UK real estate transactions being undertaken by GCC investors which we commonly hear about include the acquisition of high end residential property (Chelsea and Knightsbridge) and trophy assets (such as Harrods and the Shard).

There is another group of GCC investors which we hear less about, family offices and asset managers. These investors are also investing in UK real estate, focusing on income producing commercial real estate assets. Such investments are primarily located in non-prime areas and are financed using senior debt from bank and non-bank lenders. 

This article provides an overview of the trends we have seen over the last 18 months which are applicable to these investors.  

Cash-on-Cash Returns

The cash-on-cash return requirements of the GCC family offices and asset managers have not significantly changed over the past 18 months, with the expected investor returns remaining in the range of 6-8%. 

Such high yields are however becoming increasingly difficult to achieve as a result of a number of key factors including an increase in both the cost of raising finance (see below Interest rates bench marked to Libor) and property values.

In order for such investors to maintain their expected rate of returns they are having to move up the risk curve. Such risk entails acquiring real estate assets in non-core cities (taking on location risk),  acquiring real assets with weighted average unexpired lease terms (WAULTs) of less than ten years (taking on lease re-gearing risk) and/or taking on some development risk.  

In the current climate there are a limited number of properties available yielding 6-8% that are let with WAULTs exceeding ten years. Many investors are choosing to hold property (instead of selling) because of the concern they will not be able to recycle the cash into new assets at an attractive yield putting a further squeeze on supply.

Senior leverage 

In order to enhance equity returns and spread risk the purchase price of commercial real estate assets is often funded in part by borrowing money. Senior commercial real estate lending has remained strong and at par with the 2016 levels. 

Loan to Value (LTV)

LTV ratios have remained consistent throughout the last 18 months. Maximum LTV ratios for senior loans currently sit at a sensible rate of approximately 60%. The LTV ratio will be lower where the reversionary value of the real estate asset (being value of asset at the date the loan term expires) falls below the initial purchase price (this can occur where a tenant is over paying under its lease which has a 8-10 year term left, any re-gearing of that lease will likely result in lower rental income which in turn will impact property value).

Interest Rate Cover (IRC)

The other financial covenant commonly tested in loans secured against commercial real estate is the ICR (the ratio of annual rental income to annual interest payments). ICR ratios have also held consistent at between 230 – 260%.

Interest rates 

Usually the interest (or in the case of shari’ah compliant financing the profit) is calculated as an aggregate of margin plus LIBOR. 

• Margins: Margins have remained reasonably consistent over the last 18 months, ranging from 180 bps  up to 270 bps over LIBOR. 

The German Pfandbrief banks are the most competitive for larger single let properties. The UK clearing banks are more competitive on smaller, multi-let properties. UK clearing banks have issues with larger loans backed by a single tenant as a result of slotting issues (which may require a lender to hold more capital (which makes the loan more expensive to make) to guard against a risk of default).

• LIBOR: Banks have continued to require that a borrower hedges its exposure to movements in LIBOR by swapping its obligation to pay LIBOR on quarterly basis for an obligation to pay a fixed rate on a quarterly basis (the borrower enters into documentation pursuant to which the borrower will receive from its hedge counterparty LIBOR on a quarterly basis in return for the borrower paying to its counterparty a fixed rate on a quarterly basis).

LIBOR swap rates for a five year term have increased by approximately 50 bps over the last 12 months. In practical terms this means that an investor who has acquired a UK real estate asset for a five year holding period will be paying 50 bps per annum more for any leverage it employs to acquire its investment. Such an increase may sound immaterial, however it represents an increase in financing costs of around 20% on a loan priced at 180 bps over LIBOR.

Most hedging documents now provide that LIBOR has the meaning given to it in the loan agreement which is being hedged. This means if the definition of LIBOR under the related loan agreement changes (e.g. because a replacement bench mark is agreed to be used – see below Continued use of LIBOR as a benchmark), that revised definition will apply to the hedging documents.

Amortisation of principal

The practice of the loan principal not amortising during the term of the loan facility has continued. 

Loan term

The typical loan term has remained between three to five years.

