The rising demand for flexibility in commercial lending

The commercial property market is undergoing a shift towards flexibility. As a consequence commercial property financing from established lenders (which have traditionally been known for being rigid with very conservative risk attitudes) needs to adapt and change.

An example of this trend is shown within the office sector. Compared to a few years ago new lease terms for smaller office spaces of typically less than 3,000 square feet have reduced. It was common to see new leases of ten-years with a five-year tenant break clause. Now we are witnessing new leases in this space with a five-year term and a three-year tenant break clause.

Consequently property investors are feeling the effects; knowing they need to adapt to the evolving market, but at the same time often struggling to access the traditional financing sources. Increasingly, they are seeking lenders able to offer innovative and bespoke customised solutions.

The changing labour market together with the increase in hot-desking, remote working and flexible working patterns has led to spill over effects on the way commercial property is used. Indeed, demand for co-working spaces reached a record high in 2017, with take-up tripling in the UK’s biggest cities, according to research from Cushman & Wakefield.

You could call it the ‘WeWork effect’ – the flexible workspace provider now has the largest volume of office space commitments in London, second only to the UK government and ahead of Google and Amazon. And it’s not just the co-working pioneers operating in this space. Members’ clubs, coffee shops and pubs are developing their own work spaces, while serviced offices and apartments are springing up to appeal to tenants with a shorter-term mindset. 

Tenants are looking for flexibility, less commitment and shorter-term rental options in the face of market uncertainty, but they don’t necessarily want to pay a premium for it, in spite of a shortage of supply. For landlords, this means shorter periods of certain rental income and a greater risk of longer or more frequent void periods.

Shorter term certain income adversely affects a property’s risk profile in the eyes of traditional lenders, which typically seek to impose tight covenants on commercial borrowers. High-street banks look for income visibility and certainty and have historically, at least, wanted to see interest costs covered many times at stressed interest margins or a tight opening Loan To Value (‘LTV’) covenant.

Landlords can struggle to meet these strict lending criteria, impeding their access to the usual sources of finance. Where banks do lend, it may be on a lower LTV basis or shorter tenure and landlords risk breaching their covenants and defaulting if they experience voids or tenant failures.

As a result ambitious property entrepreneurs are seeking creative funding solutions. What exactly do they want from a lender?

• Hyper-personalisation: Where service is a key differentiator and, given the aforementioned trends towards flexibility, lending as a box-ticking exercise is impractical and ill-considered. A relationship driven approach and willingness to trust is a major attraction for clients.
• A big-picture approach: In line with the above, the development of a long-term relationship – rather than just a short-term solution – means a lender is completing due diligence, getting to know the client, their track record and the health of their balance sheet, rather than simply focusing on the asset they are looking to fund. In this way, banks can reduce risk and offer more suitable funding options.
• Beginning-to-end involvement: Lenders that provide personal support and continuity, with the same bankers dedicated to a deal throughout its full lifecycle, is an assurance to clients that they have the backing of their bank. This focus should stretch from the initial stages of a loan application to site acquisition and planning, development and, in some cases, subsequent longer-term investment lending.
• Speed and ingenuity: Ambitious investors need a bank that is able to make funding decisions promptly. In the same vein, expertise in managing clients’ often-complex situations means the changing market isn’t necessarily an obstacle.
  

To lend successfully it is essential that banks adapt and customise lending processes to meet the changing needs of investors ­who are often experienced property entrepreneurs and developers with a laser focus on their bottom line.

By way of example, Investec’s Structured Property Finance team have adapted its loan underwriting process. An example is to offer bespoke, flexible loan covenants such as less onerous rental income coverage. This gives entrepreneurial borrowers the support and room they need to manage vacancies and voids. Other aspects of the lending process that have changed include taking cash on deposit up front (or from some surplus rental income over time) as an additional safeguard and factoring this, as well as rental income, into covenant calculations. Plus offering flexible amortisation schedules, all of which allow the bank to lend without reducing gearing and so support its clients.

Responding to the shift towards more flexible lending, lenders also need the ability to react to changing market conditions and understand specialist and burgeoning sectors, such as healthcare. A current driver of change here is the NHS’s move to house general medical practices in larger purpose-built buildings with more staff and more surgical facilities. To lend successfully in this arena, Investec Structured Property Finance team members are informing themselves as to the complex income structures at play, including how landlords claim money back from the NHS.

In a current scenario, we are putting in place a loan of just under £9m to assist with the purchase of 18 medical practices throughout the UK, valued at around £13m. Given the growing interest in medical practices, it was crucial to take the time to fully understand this asset class and the wider strategy for this sector, meaning we were wholly prepared to assist the client when they decided to enter it.

The facility has a flexible repayment structure with a ratcheted margin to incentivise and assist with asset management during the term. The facility was also a hybrid of a revolving credit facility and a standard-term loan, allowing an element of overpayment and re-drawing. This assists with the borrower’s working capital, asset management and general treasury management.