As Property Values Fall, Debt Time Bomb Squeezes Dublin LTVs

Dublin’s real estate sector is stuck in the mud. The gap between what sellers want for their assets and what buyers are prepared to pay has sucked the life out of the transactional market amid a wait-and-see standoff.

One of the main reasons sellers are remaining obstinate is because loan-to-value ratios are far below the levels of the financial crisis of 2008. 

But that may be providing a false sense of comfort, as the behaviour of the world’s central banks is very different this time round, and plunging valuations and exasperated lenders could yet force owners to sell. 

Opportunity funds and alternative lenders are keeping a close eye on a market where distress might provide an opportunity to buy into assets with good long-term potential. 

“What will unlock the situation is the price coming down," said Nicole Lux, Bayes Business School senior research fellow. "Lenders will be pushing for refinancing and for an exit because many have already been given a year's extension.

"Initially, they were relaxed and gave extensions, but there has to be an end, and refinancing will be more expensive. So I really think that in the second half of this year and also early 2024 we will see more sales. And then there has to be a price."

Research from Bayes Business School at City University of London revealed that the cost of borrowing against prime real estate in Europe has doubled year-on-year from 2%-3% to 4%-6%.

While increased interest rates are a concern for borrowers, the staggered maturity profile of loans means rates will only affect between 15% and 20% of borrowers or lenders each year, the research showed.

Lux said she is concerned about the exposure to commercial real estate of the Dublin market, which is more vulnerable than many other European cities.

“Generally, the market has a key problem, which could lead easily to systemic risk," she said.

Ireland only has five banks in the market, meaning everything is very concentrated. Dublin overall accounts for 90% of the institutional investment market, and Dublin offices account for 63% of the total institutional investment market. So whatever happens with offices will have a key impact on the overall health of the property sector, Lux said.

“Also, Ireland is a market that is dominated by foreign investment flows, circa 70%-80%, and this dependence makes it highly volatile at times when foreign investors are changing their strategies," she added. "For the size of its economy, the property investment sector is also comparatively large compared to other countries, so the Irish market has a lot of volatility compared with, for example, the office sectors in Berlin and Frankfurt.” 

Although anxiety hangs over Irish lenders after Credit Suisse’s travails, the market has more equity, lower leverage in the system and more lenders than in the wake of the Global Financial Crisis — albeit a limited number of banks. Bayes’ research found that European lenders now rarely go beyond 60% of a property’s value. 

In November 2022 the Central Bank of Ireland introduced sweeping new rules for Irish-regulated funds that invest primarily in Irish real estate, with mandatory leverage limits for all Irish-regulated property funds and liquidity requirements for any Irish-regulated property fund that is not closed-ended.

The rules apply to those funds that invest 50% or more, directly or indirectly, in Irish property assets, and the leverage limit is a 60% debt-to-total-asset limit, with a five-year implementation period ending November 2027.

Yet the danger remains that if values do start to fall in earnest, borrowers will be pushed closer to lender-imposed LTV conditions, and first in line to take losses will be the Dublin owners of lower-grade and older office buildings.

That could lead to some painful conversations with creditors, especially as old loans near expiration and need to be refinanced with much more expensive borrowings. 

Alternative Lenders Come To The Fore

The scarcity of bank lenders creates an elevated systemic risk, but it also creates an opportunity for new lenders, particularly debt funds, to enter the market. 

Alternative lenders now occupy the territory that banks held during the period prior to the financial crisis, often stepping into higher-leveraged spaces, which may put them in a more exposed position than banks. That said, the growth of alternative sources of lending could also provide a key source of financing if the banks draw in their horns.

“We are seeing reduced appetite from the traditional bank lenders to underwrite new loans,” Ares Management Head of European Real Estate Debt Philip Moore said. “This pullback presents a good opportunity for nonbank lenders to step in and fill that gap.”

Moore said that it is likely to take some time for the bid-ask gap to close and before the market sees a significant uptick in acquisition activity.

"On the other hand, there is a natural catalyst for refinancing activity as existing loans mature and the interest rate hedging associated with those loans expires,” he added.