Continued use of LIBOR as a benchmark

The continued use of the London interbank offered rate (LIBOR) as an interest rate bench mark is currently under review by regulators worldwide. 

ICE Benchmark Administration Limited (IBA) became the administrator of LIBOR on 1 February 2014. ICE LIBOR is currently published for five currencies (including Sterling) and seven maturities quoted for each currency (e.g. overnight, three months etc.). IBA maintains a panel of up to 16 banks who are requested to indicate what they could borrow funds for each of the maturities for each of the currencies. It is the average of those submissions which are then published on a daily basis and which are used to price interest rates on loans.

The financial crisis highlighted concerns that LIBOR submissions could be manipulated and may not be an accurate reflection of the true cost of funding (because submissions are based on estimates of borrowing costs and not actual transactions). In July 2017 the Financial Conduct Authority (the financial services regulator in the UK) announced that from 31 December 2021 it would no longer compel panel banks to submit rates to enable calculation of LIBOR (and therefore the market should not rely on LIBOR being available post 2021).

Most loan documents now include provisions which set out options of what would happen if LIBOR was not available, one of which is that instead of using LIBOR as a bench mark the actual cost of funds of each lender (as determined by that lender) would be used. A more recent trend is for loan documentation to set out a procedure for how any replacement of LIBOR could be incorporated into an existing loan agreement (specifically what percentage of lenders would need to consent to the replacement benchmark being substituted for LIBOR in the loan documentation).

Taxation

Tax changes

Over the past five years the UK government has been introducing tax changes which will once fully implemented result in all non-UK tax residents who hold UK real estate being liable for UK tax. Prior to such changes, it used to be the case that a non-UK tax resident (e.g. a property company established in Jersey or Guernsey) owning UK real estate was exempt from certain UK taxes. In general terms such exemptions will no longer apply going forward.

The change that are still to be introduced include:

• gains on commercial property held through “offshore” structures will be liable to UK capital gains tax accruing from 1 April 2019 (property values will be rebased to 1 April 2019 for the purposes of computing gains), the changes will apply to direct and “indirect” disposals;
• from 1 April 2020 non-UK resident real estate corporates will be liable to UK corporation tax (instead of income tax), the switch will be 6 April 2020, UK corporation tax for 2020 will be charged at 17%; and
• under the UK corporation tax rules (which will apply to non-UK resident real estate corporates from April 2020) financing costs will no longer be deductible as a property business expense, instead non-UK resident property owners will be required to apply detailed UK rules applying to loan relationships which potentially could cap financing costs capable of being used as tax relief at 30% of taxable profits.

Withholding Tax (WHT)

Interest paid by a borrower who is a non-UK tax resident in respect of a loan made by a lender who is also non-UK tax resident may be subject to UK withholding tax. This will be the case if the interest has a UK source which will in turn require the borrower to withhold tax in relation to the payment of interest, typically paying such amounts to the UK tax authorities. As a matter of general market practice, if withholding tax is payable it will be a cost for the borrower as the loan documents include a gross-up obligation, requiring the borrower to pay an additional sum to the lender to ensure that the lender receives the same amount as it would have done if no tax had to be withheld from the payment of interest. 

A recent English law case provided some guidance on when interest will be deemed to have a UK source and therefore be subject to UK withholding tax. Examples of matters which could lead to interest having a UK source include, the loan is secured over assets in the UK and/or the monies used to pay the interest is in the UK.

Careful analysis of fact and law will need to be carried out if leverage (including any shareholder loan) is being provided by anyone other than a UK established bank (e.g. a debt fund established in the Cayman Islands) to ensure that the borrower is not going to be exposed to any withholding tax liability.

Outlook

We will continue to eagerly watch the market over the next six months as Brexit negotiations are coming to ahead, with the leaving date of March 2019 being imminent. Having said that we believe that GCC investment into the UK will continue to remain strong, although investments into the retail sector are likely to continue decreasing as clients will be looking for alternative asset classes to retain their high yields. 

We expect confidence among commercial real estate lenders to remain high with market liquidity remaining strong, in particular amongst non- bank lenders. Although loan margins should remain broadly the same, Libor is expected to continue to rise.