration’s policies.

The combined effect of these factors is a decline in property values, pushing borrowers to the limits of affordability, causing dwindling equity for investors and homeowners alike, alongside an increase in their debts.

Furthermore, the financial ecosystem is experiencing liquidity issues, as declining property values and rising defaults lead to reduced assets for lenders. With liquidity constraints tightening, lenders’ capacity for extending new credits or refinancing troubled loans becomes severely limited. This is compounded by a shift in investor preference from equity to subordinated debt, prompted by the high-interest-rate environment.

The consequences of inactivity
The slow decline into distress has serious consequences for lenders and borrowers. Lenders may struggle to refinance loans or recover investments, impacting their financial stability and ability to fund deals.

If refinancing is impossible, selling assets becomes the only option, but doing so too late risks flooding the market and lowering asset values. Borrowers face challenges securing refinancing or loan restructuring, risking default and property loss. Inaction has dire consequences for lenders and borrowers.

What can be done?
Waiting for the last domino to fall isn’t a viable option and action needs to be taken now by lenders and borrowers alike.

Assessment: Both lenders and borrowers must exercise caution and vigilance. Lenders are advised to reassess their loan portfolios and identify potentially problematic loans. They should maintain open lines of communication with borrowers and contemplate various options, including pre-payments, extra equity from the borrower, extending repayment periods, and securing additional collateral. Monitoring market trends closely and conducting comprehensive due diligence for new loans is also emphasised. On the other hand, borrowers should thoroughly evaluate their financial status, and those with operational assets need to consider strategies such as renegotiating leases or cutting costs to improve cash flow.

Communication: Early and honest communication between lenders and borrowers is essential for resolving potential issues. Borrowers who are transparent about their struggles may find that lenders are willing to provide additional support or solutions, whereas delayed discussions could lead to missed opportunities and detrimental outcomes.

Lenders favour borrowers with a solid track record and credible advisors who can offer alternative plans in challenging situations. Successful resolution of issues and transparency can cultivate a lasting relationship, increasing the likelihood of future collaboration after repayment.

Alternative financing: Borrowers and lenders are encouraged to consider alternative financing options that offer more flexibility than traditional methods. Creative financing solutions like partnerships, joint ventures, seller financing, lease options, private lending, and accessing alternative liquidity sources can better suit specific project needs. Although these differing methods can open up new investment opportunities, they may come with costs such as adjusted rates or fees.

In situations where cash is low, companies might need to liquidate fixed assets, but it’s preferable to revise debt terms or restructure operations to improve liquidity. Such financial adjustments are strategic methods to achieve financial obligations without the immediate need to convert assets into cash, which could disrupt business operations.

Bridging loans can be crucial for borrowers needing quick financing. However, caution is advised as the lack of a secure and credible exit strategy could pose risks, potentially leaving both borrowers and lenders vulnerable. Reputable lenders typically look for a well-defined repayment plan, valuing a solid exit strategy over credit history.

Borrowers facing liquidity challenges should work with lenders to devise a realistic exit strategy, accepting potential extra costs to avoid the severe consequences of loan default, such as damage to credit history, and considerable financial losses due to the high-interest rates associated with bridging loans.

When additional funding cannot be found
Lenders often sell problematic loans to distressed debt investors to avoid the uncertainties of debt workout, which requires specialised skills that not all lenders possess. This can lead to the borrower dealing with a more aggressive lender as a result. In recent years, receiverships have been more common among alternative lenders rather than large banks due to their higher exposure and lack of workout expertise, leading to indecision.

Receivership is typically used for single assets, especially property, due to its straightforward enforcement. However, when dealing with more complex properties or situations where the business’s other assets may also need to be realised for repayment, an administrator might be appointed.

Particularly in scenarios where the asset includes an operational business, like a care home, administrators are preferable owing to their broader powers compared to a receiver, albeit this is subject to the security documents’ specifics.

Engaging experienced legal support will allow all parties to make informed decisions to safeguard their interests, mutually and independently. The key to this is to move swiftly. Time can be costly in this sector, and while there’s no silver bullet fix to the economic challenges at hand, taking the appropriate advice, at the crucial time, should increase the chance of survival.
James Dakin is a finance expert at Newmanor Law

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