How has the commercial lending market fared over the course of this year?
We're coming up for almost one year since the world appeared to change quite suddenly. In late September 2022, we had the mini budget, and that really spiked the initial abrupt movement in interest rates, which clearly caused a lot of market consternation.
Funders across the retail and commercial sector were withdrawing products, temporarily repricing, or struggling to reprice. There was quite a lot of turbulence in that, and this was followed by the inflation impetus through this year, which has pushed base rates up. So, it's been quite an eventful year in terms of macroeconomics, and this has fed through into significant changes in the cost of money in the markets.
We raise our money through retail deposits, so we’re paying a lot more to retail savers in the current environment than we were — and that pushes up the price of lending. It's the same for most lenders, however they fund themselves.
So from a client point of view, if you are a borrower looking to invest in commercial property, clearly the cost of money has increased quite substantially over the past 12 months.
You may have lease income from the asset which, if it's a long-term lease, might benefit from rent reviews which can help push it up. You might have even got an extra tenant but, fundamentally, the income side of the equation won't have grown at anything like the rate of interest.
If you want to raise debt to acquire a commercial property, you [will likely] raise less against the same asset and income profile now than you could have one year ago, [as] commercial real estate prices have fallen [by around] 15-20% as a sector average. That is a big change.
Historically, commercial real estate trades at a premium over government bonds or gilts, which is effectively risk-free money. So, if you're taking the liquidity, pricing, and credit risk of buying commercial property, you want a premium.
Government debt has risen, therefore the yield requirements from commercial property have also grown commensurately. If you link those two things together, the value of a commercial property is basically a function of its yield.
If you've got something that is yielding 5% [and] if the yield requirements — because bonds are going up — go up to 10% then, in theory, the value of the property falls by one-half.
As a result, there's been a lot less demand for new purchase activity in commercial real estate because the mathematics have changed.
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So, I think the bulk of activity we've seen from a customer base in commercial real estate is on refinancing requests rather than new purchases.
It's quite an uncertain time and has been in commercial real estate over the past 12 months, and I don't really see anything on the horizon in the short term that's going to change that.
With that in mind, are there any opportunities in the commercial real estate market?
What we've tended to see in past cycles is there comes a point when people who are looking to invest over the longer term start to see periods of time when there's not a lot of buying activity. This is a really good time to buy and, crucially, buyers who can do that will have a good level of their own equity to commit to a deal.
Either they've got their own cash to do it entirely, or they work with the bank and say, for example, “This building was worth X, it's fallen to Y [and] I want to buy it at Y at 50% LTV,” and that starts to become quite an attractive deal.
The reason they’re doing that is because the price is adjusted, so they’re using a moderate rather than full leverage, and therefore suddenly they get to a position where they [can] make the mathematics work.
Alternatively, we have a lot of clients who are SME developers who might see an office block that’s a bit tired and it needs money spent on it to get it up to modern office standards.
It's not necessarily in the business core anymore — the city has moved a bit — but they could buy that quite cheaply and get planning permission to convert it into a residential [building]; knock it down [if] the site has value; or do something with it, such as a full refurb and add additional floors. Entrepreneurial buyers will see an opportunity to create value through doing something active to the property — rather than just owning it.
As market conditions have become more challenging and the cost of finance increasing, we’ve seen a rise in enquiries for mixed-use assets as investors widen their focus and think outside the box. We can blend the commercial and residential finance elements together or treat separately to structure the right deals that work for all parties, depending on the specific circumstances, using our commercial experience but with residential pricing.
In the development finance space, we continue to see interest in our core development finance product. This is a positive sign for the market, showing developers are starting to rebuild confidence and moving to create much needed new homes in the UK. Hodge is pleased to play its part in supporting this.
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