Summary:

Valuation
Francisca Sepúlveda discusses valuation uncertainty in UK commercial real estate triggered by the political and financial upheaval following the vote to leave the EU

The outcome of the referendum on 23 June has put valuers of commercial real estate in an unenviable position. The RICS Red Book requires a valuer to identify a situation where a reduced level of certainty should be attached to their valuation (VPGA 9 – Valuations in markets susceptible to change: certainty and uncertainty).

The effect of the general political and financial uncertainty generated by the leave vote as regards the UK commercial property market is not yet fully clear. Several large valuers have made the decision to caveat their valuations finalised post-23 June with a note to the effect that the valuer has less confidence than usual in the probability of the valuation coinciding with the price achievable on a sale, as a result of the Brexit vote. Knight Frank has announced it is removing the market uncertainty provisions from its valuations, but it remains to be seen if and when the other valuers will follow suit.

Absent other mitigating features, this may not be welcome for a lender basing its credit decision on a riskier loan to value, in particular, junior or mezzanine lenders, and we have already seen caution in the market on this basis. Loan-tovalue covenants as well as pricing have tightened, leaving borrowers reconsidering their capital stack for certain assets.

Sponsor recourse
Speculating on mitigating features, we note that US lenders are used to relying on “bad boy” guarantees. These guarantees (and the related loan agreements with the borrowers) typically alter the liability of the borrower and guarantor under the financing transaction in two respects once triggered.

First, the guarantee of the borrower’s obligations, usually given by an owner or principal of the borrower, will become operative (or “spring” into effect) on the occurrence of one or more enumerated “bad acts”. Second, the otherwise nonrecourse loan obligation of the borrower will convert into a recourse loan obligation, thereby making the borrower and the sponsor guarantor fully liable for all obligations.

Although this approach has so far been robustly rejected in the European market, perhaps the next two or three years will see these requests become more prevalent, where a borrower seeks to retain a pre-referendum loan-to-value covenant level. Alternatively, lenders might seek to rely on a more onerous cash trap or cash sweep trigger to mitigate valuation uncertainty.

Completed transactions
For transactions that have already completed and/or been funded, Loan Market Association standard terms for real estate financings provide that a borrower pays for a valuation on an annual basis. In our experience, these provisions are not generally heavily negotiated, and indeed bank policies tend to require an annual paid valuation. Borrowers often rely on their lender relationship to call for an annual desktop rather than full Red Book valuation, without making this explicit in their loan contract.

Re-negotiating
Many loan agreements allow the facility agent (on behalf of the lenders) to obtain an updated valuation if it considers that a default as a result of breach of the loan-to-value covenant is likely to be evidenced as a result.

From a relationship lender’s perspective, an adverse valuation may not necessarily be a welcome outcome in a deal that is performing on an income/debt service basis. Anecdotally, we have already seen the greater uncertainty in valuations trigger re-negotiations as to pricing. This is not welcome news for a borrower financing an otherwise performing deal.

Commercial mortgage-based securities
In CMBS transactions, a servicer (acting on behalf of the facility agent) tends to take a cautious approach to triggering an updated valuation in these circumstances, and will do so only if it is of the view that such action would be in accordance with its servicing standard. If the loan agreement does not provide for annual valuations, a servicer might be reluctant to call for a valuation unless the loan maturity is approaching.

CMBS transactions tend to include an appraisal-reduction mechanism. This broadly allows for an examination of the total exposure of the loan versus the latest market value of the property and the amount of liquidity facility available to support payment of interest on the notes. Any evidence of reduction in the market value of the property could therefore lead to an appraisal reduction and a reduction in the liquidity facility commitment available – an undesirable outcome.

Steps to take
Servicers, lenders and borrowers will no doubt review the valuation provisions in their loan and servicing agreements, both as to their rights and obligations, and consider carefully whether a new valuation in the current climate would be a benefit or is to be actively avoided. Interestingly, the market has historically tended to view a default called on MAE alone as an aggressive strategy. It strikes us that calling a loan-to-value default on the basis of a fresh valuation in the coming months may well be regarded in a similar light.

Currently, it seems that article 50 of the Lisbon treaty initiating the UK’s departure from the European Union will not be triggered before the end of 2016. There is likely to be continuing uncertainty in the market and, for loan transactions approaching maturity in the near future, borrowers will need to reconsider their equity and junior debt positions, as the lack of confidence included in valuation opinions is reflected in tightening of loan-to-value covenants. Refinancing risk will need to be carefully considered on a case-by-case basis.

On the other hand, the tightening of credit terms by certain of the more mainstream lenders could present a potential opening for the “alternative lender” market, or other institutions flexible enough to consider a higher valuation risk on the basis of fundamentals which continue to be solid. There is still liquidity in the UK commercial real estate market and, as ever, the caution of some will no doubt represent a lucrative opportunity for others.