Is the next wave of NPL’s finally on its way?

In the immediate aftermath of the Global Financial Crisis (GFC), an entire industry was created around non-performing loans (NPL’s). Banks and other lenders who had been lending on commercial real estate (CRE) started off-loading NPL’s from their balance sheets, with NPL buyers, largely hedge funds, buying up huge portfolios of NPL’s at significant discounts to ‘par’. What followed was a number of years of loan restructuring, loan enforcements and very little new lending.

The CRE lending market has broadly been on an upward trajectory ever since.  The emergence of debt funds and challenger banks, a highly liquid market, unprecedented low interest rates, the emergence of new market sectors (Build to Rent, PBSA, Later Living) – all these factors have led to many years of high lending volumes and low defaults.

Prior to the onset of the Covid pandemic, loans which were secured on certain asset classes started to see challenges, retail assets being the obvious example. As a seemingly infinite number of new lenders entered the market across the past decade, all fighting for market share, more and more lenders were climbing up the risk curve. Senior lending became ‘stretchier and stretchier’ and mezzanine lenders were plentiful.  Insolvency practitioners and restructuring professionals were all (perhaps hopefully) predicting a rise in loan defaults. The Covid pandemic put paid to that, the various initiatives introduced by the government preventing an inevitable wave of loan defaults.

That could now be set to change.

The current CRE lending market is certainly different to the pre-GFC lending market – interest rates are not (yet) as high as in 2008 (when the global financial crisis broke in 2008, the Bank of England base rate was 5%), loan to value ratios have creeped up in recent years but not to pre-GFC levels and liquidity levels remain high, remembering of course that a major liquidity crisis followed the GFC.  That said, a perfect storm of events could be brewing. Interest rates are rising rapidly, already challenged borrowers are no longer being ‘propped up’ by government initiatives, rising energy costs are putting pressure on businesses and the cost of living crisis is impacting on consumer spending. Whilst professionals working in the sector are not yet reporting floods of loan defaults, there is a general feeling that they are on their way.

The most immediate challenge faced by borrowers appears to be covenant breaches.  Even if valuations remain unaffected (with the effect that LTV covenants are complied with), a borrower could find itself in breach of its financial covenants as a result of rapidly rising interest rates. CRE lenders ordinarily require a borrower to maintain a minimum debt service cover ratio (DSCR) throughout the life of a loan, a metric that evaluates a borrower’s ability to repay its debt by dividing a property’s net operating income by the amount the borrower is required to pay to the lender to service the loan. As interest rates continue to rise, and assets start to underperform, those borrowers on non-fixed rate loans could find themselves on the wrong end of a covenant breach. Similarly, those borrowers on fixed rate loans could find themselves with limited refinancing options when their loan term expires.

Time will tell whether there will be a flood, or a trickle, of NPL’s. However, in preparation for some choppy waters ahead, now is the time that lenders should be evaluating their loan portfolios, and ensuring that there are no issues with the security that was granted to them at the time of loan origination.

Edwin Coe acts for lenders, buyers, sellers and servicers of non-performing loans, advising on loan restructuring, enforcement and recovery strategies, as well as advising on NPL acquisition/sale transactions. If you are interested in learning more about our experience in this area, please contact our Banking & Finance team.

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