Challenging Real Estate market conditions - underlining the benefits of Lenders Insurance Due Diligence

Inflation, already rising in 2023, has now clearly become the key source of economic concern for governments and central banks around the world, following Russia’s invasion of Ukraine in February 2022. They have responded by tightening monetary policy, terminating quantitative easing programmes, and raising interest rates, thus cutting growth forecasts, and raising the spectre of recession throughout Europe.

In the UK, the situation has become even more acute in part exacerbated by the disastrous September 2022 Truss ‘mini-budget’. The immediate crisis has eased somewhat since then, but the economic headwinds remain strong.

On 1st February, the IMF announced that the UK economy is expected to be the only major economy to shrink in 2023, with the Bank of England raising the base rate 0.5% to 4%, its tenth consecutive rise. CBRE believes that further rises are likely to peak at 4.5% in Q3 whilst globally, Oxford Economics expects capital values to decline 6% in 2023. This economic turmoil has naturally led to a great deal of uncertainty in the UK real estate market as we move through the first quarter of 2023.

So how has this market turbulence manifested and what can be done to alleviate the challenges?

Lender Caution and Withdrawal

Fundamentally, we are seeing the large lending banks and institutional lenders becoming increasingly cautious, and potentially unwilling, to finance certain verticals within the real estate market. As adverse market conditions have seen these lenders step back, alternative lenders have sought to fill the gaps. An example of this is Generali Real Estate (the property asset management arm of the Italian insurer, Generali) who recently launched their second European commercial real estate debt fund – a €1 billion lending vehicle to follow a predecessor fund of €1.45 billion launched in 2019.

This lender caution is most marked with development schemes, which may be unattractive for lenders who typically have a focus on fully let properties. Additionally, with a widespread need to modernise property and improve environmental efficiency, we are seeing lenders reducing their appetite for non-stabilised assets undergoing meaningful change because of conversions from, say, offices to retail and apartments.

Financiers of developments are coming under direct threat because of increasing construction costs. Statistics demonstrate that in the two years from July 2020 to July 2022, the year-over-year construction output price change in the UK went from just above 0% to reach an annual growth rate of almost 10% in July 2022. As a result, borrowers face much tighter lending terms and some lenders have withdrawn from the market entirely. The perception amongst lenders is that interest rates will continue to rise, and this is being considered in advance projections, with lenders re-focussing on developments that can clearly support cost inflation.

It is in these circumstances, where margins are more uncertain, that effective insurance Due Diligence can help mitigate risk by providing expert advice to real estate lenders both pre-funding and post-funding. Other mitigation factors include the location of the development, which still plays an important part with optimum and prime locations maintaining access to traditional sources of investment. There are also more reasonable rates and terms available for those borrowers with clear ESG/low carbon development plans or who are planning to refurbish old buildings up to new ESG standards. According to Mount Street, an estimated £100 billion of capex is required to adequately deliver the UK’s required green upgrade.

Contractor Insolvency

Equally, as inflation rises, the chance of contractor insolvency increases. According to Red Flag Alert, 2023 is going to be a particularly challenging year with over 6,000 company insolvencies expected - more than 100 building firms going bust every week. Rising materials prices and increasing labour costs, combined with supply chain issues, mean that already thin margins will become even slighter, increasing the risk that a contractor might cease trading. Expert Due Diligence advice will provide specific consideration to robust contingency planning in the event the contractor becomes insolvent, at which point the construction insurances the contractor places are unlikely to respond, with security of the loan compromised.

Adequacy of Policy Terms and Cover

In an economic landscape of increasing costs and supply chain constraints, with development schedules in danger of slipping on time and refinancing required, the question must be asked, are insurance policy terms still sufficient? With the insurance market having been through a hard cycle in recent years it is important to assess that those insurances in place protecting assets, remain fit for purpose and crucially comply with the Facility Agreement. A Due Diligence review, provided by Lockton, will identify aspects of cover that may be restricted with potential solutions to overcome these challenges.. Whilst the general feeling from commentators is that the current downturn will not be as acute as the Global Financial Crisis of 2007-2008, there will still be significant difficulties for borrowers that cannot refinance their loans at an affordable price. Insurance Due Diligence can be particularly useful for these distressed assets in that an experienced Due Diligence advisor can identify limitations in cover or onerous conditions that the lender should be made aware of, where the risk is greater.

Lockton Due Diligence Practice

The above factors, along with wider economic uncertainty, clearly require rigorous Due Diligence analysis to be conducted to ensure the borrower’s insurance placements remain fit for purpose and are placed with an insurer of suitable security worthiness acceptable to the lender. Lockton’s dedicated Due Diligence Practice comprises experienced risk and insurance experts who provide independent professional advice, reviews, and tailored cover to support and protect your business throughout the transaction process. In addition the Lockton Contingent and Special Risk Practice is likely to be able to provide innovative insurance solutions to fill non-compliant gaps which may exist in the borrowers insurance placement.