Dealing in Debt: The impact of COVID-19

Hosted by David Gippel, guest Andrew McCasker
Wednesday 10 June, 2020

DG:
Hello and welcome to Talking Property with CBRE. My name is David Gippel from the Debt in Structured Finance team at CBRE and I'm your host for today's episode. 

Uncertainty over lenders willingness to provide loans and on what terms is a concern being faced by both investors and borrowers alike in the current environment. There is evidence that there is a weight of capital sitting on the side-lines ready to invest but transaction activity is slow, primarily due to COVID-19 related issues and that includes the provision of debt. 

Lenders are no doubt being selective and are less willing to provide the usual volume of debt financing on terms borrowers have been used to. Credit risk has been repriced and in addition to a more conservative approach being adopted by lenders, this has caused concern for both existing and new borrowers. 

The COVID-19 pandemic and the lack of clarity on availability of debt is an issue for us all, so over the next 20 minutes we will be discussing the current situation. I'm joined by Andrew McCasker, my colleague from the Debt & Structured Finance team, who hopefully has some answers for you all. Hello Andrew.

AM: 
Hello David. 

DG:
So, let's start by asking what have you seen has been the impact so far from COVID-19 for the banks and lenders generally? 

AM: 
Look that's an interesting question. In Debt & Structured Finance we have the opportunity to connect with all of the domestic Australian banks as well as offshore banks and international non-bank providers. What we've seen from the Australian banks and heard from the Australian banks is that currently they are managing the situation that's being created as a result of the government shut down throughout Australia. So, what this means is that people that are borrowers are potentially impacted by the ability for them to be able to continue to earn income from their investments and meet their interest costs to the banks. 

The other impact, of course, is what's going to happen with valuations. What we are seeing is the banks and offshore lenders are looking to push out covenant monitoring. So, whereas covenants may be monitored quarterly or half yearly for interest cover ratios and LVRs, we're seeing these testing periods being moved to the back end of the 2020 calendar year. So, we're expecting full covenant testings to start back in September and December of 2020 for existing borrowers. Now what we may see with this is that as the COVID-19 impacts continue to roll through the Australian economy and the grace period that the banks have provided to borrowers, that at some point during that period the banks and the borrowers will need to make decisions about their ongoing viability of their investment and of the loan that they have with the organisation. 

DG:
So, we've both been around long enough - do you think this is the same as what we went through during the GFC in 2008? 

AM: 
I think the process is going to be the same. So, the decisions that the banks take around management of potential impaired loans going forward will ultimately be the same process as what they followed through the GFC. The biggest difference that we have now is that the GFC was as a result of a capital shortage crisis and the banks truly didn't have the money to be able to support and lend for not only existing clients but for potential new clients and people looking for acquisitions. 

The situation we’re in at the moment has been caused by COVID-19, the Australian banks, as are the world banks have never being better capitalised as a result of Basel III, which was an outcome from GFC, and in Australia in particular APRA have overlaid a further allocation of capital against commercial real estate. So, whilst the management of the loans and the management of the borrowers going forward, may take the same line of the GFC the biggest benefit we have is that the lenders are not short of capital in the Australian market.  

DG:
Yeah, I think the experience that we both had during 2008 on either side of the fence you as a lender and I as a borrower, there was definitely a liquidity issue as a result of the GFC. It's certainly not the case I don't think this time, but I do think we'll see a greater competition of capital internally within the banks for them to allocate their balance sheets. 

The best example, I don’t know if you recall ,in 2008 the business I was at the time, we were looking to acquire an asset which was circa $180 million backed by a 15 year state government lease, we're only seeking a 50% LVR loan, so $90 million in total, but I recall vividly that we couldn't get one Australian bank to fund the full $90 million. The solution came in a comp loan between two of the Australian banks for $45 million each, which was basically the allocation that they had at the time. So, do you see that event sort of occurring again as this evolves over time? 

AM: 
Yeah, I think, absolutely, David, that we're going to see a competition of capital from within the banks. So whilst I say the banks really well capitalised with a good balance sheet and support side of things, the banks also that need to make decisions around what's going to be their best return on capital. Traditionally commercial real estate lending or property lending has not been as profitable as other lending into the Australian market, so competition for capital will be absolute. I also see that issue for the domestic banks in the competition for capital as providing a great opportunity for offshore banks and non-banks, too increase their exposure into the Australian market.

DG:
I think that's a valid point. So, since the event that is COVID-19 we’ve seen the banks assess their risk as landlords have been doing at the same time. Have you seen an impact on funding costs and those that have been passed on to borrowers in terms of higher interest rates?

AM: 
Definitely an impact in funding costs and again if I just revert back to the GFC when I was working for one of the major Australian Banks, all the banks moved quickly to change their risk margins, predominately driven off the cost of capital increasing because again, it was the capital crisis, the ability to access the capital was difficult and expensive. So, the banks tried to pass on a majority of that liquidity cost or capital costs to the market. We don't have that now, but what we do have is an increase in risk premium. So, a bit of uncertainty about what the future, or the immediate future looks like for the banks and as a result of that, pricing has changed. 

We've seen on a traditional investment style debt for three or five years; we've seen banking price move from anywhere between 50 basis points to 100 basis points. Now that seems like a lot, but if we then look at the yield curve so the fixed rates from 1 through to 10 years and even the BBSY today's trading at 20 basis points, which is unheard of. We've got five years, fixed rates of 45 basis points and 10-year fixed rates at 90 basis points. So, what we're seeing is whilst the margins have moved out, we've seen the yield curve sell off so on a net for net basis, the pricing that borrowers are achieving today is not much different than what they would have been achieving six months ago. 

