Increased refinancing risk looms for UK commercial real estate borrowers

Financing markets for the UK commercial real estate (CRE) sector continue to be defined by persistent high interest rates and elevated borrowing costs. Although long-term interest rates peaked last summer, ongoing inflation worries has pushed back market expectations for interest rate cuts to at least August, potentially extending into late this year. Amid macro and political uncertainties, transactional activity has softened, reducing demand for acquisition finance and reducing banks’ appetite to refinance for all but the strongest borrowers with modern, ESG-compliant properties.

Liquidity remains accessible for properties that have adapted well to changing consumer behaviours and more exacting sustainability requirements. However, those falling behind will face refinancing risk even as the tight monetary environment gradually eases. The polarised market for CRE finance is not simply between winning and losing sectors, but more broadly between “best-in-class assets and everything else”. In the coming year, pressures from refinancing and fund redemption may force more legacy assets onto the market and these may struggle to attract buyers and secure new financing after factoring in ESG compliance costs.

Recent new lending trends

Lenders to the UK CRE sector experienced their most challenging year since the global financial crisis (GFC), according to the recently published Bayes CRE Lending Report 2023. Total origination plummeted by 33% year-on-year to £32.7bn, with non-bank lending decreasing by 50% (£5.2bn) and insurance lenders by 38% (£3bn). Over the past 12 months, lenders have primarily focused on refinancing existing loans, with reported covenant breaches and defaults reaching up to 61% across loan portfolios, according to Bayes.

Loans issued during the competitive investment markets of 2021 and 2022 now face higher default risks due to their initial issuance under more lenient credit standards. Many of these loans, which financed assets at inflated valuations and high leverage, are set to mature between 2025 and 2027, according to ratings agency Moody’s. Senior loans secured by secondary offices and retail properties at 65% loan-to-value (LTV) are particularly vulnerable, with current valuations suggesting LTVs could reach 85%–90% for these 2021–2022 vintage loans. These dynamics pose significant refinancing risks over the next two years, according to Moody’s, affecting non-bank lenders and loans securitised into CMBS transactions by investment banks. Mezzanine financing, a significant share of which was extended during this period, is also at heightened risk of default.

Sector divergence

The CRE market continues to diverge, driven by sustainability-focused modern assets and legacy properties failing to meet evolving occupier demands and behavioural shifts. The London office market presents a mixed picture, with an increase in new office space uptake countered by the impact of remote working culture on vacancy rates and rental growth. The condensed workweek, typically from Tuesday through to Thursday, has suppressed occupier demand, prompting many corporates to reassess their real estate requirements. Some have found that a flexible working model sustains revenue and profitability without the need for extensive office space. Notably, Canary Wharf has seen an increase in  prominent tenants like HSBC, Clifford Chance, and Moody’s looking for smaller offices away from the area, resulting in  vacancy rates being pushed to approximately 15% and increasing rental yields by 150 basis points in 2023, according to Fitch Ratings. Owners Qatar Investment Authority and Brookfield are diversifying the Canary Wharf portfolio with additional residential, retail, and leisure tenants, but smaller office landlords face challenges in securing financing for asset repositioning.

In regions such as Birmingham, Leeds and Manchester, the oversupply of office space has been exacerbated post-Brexit, with economic recovery slow following the pandemic. While some have attempted office-to-residential conversions, these refurbishments are complex, time-consuming, and costly.

Conversely, out-of-town shopping centres, self-storage facilities, student accommodation and modern logistics properties are thriving. These sectors benefit from changing consumer behaviours, increased e-commerce, and proximity to retail and leisure amenities as remote working practices mature. LondonMetric, a significant player in logistics warehouses supporting online retailers, exemplifies success in capital raising and securing favourable financing terms. The REIT prioritises sectors with structural support and strong consumer tailwinds, stating: “A sector requiring capital expenditure to grow is less attractive than one that grows organically without significant capex.”

Influence of sustainability on lending decisions

Sustainability criteria are increasingly shaping the CRE financing market. Lenders scrutinise borrowers’ environmental, social and governance (ESG) credentials, influencing financing terms, covenants, and funding accessibility. Buildings prioritising energy efficiency secure more favourable financing terms. Conversely, older properties failing to meet sustainability standards struggle to secure bank financing due to regulatory disincentives against non-green assets, pushing non-compliant borrowers towards alternative lenders. Within the office segment, a significant portion of existing spaces falls short of modern sustainability benchmarks. This shortfall translates into higher financing costs and reduced liquidity for owners seeking refinancing or new loans.

BTG Advisory is well placed to help those borrowers who are struggling to keep pace with the sustainability criteria of lenders to find financing. We can help improve asset appeal for alternative lenders to secure attractive terms and address sustainability bottlenecks. 

Role of alternative lenders

Alternative lenders offer flexibility compared to traditional banks. They prioritise steady performance and are content with borrowers maintaining reasonable performance levels without de-risking. This approach often leads borrowers to refinance with the same lender at loan maturity. Alternative lenders have become more discerning following recent market stress, deploying additional resources to manage problem loans. They remain a viable option for borrowers unable to meet stringent bank criteria, particularly in sectors like storage, online logistics, and student accommodation.

Conclusion

The UK CRE financing market reflects the bifurcated trends evident at the underlying property sector level. While some subsectors thrive, such as logistics, storage and student accommodation, legacy market segments and struggling sectors (e.g. older offices and retail) face significant challenges. Liquidity ranges from ample to scarce – and this divergence will likely outlast the peak interest rate environment borrowers are still enduring. 

Navigating the financing market requires market knowledge and deep financing relationships to ensure the best possible terms. Borrowers grappling with non-compliant properties, or assets that do not meet the entirety of rising ESG lending requirements, will face diminished liquidity options. BTG Advisory can help these commercial property investors – from securing alternative funding to advising on sustainability initiatives. As always, proactively addressing these looming refinancing challenges early improves outcomes. Contact our team today to discover how we can help.