New lending to UK commercial real estate fell 33% last year to its lowest level since 2013, according to the latest Commercial Real Estate Lending report from Bayes Business School.

Researched and written by Nicole Lux, senior research fellow at Bayes Business School and focused on 2023, the report also shows that 42% of the £170 billion of loans outstanding will have to be refinanced within 12 months. Lux expects that to cause ongoing stress in the market although outstanding debt is at its lowest level since 2017.

She said the fall in outstanding debt probably stems from lenders not replacing repaid debt with new loans at the same pace. That, she suggested, is probably due to low overall transaction volumes in real estate equity markets, together with valuation uncertainties and discrepancies in debt transactions.

The UK lending market is slowly changing to a more domestic market, Bayes reports. While London commercial properties are still the target for international lenders, the rest of the UK market is dominated by UK banks and debt funds (57%).

Appetite for prime and secondary office assets is declining, while lenders are focusing on logistics assets, student housing and residential property.

There is a significant difference in lenders offering financing against prime versus secondary properties. For example, 86% are willing to finance prime office, but only 32% offer loans for secondary office properties.

German banks, in particular, have reduced their overall UK loan books, by 17%, and together with other European banks have been affected by higher lending costs due to Basel IV and higher sterling funding costs making the UK less attractive, Bayes reports. Basel IV is a new set of European regulations for banks calculating risk.

Bayes finds that international banks have reduced their activities in the UK, accounting for 25% of the market, compared with 32 to 34% prior to the Brexit vote. Bayes says this has particularly been apparent in the UK regional markets.

Other key findings from the report include:

• All lender groups were affected by the decline in lending appetite, with new lending declining by between 14% (UK banks) and 50% (other non-bank lenders).
  
• New development lending totalled £5.8 billion – with just over half (52 per cent) going to residential development financing. The overall development debt pipeline declined, and development lending accounted for only 16% of all new lending.
  
• Some 30% of residential development finance came from small lenders (with balance sheets under £1 billion), which may be more at risk of ceasing business within the next 3-5 years, or of merging with larger funds.

Lux said the UK lending market is becoming more binary, with borrowers sourcing their debt either from UK banks or from debt funds.
"European banks are finding it increasingly difficult to provide funding due to European Central Bank regulations and implementation of Basel IV rules, as well as unfavourable currency movements between sterling and euro funding costs."

Peter Cosmetatos, chief executive of finance trade association CREFC Europe, said: “This report shows how lenders handled a very difficult year for CRE in 2023. Despite continuing stress in the UK CRE market, a range of diversely funded lending has generally remained open. The pullback by international banks is one to watch: regulatory and commercial challenges in their home jurisdictions may be more decisive for many of them than the state of the UK market.”

Bayes finds 60% of lenders have reported breaches and 61% have reported defaults across their loan book. In total, the average amount of loans in defaults reported was 3.9%, showing an increase again since 2022 (3.5%).

There is a significant difference in loan book quality between lenders with smaller loan books versus larger ones. The weighted average default rate of portfolios of larger lenders is 1.5% compared with smaller lenders of 7.5%.

Loan to value ratios are at a historic trough with the lowest LTV being offered for secondary logistics at 52%. The overall reduction in day-one loan to value for new lending is due to uncertain market conditions, and further declining property values, Bayes says.

Aparna Sehgal, a partner with Dechert, added: “There is more deal activity, and more commitment to deal activity, in each six-month block as compared to the previous period, but overall transactional levels, particularly the volume of new money financings, remain constrained. The data on pricing stabilising, albeit coupled with lower leverage, is encouraging however – and should lead to more transactions being done.

“The continuing increase in alternative lenders providing capital also reaffirms that the CRE market remains attractive to investors, and indicators outside the scope of this report suggest a wider pool of available capital through the provision of back-leverage. Collectively, the CRE eco-system looks ready to respond to more favourable macro-economic conditions as these crystallise.”

Generally lending margins across all asset types have been rising since 2016. The report found, in terms of asset-specific lending focus, fewer than 10 lenders are willing to finance secondary retail assets or shopping centres. By contrast, 45 and 43 lenders are prepared to finance prime logistics assets and finance student housing assets respectively. These are among the most attractive asset types for lenders.

Average loan pricing largely remained stable across property types through 2023. Loans against prime office properties ended at 275 basis points, an increase of 5 basis points over 12 months. And for very prime assets, pricing remains competitive, ranging between160 and 200bps.

When it comes to alternative asset classes, insurance companies offer some of the most competitive margins against hotel assets (315 basis points), as well as for student housing (239 basis points). All lenders offer competitive terms for residential assets.

Chris Gow, CBRE’s head of finance and structured debt in Europe, said 2023 had been a year when lenders sought to prioritise the identification of the nature and scale of their problem loans over new loans origination. This process is now largely complete, he says, adding there has been a strong recovery in lender liquidity so far in 2024.

"Competition is strongest for investment loans in all asset classes and for developments in the most favoured living, hospitality and data centre sectors with pricing, leverage and covenants all becoming more borrower friendly.

“Some lenders are more assertively protecting their positions on defaulted loans. While enforcement rates are increasing, they remain very low overall. Combined with amend and extend strategies deployed by many lenders, we believe the bulk of short term maturities will be solved over a period in excess of 12 months."

Ben Thomason, head of UK and EMEA debt advisory at Colliers, said the findings in the Bayes report highlight just how much the real estate market has been impacted by rising rates and the impact on servicing, which resulted in exceptionally low transaction volumes last year.

"In the interim we've seen ever more debt funds being launched which are able to move quickly, provide greater flexibility, and are able to take a view on [interest cover ratios] and overall covenant packages. However, we are expecting the wheels to start turning again towards the middle of this year as interest rates and inflation starts to fall. We are already seeing margins contract to well below 200 basis points for strong propositions with lower ICR requirements from a number of the main UK banks. At the same time confidence is returning to the market from investors as pricing expectations have settled following a period of readjustment over the last year."

Nick Harris, head of UK and cross border valuation at Savills, says the higher underlying cost of money in 2023 curtailed the viability of many commercial property transactions.

“The latest Bayes report also shows that lenders increasingly became inward focused, seeking to refinance their loans, which accounted for 42% of their total lending. Although loan breaches have increased, lenders have generally been supportive of their customer base, especially where there is debt interest cover. Loan extensions or restructuring were the preferred options, rather than enforcing sales into a weaker market.”

A total of 71 lenders contributed to the year-end 2023 Bayes data. Between 2022 and 2023 three lenders stopped lending, four lenders merged portfolios and three no longer contribute to the survey.