Fitch Ratings has come out with its special research report on 'risks in lease rental discounting (LRD) loans'. As per the rating agency the failure to appreciate the inherent risks of LRD loans may leave market participants exposed to stress in commercial rental market in an economic downturn.
Percieved as Less Risky: Lease rental discounting (LRD) loans are widely perceived by lenders to have lower risks than construction loans or direct lending to real estate corporates. The structure of a typical LRD loan ensures relatively higher availability of cash to service the loan and easier access to collateral in the event of default. Furthermore, anecdotal evidence suggests that the performance of such loans has been significantly better than other real estate loans (see Appendix 1: Survey of Institutional Lenders of LRD Loan).
Lenders Underestimate Risks: While LRD loans have a lower risk profile than other real estate loans, most such loans are unlikely to have medium to high investment-grade credit profile. As shown in Fitch Ratings survey (see Appendix 1) in some cases, the pricing of such loans is comparable to the loan pricing of high investment grade corporates. Strong linkage of a typical LRD loan to the corporate owner of the property and a relatively low cash cushion may limit the credit profile of such LRD loans.
Credit Linkage of LRD loans: Long-term lease contracts with high quality corporate tenants provide strong cash flows to service debt, while mechanisms such as rent deposits in an escrow account reduce commingling risk. However, linkage of the LRD cash flows with the credit of the borrower (who is often the owner of the building and is a real estate corporate) remains strong in a many LRD transactions. As such, if the borrower enters into bankruptcy proceedings or debt restructuring, the LRD cash flows would be affected by a time lag.
Low DSCRs: In many transactions, the implied debt service coverage ratio (DSCR) may be lower than the DSCR of similar structures rated investment grade. This is because the typical implied DSCR range of 1.1 to 1.3 seen in Indian LRD loans may not provide a sufficient cushion to debt payments during (even moderate) economic downturns. As such, over the last 10 years the Indian market has experienced downward rent revisions in the range of 10% to 40% (depending on location).
CMBS vis-vis LRD Loans: Significant similarities exist between Indian LRD transactions and CMBS transactions, particularly in the Asia-Pacific region. CMBS transactions with investment-grade ratings usually have a DSCR above that of a typical Indian LRD loan. As such, they are able to withstand much higher volatilities in rental cash flows. However, many CMBS transactions are exposed to refinancing risk at maturity, since the principal is usually not fully amortised.
LRD Loan StructureFitch has been presented with a wide variety of real estate financing structures. In addition to LRD loans, proposals include CMBS and construction-linked loans (also known as progress payments in other jurisdictions). To develop a complete view of the variety of LRD structures in the market, Fitch surveyed market participants.
The typical LRD structure consists of a real estate loan with a charge on a commercial property, along with an assignment of the future lease receivables. Thus the debt obligation is serviced by the rent/lease payments of tenants occupying the commercial property. These features ensure significant cash flow visibility for debt servicing, particularly if the tenants are financially stable corporates and are likely to remain in the property well beyond the initial lock-in period. Additionally, if the lender is a bank, the lender then draws comfort from its ability to enforce security (the underlying commercial property) under SARFAESI Act in the event of default.
Such features result in LRD loans having a relatively lower likelihood of default than a loan extended directly to a real estate corporate. The key structural features of an LRD loan are provided below.
Discounted Rent Value (DRV)The rent contractually received from the tenant (also known as gross rent) is adjusted for taxes, maintenance and other administrative costs to calculate the net rent. Where there are separate payment arrangements by means of a Common Area Maintenance (CAM) agreement between the tenant and the owner, less weight may be given to maintenance and administrative costs. However, while calculating net rent for LRD loans with a tenure greater than five years, not all lenders explicitly consider major maintenance expenses. As such, periodic capital expenditure will likely have a significant impact on cash flows. The net rent, thus calculated, is discounted by the interest rate of the loan over the life of the loan to determine the discounted rent value.
Volatility in Occupancy LevelsCorporate tenants in India typically stay the full term of their contract, owing to lock-in periods (usually three years), high upfront set-up costs (ranging from 18 months to 40 months of rent) and social costs (eg proximity to business partners/customers and employee convenience). To ensure occupancy levels are maintained over the tenure of an LRD loan (particularly loan tenures exceeding five years) it is important to evaluate the attractiveness of the business district and the supply of commercial real estate in the locality. An excess supply of commercial real estate at relatively lower rental rates is likely to result in a downward renegotiation of rents, or an increase in vacancy rates; either would affect the DSCR of an LRD loan.
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To read the full report click on the attachment
Risks_LRD_Loans_Fitch_091211.pdf
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