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Banks' patience with UK landlords faces test in 2021 as COVID-19 crisis bites

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Owners of retail property in the U.K. are among the most exposed to the impact of the COVID-19 pandemic.
Source: Matthew Horwood/Getty Images News via Getty Images

Banks and property do not have a great record when it comes to global recessions.

The 2008 financial crisis was infamously spawned by loose lending to homeowners in the U.S. The contagion that subsequently spread through the global financial system exposed similarly reckless lending to the commercial property sector, leading to a collapse in values as banks beat a hasty retreat.

In the latest downturn, banks in the U.K. so far appear to have avoided falling into the same traps. The harsh lessons of a decade ago meant leverage in the U.K. property sector was significantly lower as it entered the COVID-19 pandemic than in 2008, and banks have appeared reluctant to act as hastily against struggling landlords.

That is likely to change as 2021 progresses, Dr. Nicole Lux, project director of real estate lending research at Cass Business School in London, said in an interview. "We haven't seen loan defaults and receiverships yet," she said. "But banks will start triggering defaults and go down the foreclosure route with landlords that are not expected to recover, and we expect that to happen by the middle of [2021]."

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The U.K. commercial real estate lending market is estimated to be worth around £238 billion, including undrawn exposures, according to data from Cass Business School. Cass' research covers lenders holding £185 billion of secured loans on their books, in addition to £18 billion of undrawn facilities for property development.

Secured lending in the U.K. commercial real estate sector is about 15% or 16% of total lending exposure on institutional lenders' balance sheets, according to Lux. That figure has fallen from above 20% before the global financial crisis, she added.

Impact on landlords

The impact of the COVID-19 pandemic on the U.K. commercial property sector has been severe in places. National lockdowns and widespread restrictions on movement and behavior have particularly affected tenants in the non-food retail, hospitality and leisure sectors. The U.K. government introduced a moratorium on commercial property evictions in March, which has since been extended to the end of March 2021.

Such measures have meant that much of the pain felt in affected sectors has been passed on to landlords. U.K. tenants had paid just 67% of rent due 60 days after the March quarter rent collection date, according to commercial property management software firm Re-Leased. Rent collection rates for 60 days after the June quarter and September quarter dates stood at 68% and 75%, respectively.

The sharp drop in income for landlords has seen many struggle to meet commitments to their lenders. While banks have been in a position to take punitive action, they have "stayed their hand" so far, said Jon Knowles, head of national capital markets at real estate services firm Colliers International.

"There are a lot of landlords who are in technical breach of their interest cover ratio because they've not been making the interest payments on whatever loan they've got in place," he said. "But we've seen very little enforcement on that. There's a lot more patience in the market."

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The exposure of the U.K.'s four major banks to the sector's most severely impacted landlords is unclear. Lloyds Banking Group PLC reported net exposure of £14.7 billion to the U.K. commercial property sector in its first-half of 2020 report, down from £31.5 billion in 2012. HSBC has £12.3 billion of wholesale loans and advances to U.K. real estate of £70 billion total lending to businesses in the country, according to its first-half of 2020 report.

Barclays PLC and NatWest Group PLC did not provide data on their exposure to the commercial property sector in their most recent reports. All four major U.K. banks did, however, outline their exposure to the sectors most vulnerable to the impact of the COVID-19 pandemic, which showed retail, hospitality, restaurants and leisure as areas of concern.

U.K. banks have reduced their exposure to the country's commercial property sector in the last decade and currently account for around 45% of the lending market, said Lux. The rest of the market is comprised of foreign lenders, debt funds and insurance companies. U.K. banks are strongest in the country's regions as the pricing model is slightly higher than in central London, where they have been pushed out by stiff competition from German lenders, Lux added.

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The pandemic saw lending to the U.K. commercial property sector shrink in the first half of 2020. New loans to the sector totaled £15.5 billion in the first half, down 34% on same period a year before, according to Cass data. Of the 76 lenders covered by Cass' research, 17 did not originate any lending in the first half of 2020. "Pricing has absolutely increased across all types of lending," said Lux.

Banks yet to penalize landlords

Current loans to the commercial property sector have generally been managed with a degree of sympathy for the unprecedented situation faced by landlords, said Keith Breslauer, founding partner and managing director of private equity firm Patron Capital. "If you can pay them a bit of cash and you can show them that you really care about your asset, that you're not just giving up on it, the banks will work with you."

Much of the activity in the U.K. lending market in 2020 involved loan extensions, usually between six and 12 months, said Lux.

U.K. lenders are more likely to act against landlords as greater clarity emerges on the pandemic's impact on property valuations and landlords' loan-to-value covenants are tested. The Royal Institute of Chartered Surveyors has gradually eased a "material uncertainty" clause on valuations it introduced in response to the initial shock of the pandemic. Some landlords have already breached loan-to-value covenants, but banks have yet to act, Knowles said.

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A clear indication of the pandemic's impact on U.K. commercial property valuations came in November 2020, when one of the country's largest real estate investment trusts reported its fiscal first-half 2020 earnings. Landsec, which owns a U.K. property portfolio worth £11.8 billion, saw the value of its regional shopping center portfolio plunge by 20.4% in the 12 months to Sept. 30, 2020, its London retail assets drop 16.7%, and its London offices fall by 2.3%.

Such valuation evidence could put many more landlords' loan-to-value covenants at risk, and some lenders have become "a little bit more aggressive" in recent weeks, Breslauer said.

But the majority remain patient, he added. "Most banks have agreed to defer any kind of covenant testing, if it's not residential, until the first quarter or second quarter of 2021," said Breslauer.

Whatever action lenders eventually take, the pandemic's impact on their loan books is unlikely to be anything like that seen in the aftermath of the financial crisis, according to industry experts. The level of debt in the commercial property sector is much lower than it was a decade ago, and exposure to speculative development is minimal, they said.

Furthermore, the secured nature of real estate mending means that, just like in the years after the financial crisis, banks can recover apparent losses through the eventual sale of property assets once the market improves, said Lux. "That's the point of secured lending," she said. "You're supposed to recover most of it."