CRE loan-on-loan financing a 'relationship-oriented business'

Speakers on the loan-on-loan financing panels at SCI’s inaugural European CRE Finance Seminar last month stressed the importance of a good working relationship between lender and borrower. They also noted that “capital is king” for banks, pointing to securitisation as an effective way to lower RWA treatment for such lending.

Commercial real estate loan-on-loan financing is a relationship-oriented business, the panellists agreed. Their advice was to “tend the relationship carefully”, as ideally it will evolve in tandem with a borrower’s business.

“The key is to get comfortable with what happens if anything goes wrong with a loan,” observed one speaker. “It’s important to be able to request something in short order, so aligned interest between lender and borrower is crucial. Set the framework regarding consents and waivers upfront and work together to resolve issues as they arise.”

Another speaker noted that with development finance in particular, unexpected situations always crop up, so borrowers need to understand when to talk to the lender. “Communication between borrower and lender is crucial. As a borrower, you need clarity about which activities approval is required for and which you can undertake without approval,” he said.

Within the CRE financing space, panelists suggested that loan-on-loan facilities are appropriate for income-producing real estate and transitional assets, while repo arrangements are more appropriate for properties with material construction risk or capex requirements. Protections for lenders include mark-to-market mechanisms, full or partial recourse and guarantees.  

AJ Storton, executive director at JPMorgan, indicated that the level of protection depends on the nature of the underlying loans. “Recourse would typically be required for a higher risk asset or jurisdiction, or until a certain level of diversification is reached, for instance. Another example is requiring future funding guarantees for development loans,” he explained.

He added: “In terms of MTM mechanisms, there can be limited to full discretion, with marks often reflective of the underlying loan covenant triggers. Marks can be benchmark, spread or credit-based, with the latter being the most common.”

Cross-border facilities – whether in Swiss francs, Swedish Krona, sterling or euro – are common in Europe. Under such facilities, each loan is structured as a separate drawdown under the relevant currency. Supplemental security may be required to ensure recoveries are recognised in each jurisdiction.

There are high barriers to entry for newer players and smaller debt funds, according to Rick Hanson, partner at Morgan Lewis. “Bigger players have more bargaining power, but we try to ensure that the documentation is as objective as possible. Often, the most problematic issue is how collateral assets should be valued, given that such assets are fundamentally illiquid and mark-to-market provisions are typically seen in valuing more liquid assets,” he observed.

Hanson noted that over the last 18 months, discussions have increased around ‘bad apple’ risk. In such situations, the discussions revolve around whether the asset can be isolated in a sidecar or other vehicle, or a bridge facility can be utilised while the asset is worked out.

Meanwhile, the office sector – which is seeing vacancy rates of below 10% in Europe, compared to around 20% in the US – was the focus of much discussion on the event’s CMBS panel. “People are demanding a lot more and looking to pay a lot less because of vacancy rates across the board in Europe,” observed one speaker.

Against this backdrop, a seismic shift is occurring in the office sector, with a polarisation between Grade A sustainable office spaces and standard office spaces that haven’t been upgraded over the last 25 years. Redevelopment was promoted as a means to future-proof these office assets.

Grade A offices are also now invariably those in a good location close to transit routes. These properties are expected to perform well, to the detriment of Grade B and C office assets.

Looking ahead, while more CMBS are maturing over the next three years, educating stakeholders on reasons to extend the underlying loans and where the market is in the credit cycle can help. Panellists agreed that lenders would rather not enforce if they do not have to and, thus, extending is often a better option than foreclosing.

Corinne Smith & Claudia Lewis