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Fear of sharp price corrections due to high financing costs

Maud Visschedijk • 17/11/2022
Higher financing costs are a major reason why sentiment in the real estate investment market and for property development has turned abruptly in recent months. In several segments, interest costs are already substantially higher than initial yields. 'The math simply doesn't add up.'

So says Maud Visschedijk, Head Debt & Structured Finance EMEA at Cushman & Wakefield in Amsterdam. Six months ago, in an interview with Vastgoedmarkt, she predicted a deterioration in the commercial real estate finance market. Unfortunately, that prediction has largely come true due to rising interest rates, skyrocketing inflation and impending recession. As a result, real estate financiers are demanding higher margins and are more risk-aware.

According to Visschedijk, both margins and interest rates have risen significantly over the past six months. For 5-year fixed rates, you now pay around 3.0 percent. That was still 1.3 percent in April. In addition, the margin is roughly 50 to 100 basis points higher than six months ago. 'All in all, you quickly get to 5.0 - 6.0 percent financing costs. At the same time, banks are showing more restraint and there is more focus for the quality of the borrower and the property. As we also saw in the credit crises, the counter is no longer open to everyone,' Visschedijk said.

No drying up of the market

But those who fear a completely drying up commercial real estate finance market, as during the credit crisis, she can immediately reassure. 'There is still plenty of supply thanks to the many debt funds; these funds have no trouble raising capital. With these funds, financing is a lot more expensive, but they can also accept more risk.'

There is also a group of investors who have the luxury of buying entirely with their own money. Thanks to these buyers, there is activity in the investment market. Visschedijk: "Such parties reason 'in a year or two or three, inflation and interest rates go down and the market improves. By then I'll finance it.' But of course there are also many investors and developers who do not have this alternative. They have to acquire or (re)finance at significantly higher costs or by issuing a lower bid.'

Vastgoedmarkt article - Fear of sharp price corrections due to high financing costs

Source: Chatham Financial

Which sectors are most vulnerable to price corrections due to high financing costs? And how much do you expect prices to drop?

'It varies greatly by asset and sector, but I expect a substantial price correction, between 10 and 20 percent. Low financing costs have helped drive down yield requirements, and to make the math work, the price will have to be adjusted downward. 'Core' properties with low initial yields are vulnerable in this regard because these properties have benefited the most from low financing costs. Examples can be cited where financing costs are four times higher now than they were a year ago. However, there are also countervailing forces, such as indexation due to inflation and scarcity of sustainable, high-quality product. The property that excels in this will emerge as the winner.'   

'Looking at sectors, logistics and housing in particular are facing robust price corrections. These are sectors with low initial yields and are therefore sensitive to increases in interest rates or margins. At the same time, thanks to the high occupancy rate and high demand for storage space, the logistics market is experiencing solid rental growth. The question is, however, whether the user market will remain so strong given the developments in the macro economic field. Here, too, the difference between core and non-core will widen. Financiers will look more critically at asset quality, location and cash flow stability.'

'The impact of policy adjustments is creating negative sentiment in the housing market. With government imposed restrictions on housing rents, the residential market is hardly experiencing full indexation. In contrast, the fundamentals of the housing market are strong due to continued deficits, immigration growth and rising wages.'

So you foresee substantial price corrections. What does that mean for the agreements borrowers have made in their financing agreements about the level of loan-to-value and interest coverage ratio (ICR)?

'You often hear that the financing rate, the loan-to-value, is much lower than 15 years ago, which would make borrowers and banks less vulnerable to drops in value now. This is true in a sense, because the LTV is indeed lower on average than it was then, but the financing per square meter, on the other hand, has not necessarily decreased. It is primarily the high appreciation that has caused the lower LTV, and that high appreciation largely floats on low financing costs. Now that interest rates and margins have started to rise hard, the question is how this is reflected in value.'

'In addition, the importance for financiers of the ICR, or net rent divided by interest expenses, has increased again. This ratio ideally sits at a level above two, but due to the higher interest rate and margin, the net rent is sometimes insufficient to meet these charges, especially if repayments also have to be made. This is going to have implications for refinancing options.'

But what does that mean for bank lineups?

'The previous crisis the Dutch banks did reasonably well by burying their heads in the sand. Extend-and-Pretend was the catch phrase. That strategy ultimately worked out nicely for the sector as a whole, because there were hardly any forced sales of parcels of distressed real estate in the Netherlands.'

'Big question is whether that will happen this time. Today there is more regulation and supervision by the Dutch Central Bank and the European Central Bank for the sake of financial stability. As a result, banks may intervene more quickly. If a borrower breaks the agreed ICR and/or the LTV, the two most important ratios that banks steer on, there will be financial consequences for the bank itself. Financiers will have to engage in faster balance sheet management to minimize the impact.'

Another difference is that debt funds hardly played a role in the Dutch real estate finance market back then. Aren't they much more likely to attract the underlying real estate to themselves? Indeed, isn't part of the business model of some debt funds, the so-called loan-to-own, based on that?

'No, I don't see that danger. In the Netherlands, borrowers are protected by law from such practices. The debt funds are here to make returns as financiers. The fact is that they have high return requirements. Caution is required with the contract terms, because their conditions vary quite a bit. I am now preaching to my own parish, but it is important in the current market to be well advised. And if I may give another piece of advice: start considering your options in time, well before your financing expires. I don't rule out financiers becoming less active next year.'

What does all this mean for your consulting practice?

'The main change is that we are increasingly engaged in refinancing. Financings for acquisitions and project development are still done, but they are time-consuming processes in which it by no means always leads to a transaction. So we consciously choose to be involved in refinancing, here we can add a lot of value given our network and knowledge of real estate.'


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