Stamford Capital has released its annual Real Estate Debt Capital Markets Survey, the first comprehensive dataset analysing the impacts of 13 months of sustained interest rate rises on Australia’s commercial finance sector.
Not surprisingly, the data revealed the velocity of cash rate growth over the past 13 months has put Interest Coverage Ratios (ICR) under pressure, with many borrowers in breach. Lender scrutiny is subsequently on the rise, particularly for investment and construction loans while ESG lending continues on a growth trajectory.
The Real Estate Debt Capital Markets Survey 2023 shines the spotlight on continued post-COVID impacts on all asset classes with most property sectors perceived as in decline – notably commercial office, retail and residential apartments. Industrial remains a preferred asset class, yet over half of respondents see the market as peaking.
Interestingly, survey respondents see some categories of the residential sector as improving – but it’s the speed that this sector has swung back with that is most significant. But according to the Stamford Capital Survey, lenders haven’t fully embraced the Build to Rent (BTR) model yet with the emerging sector still in infancy in Australia compared to more mature global markets.
Deal scrutiny heightens: ICRs under pressure from rising cash rate
Lenders are becoming increasingly selective amid the escalating cash rate environment and increasing ICR covenant breaches. According to the survey this is set to continue with 46 per cent of respondents expecting major banks to tighten investment loan credit, and non-banks expected to do the same.
Rising interest rates coupled with vacancies in some market sectors are posing a challenge to developers and investors, with many unable to leverage their properties as they previously did. An overwhelming 72 per cent of Survey respondents require a minimum ICR of between 1x and 2x – up from 45 per cent in 2021.
And the cash rate pain is not expected to ease any time soon with only 31 per cent of respondents expecting the Reserve Bank of Australia (RBA) will reduce rates this year.
Weakened appetite for construction and investment lending
With the construction sector plagued by rising costs, labour shortages and insolvencies, it is not surprising that 52 per cent of respondents anticipate major banks to decrease construction lending. In addition, 33 per cent of respondents also expect decreased investment loan activity.
According to Stamford Capital, product demand will become critical to securing access to capital. Pre-sales are tipped to become a key lending criteria in construction lending again with 18 per cent of respondents prepared to fund zero pre-sales in 2023, down from 30 per cent in 2021 and 22 per cent in 2022.
Despite majority of respondents planning to maintain current pre-sale requirements, 15 per cent are set to increase them in 2023 – up significantly from the 6 per cent in 2022.
Amid reduced appetite to fund construction, an overwhelming 76 per cent of lenders surveyed expect to grow their loan books in 2023.
The outlook for construction finance is grim with more than half of respondents expecting to decrease construction lending. Non-bank lenders are showing increased appetite for construction funding with 34 per cent expecting to increase lending for building projects, compared to just 13.5 per cent of major trading banks.
Similarly, some 33 per cent of major trading banks plan to decrease loan exposure to investments in 2023, compared to 17 per cent of non-banks.
Commercial office, retail and residential sectors in decline
Sentiment has waned significantly with respondents perceiving most asset cycles in decline – particularly commercial office, retail and residential development sites.
Despite signs that commercial office and retail assets were recovering in 2022 – 63 per cent of respondents now say the commercial office market is in decline and 53 per cent believe retail is in decline, a stark contrast to 49 per cent seeing the retail sector in recovery a year ago.
The post-pandemic commercial office market is characterised by reduced demand and high supply – driven by the continued ‘flight to quality trend’ coupled with the continued popularity of hybrid working styles. A two-speed market is in play with demand for Premium and A Grade space increasing, while B and C Grade office stock remains overlooked.
Retail continues to suffer with oversupply in some locations as online shopping remains popular post-COVID and reduced household spending is expected catalysed by growing cost of living pressures.
Interestingly the outlook for residential property is improving, with 31 per cent of respondents seeing it as recovering while 44 per cent still see it in decline. Not all categories of the market are equal however, with sentiment less optimistic for residential development sites and 62 per cent of respondents seeing them in decline.
Industrial assets continue to perform and remain a sough-after asset globally and 52 per cent of respondents believe the industrial market is at its peak.
Future lending: Expect new ESG lending products but BTR not on radar
Sustainable building practices remain firmly on the industry’s agenda, with 52 per cent of respondents saying they have or intend to develop loan products favouring assets with environmental, social and governance (ESG) credentials.
This volume could potentially increase following the 2023 Federal Budget announcement of low-interest loans for energy efficient upgrades.
While commercial office assets have long embraced sustainability with established ratings systems enabling ESG credentials to be benchmarked – other sectors have lagged behind and it is evident that change is imminent.
“It is too early to see any meaningful examples of ESG credentials being rewarded by capital, but there is clearly an appetite for change,” said Michael Hynes, Joint Managing Director at Stamford Capital..
Despite the perfect storm presented by Australia’s continued housing crisis with historically low residential rental vacancy, rising interest rates and declining affordability – Australia’s banking sector is not showing appetite for BTR projects.
According to Stamford Capital, the BTR model requires a long-term income view, backed by large balance sheets and multi-asset cross-collateralisation, making them the domain of institutional players and high-net worth family offices for the time being.
“Right now, you have to be equity heavy to make BTR stack up, and you have to be prepared to hold it for generations. But it’s such a big asset class overseas with proven returns and with global funding, we should see it gain more traction in Australia,” Hynes said.
He noted that recently announced government tax incentives for BTR could help fast-track both developer and lender interest in the emerging sector.