This typically puts pressure on those existing capital structures and means the borrowers and their lenders will need to find a solution, whether that involves a roll of the existing financing with potentially a new capital injection or a wholesale replacement of the debt stack. As the year continues, there will likely be a material increase in refinancing activity, Moore said.

“We are of the view that opportunity is there for nonbank lenders to step in and either provide the plug capital required to enable borrowers to roll their existing loans or to provide whole loan refinancing,” Moore said. “As asset values decrease, this may exacerbate the pressure on bank balance sheets and further constrain their ability to write new business.”

This dynamic comes on top of an existing push by regulators to get banks to reduce their CRE exposure. This, combined with the existing debt maturity clock, means that Ares expects there to be a steadily growing opportunity for nonbank lenders to grow their market share in the near and medium term.

Opportunities In Dublin

Some lending deals are being done. In early July, developer Marlet Property Group secured a €102M refinancing facility with Cheyne Real Estate for its Shipping Office scheme on Sir John Rogerson’s Quay in Dublin’s south docklands.

Developed on the site formerly occupied by the British and Irish Steam Packet Co., it consists of 182K SF of offices over eight storeys and a 12.7K SF roof garden, plus five terraces.

Anna Bulach of Cheyne Real Estate said that the deal underlines the company’s interest in “best-in-class offices built for the future.”

Confirmation of the Shipping Office’s refinancing came just five days after Marlet secured a €25M loan from Cardinal, Ireland’s largest provider of alternative investment capital, to fund the construction of a purpose-built student accommodation scheme on Prussia Street, Dublin 7, expected to be ready for occupation in the third quarter of 2024.

And other debt fund managers are starting to look at the opportunities offered by the Dublin market. 

“Offices need be approached with a lot of caution across the entire European landscape, including the UK,” LaSalle Investment Management Managing Director David White said. “Pricing is definitely difficult, and debt is not available and expensive. That means our opportunity exists in refinancing.

“The big question is pricing. There's not a lot of price discovery. There's not a lot of transaction volume. And so I think you have to be pretty conservative in terms of how you think about it. For the foreseeable near future, we're certainly going to be in a higher-interest-rate environment, and I think that there will be some price correction.” 

While LaSalle has been busy across Europe, White said the debt provider had not been active recently in Dublin but has spent time looking at opportunities and remains keen to source opportunities in Ireland, believing the current impasse will unlock.

“We like the fundamentals there. We think there's some attractive supply-demand factors in spaces like residential,” he said. “Even with offices, you see some strong fundamentals.

“At some point, people will start to be motivated, motivated sellers, and you'll find motivated buyers. I think we're just at the beginning of that now.

“I think we all need to be honest about valuations and where values are for various assets, and so it's more than just getting a rubber stamp. It's really digging in and understanding where true value is and adding value.”

Bayes' Lux said that some price transparency is beginning to emerge as agents try to complete transactions. She cited discounts anecdotally in the 30%-35% range.

“So I think there's no question what the value is. People say there's not a lot of evidence, but if you get an offer that is 30% or 40% lower than book value, that is what the price is,” she said. “And I think that's true for literally all of Europe.”

LaSalle’s White said that while there is more cash equity in financial structures than there was in 2008 and LTVs are still low, falling values would start to stretch those LTVs.

“I would argue it’s not yet tested,” he said.

Lux said it will take more time for asset values to adjust, with many loans still having 12 months or more before they need to be renegotiated, meaning the full impact may not be felt until late 2024.

“It comes back to LTVs, and although they're conservative, if values fall 40%, we are tight, close to the level where senior loans might see some stretch, and often there is some mezzanine on top,” she said. “There are also a lot of costs to be considered. It means senior lenders have to start being careful.”

And while LaSalle’s transactions are somewhat dictated by the needs of borrowers, White said that the company has identified opportunities it is most likely to pursue and sees potential in the Dublin market.

“We've stepped back and looked at themes that we like, such as the living sectors, logistics, hospitality and, very selectively, offices, especially life science offices,” he said. “We look for people that are well-capitalised and will continue to capitalise their projects going forward, with borrowers that generally are thinking the same way.

“You're obviously seeing a funding gap, and there is definitely going to be opportunity in Dublin, focused on the sponsor and the asset class, and there will be refinancing opportunities. All in all, it's probably quite a good time to be a lender.”