Most property sectors in decline, new survey shows
The speed of cash rate hikes over the past 13 months has put interest coverage ratios (ICR) under pressure, with many borrowers in breach and with lender scrutiny now on the rise, particularly for investment and construction loans.
This was according to Stamford Capital’s annual real estate debt capital markets survey, which polled more than 100 active lenders to analyse the impacts of the successive cash rate hikes on Australia’s commercial finance sector.
Michael Hynes (pictured above), joint managing director at Stamford Capital, said that following successive rate hikes, market sentiment remained strong in some asset classes, but tightening lending criteria and reduced appetite are now playing out.
ICRs under pressure from increasing cash rate
The commercial finance brokerage said the current lending climate has become “brutal” amid the escalating cash rate environment and rising ICR covenant breaches.
Lenders were becoming increasingly selective – and this is tipped to continue with 46% of the survey respondents expecting major banks to tighten investment loan credits, and the non-banks to do the same.
The combination of surging interest rates and vacancies in some market sectors were posing a challenge to developers and investors, with many unable to leverage their properties as they previously did. A massive 72% of respondents require a minimum ICR of between 1x and 2x – up from 45% in 2021.
And the cash rate pain would not likely ease any time soon, with just 31% of the respondents expecting the Reserve Bank of Australia (RBA) to cut rates this year.
“In today’s market, you either fit the lenders’ criteria or you don’t. It’s binary and there’s no room to pay at the margins,” Hynes said.
Weakened appetite for construction and investment lending
With rising costs, labour shortages, and insolvencies plaguing the construction sector, it is not surprising that 52% of respondents expect major banks to reduce construction lending. Some 33% of respondents also expect investment loan activity to decline.
Product demand is expected to become crucial to securing access to capital. Pre-sales would likely become a key criteria in construction lending, with 18% of respondents braced to fund zero pre-sales in 2023 – that’s down from 30% in 2021 and 22% in 2022.
Despite the majority of respondents planning to maintain current pre-sale requirements, 15% are set to lift them this year – a major jump from the 6% the prior year.
Amid reduced appetite to fund construction, a whopping 76% of lenders polled were expecting to grow their loan books this year.
The outlook for construction finance appeared grim, with more than 50% of the respondents planning to reduce construction lending. Non-bank lenders, on the other hand, were showing increased appetite for construction funding, with 34% planning to raise lending for building projects, compared to just 13.5% of major trading banks.
Some 33% of major trading banks were also planning to reduce loan exposure to investments this year, compared to 17% of non-banks.
Property sectors still impacted by COVID-19
Most asset cycles were now perceived by the respondents to be in decline – particularly commercial office, retail, and residential development sites.
Despite the commercial office and retail assets showing signs of recovery in 2022, the proportion of the respondents who believed the commercial office and retail were in decline were 63% and 53%, respectively, a stark contrast to the 49% who perceived the retail sector to be in recovery a year ago.
Stamford Capital said the post-pandemic commercial office market is marked by reduced demand and high supply – driven by the continued “flight to quality trend” plus the continued popularity of hybrid working styles. There’s a two-speed market now in play, with demand for Premium and A Grade space rising, while B and C Grade office stock remains overlooked.
Retail continues to suffer with oversupply in some areas due to the continuing popularity of online shopping and with growing cost-of-living pressures dragging down household spending.
Interestingly, many respondents believed the outlook for residential property is improving, with 31% seeing it as recovering while 44% still seeing it in decline. Sentiment was not as optimistic for residential development sites though, with 62% of respondents seeing them in decline.
Industrial assets remained the most popular asset globally, with 52% of the respondents believing the industrial market to be at its peak.
New hope for residential development
The Australian resident values have remained resilient despite continued interest rate hikes, due to a shortage of housing supply amid increasing demand.
Demand is expected to continue to spike, with an anticipated surge in migration and a forecast net migration of 400,000 this year – the most significant migration rise in more than a century.
Residential rental vacancies were still at a historic low, presenting investors and quality projects with opportunities in desired locations, despite lenders remaining cautious and rates remaining at an all-time low, Stamford Capital said.
What’s up for future lending?
The industry has continued to prioritise sustainable building practices, with 52% of the respondents saying they have or plan to develop loan products favouring assets with environmental, social, and governance (ESG) credentials.
This volume could potentially rise after low-interest loans for energy efficient upgrades were announced in the 2023 federal budget.
Commercial office assets have long embraced sustainability, having established ratings systems enabling ESG credentials to be benchmarked. Other sectors have lagged behind though, but it is evident that this will change soon.
“It is too early to see any meaningful examples of ESG credentials being rewarded by capital, but there is clearly an appetite for change,” Hynes said.
Despite the perfect storm presented by Australia’s continued housing crisis, rising interest rates, and declining affordability, Stamford Capital noted that the country’s banking sector is still not showing appetite for build-to-rent (BTR) projects.
According to the commercial finance brokerage, the BTR model necessitates a long-term income view, supported by large balance sheets and multi-asset cross-collateralisation.
“Right now, you have to be equity heavy to make BTR stack up, and you have to be prepared to hold it for generations,” Hynes said. “But it’s such a big asset class overseas with proven returns and with global funding, we should see it gain more traction in Australia.”
He said the recently announced government tax incentives for BTR could help accelerate both developer and lender interest in the emerging sector.
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