DG:
It certainly is part of the central bank’s response to COVID-19. They've been very active in that shorter end of the curve as well buying three year government bonds, which we understand, is big part of the overall policy response to trying to keep borrower costs as low as possible and effectively that support has seen those base rates for three years at all-time lows that ultimately assist both those funding costs. So, if you were an existing borrower or being affected at the moment, what's your advice?

AM: 
Just before I answer that David, I might just go back to the comment you made about the government's standing in the market up to three-year bond rate. Do you see the government continuing to do that for an extended period of time or is there a line in the sand that they just say no more? 

DG:
Well, it depends what they consider to be normal. I mean, as I said, the support from what we understand is the federal government level is heavily supported SME borrowers. So therefore, funding costs, debt costs are basically, in any business, the highest expense on a profit and loss basis. The support at the three-year level is interesting. There has been indications that they may extend that to the longer part of the curve as time goes on. But it all comes back to how quickly we all recover, you know everyone getting back to work, going back to whatever the new normal is. So, it's all timing from that perspective. 

AM: 
Picking up on your question around existing borrowers and what’s our advice? The number one thing that we're talking to our clients about now is communication and factual based information. So within our business, we specialise in engaging with not only banks but non-banking markets, or alternate debt finances and what we have been doing is ensuring that we are having our clients proactively engaging with the lenders, so being able to talk to the lenders around what the impact of COVID is going to be. So for example, if we take a retail asset that one of our lenders owns, there's request for rental abatements, tenants are leaving shops altogether and what we are doing is looking what the cash flow is today, looking at what the cash flow is in the future and also identifying what the covenants are and then going to the lender with a solution based response, as opposed to, here is the problem – tell me what you need me to do. 

DG:
Great advice, and what about funding of new acquisitions in an environment where banks are tending to be a bit more conservative and the availability of term debt or debt on terms that are satisfactory to borrowers, what's your recommendation there? 

AM: 
Look we have been advised by the banks that they are actively supporting their existing client base for new acquisitions. What we are seeing, though, is that the banks are very focused on managing their current loan book as they work through the COVID-19 issues. So, whilst they may be willing to support existing borrowers buying new acquisitions, the impact on their ability to deliver an approval in an expected time frame could be an impediment. So, we are seeing time frames for processing and applications through to approvals have blown out quite a bit and we see that being the norm, certainly for the remainder of the 2020 year. 

DG:
And so that may be related to the domestic banks. Fortunately, being part of a global company with a very large debt platform there are obviously alternatives to the domestic banks. Can you give any guidance or recommendations for anyone listening for debt solutions along those lines? 

AM: 
Definitely. As you indicated we are fortunate as a business in Debt & Structured Finance to have arrangement with a number of offshore not only banks but offshore non-bank debt providers I do need to stress, sometimes when we talk about non-bank providers people think of lender of last resort or loan to own, but these groups that we deal with are insurance companies, life companies, mutual funds, securities companies and they are looking at doing bank style debt to get bank style returns and when a customer is in covenant managing in turn.  So, yes, that domestic banks are in the market and looking support existing clients, but we are fortunate because it's a different situation to the GFC. The non-banks are looking to participate at quite a reasonable level into the Australian market. So, as we see the market become tighter, the non-banks from the international market and the international banks, will continue to increase their commitment into the Australian market with the view of attracting high quality sponsors with good quality transactions. 

DG:
So, Andrew, what can we expect from both the domestic banks and the offshore lenders moving into the future?

AM: 
Yes, so if we look at the domestic banks first, once they get through the initial understanding of what their loan book looks like and how they could manage it going forward, particularly come the end of September where we will see the government stimulus package start to fall away, we'll start to see a bit more of an impact in the Australian economy and what the true position looks like and how that's going to affect the property market and people’s ability to be able to continue to pay interest. So the banks will be very closely watching that they'll be looking for economic indicators for recovery and, like every organisation we will be doing significant amount of research about what the future is going to look like, they'll be managing capital, they'll be looking to ensure that they can manage their returns and invest their capital into loans, which will give them the best return. 

At the end of the day, the banks are a public owned vehicle, and the shareholders are looking for shareholder return. And we've seen impact already in the banks, with their half yearly reporting allocating large amount of provisions with the tagline of COVID-19 and what the impact has been on their half year results and obviously the banks will be looking to start to claw that back and improve their profitability position. 

For the offshore groups again, this is an opportunity for the offshore groups to increase their market share into the Australian platform. The offshore groups as I mentioned before are the Life Companies, mutual funds, insurance companies, they are pro Australia and they are positive with the Australian market. They like the transparency for us to invest into Australia on their behalf. So, they see this as an opportunity for them to obviously increased their exposure into the Australian market and being able to attract high quality clients with good quality transactions to be able to support their platform going forward. 

I think the other thing to your highlight is that the biggest issue of being an existing borrower or potentially a new borrower domestically is each of the banks are in and out of the market, depending on how they're managing their balance sheets. So, if you've got a great relationship with one of the Australian banks and you turn up that quarter and industrial distribution centres are not on their radar you could potentially have some issues around setting the bet.

The benefit with our practice and our business in Debt & Structure Finance is that we're connected with all domestic banks, a lot of the offshore banks and several of the offshore non-bank providers. So we're able to quickly understand the risk profile of the transaction you’re looking at and then place it with the relevant party that has capital that matches the profile and the returns have been looking to achieve at a cost that the borrower is willing to pay. 

DG:
Thanks, Andrew, for that insight. Thanks everyone for listening to Talking Property with CBRE. Please do not hesitate to reach out to Andrew or I or any of the Debt & Structured Finance team to discuss the topics that have been discussed today. If you like the show and want to check out more, please visit CBRE.com.au/talkingproperty.