How is UK real estate finance developing in 2022?

2021 was a year of cautious recovery for the UK real estate finance market, gaining momentum through the year, resulting in a very busy Q4 for most. As we enter calendar Q2 of 2022, how does the Simmons & Simmons Real Estate Finance team expect the rest of 2022 to unfold?

As we publish, Ukraine dominates thinking for understandable reasons, but we cover other topics here as well.

The COVID-19 backdrop

Much of 2022 will be shaped by the end of COVID-19 related restrictions on landlord enforcement.  These were originally enacted to provide protection for tenants in relation to rental payments during the first lockdown of 2020 where business had been adversely affected by coronavirus, hindering the ability to generate revenue. The changes in law coming into force include the enactment of the Commercial Rent (Coronavirus) Bill to coincide with the end of the moratorium on landlords exercising forfeiture rights and seeking to recover commercial rent arrears. With the new legislation, commercial landlords and tenants will be able to apply to an arbitrator to resolve any business tenancy disputes regarding rents accrued during the time period that a business was mandatorily closed due to COVID-19 restrictions.

How landlords and tenants react to these measures will directly impact lenders and next steps in respect of property assets currently financed. We expect that the second half of 2022 will mark the end of any outstanding pandemic related financial covenant waivers as lenders consider their enforcement and refinancing options to coincide with the end of government support. It is likely that landlord and tenant behaviour during the height of the pandemic will be indicative of how successful any arbitration process may be.

Ukraine

The human cost of Russia's invasion of Ukraine is both horrifying and clear to see.  It may take more time to understand the true implications for the worldwide property market.

The sanctions imposed are having immediate implications for banks and borrowers with ties to Russia as they now face restrictions which will instantly impact refinancing and drawdowns on existing loans. Furthermore, companies with cash stuck in the Russian system will now require more cashflow to service their debt and run their businesses and many are having to write off their Russian investments. Lenders will have to think carefully about how or whether loans can be restructured going forward in order to ensure compliance with sanctions measures.

The longer the war continues, the more we will see disruption to production in Ukraine including the impact on global commodities, in particular ore and steel. This may well exacerbate the supply chain issues we cover in 'The Development Cycle' below.

These factors will play a part in further inflation and interest rate increases which will impact borrowers and lenders alike in the real estate market and beyond.

The longer-term impact of the war in Ukraine is harder to predict, although a flight of capital and real estate requirements west, away from Russia and neighbouring states is likely. The changing political landscape (and government spending) will also have an impact, driven by defence and infrastructure needs that will flow.

Stricter ESG measures

As predicted in our 2021 outlook, the ESG agenda is gaining further momentum in 2022. Many lenders operating in the UK will be required to comply with the UK Government's Sustainable Finance Roadmap with certain rules already set out in detail and others to follow in the latter half of 2022.  

One of the impacts of the new regulations will see the FCA clamping down on greenwashing by requiring lenders to report on the framework of the Task Force on Climate Related Financial Disclosures in respect of their financial products. Failure to do so may result in fines for those lenders. Careful thought will be needed before lending on property to ensure it meets the standards set by the FCA, all the while keeping their reporting functions flexible to meet the ever-evolving ESG regulations.

Looking beyond 2022, one of the factors property investors will consider when sourcing debt will be to identify those lenders who are meeting ESG data collection and other reporting requirements in the most functional and practical way possible for all parties.

The office

2021 was an uncertain year for the return to the office. The on-off nature of pandemic related restrictions meant a return to the office was not fully visible and, whilst most companies were unwilling to forgo their real estate, new COVID-19 variants meant workers were not able to move back to the office.

2022 sees a more optimistic outlook with offices seeing more footfall. This year, the choice to reconfigure existing office space or to downsize (in the longer term) will be one that tenants will make. If the decision is made to reconfigure, employers will need to put plans in action to create a better office experience for their employees by developing hybrid working facilities and embracing technology. Previous office data and trends will become redundant in the new normal and employers will have to respond to employees' needs in real time to optimise their real estate.

As a result of the growing ESG agenda, we expect the fight to invest in the greenest office space will see further disparity in performance between prime office assets and those that do not meet ESG standards. This will be further exacerbated by lenders' growing ESG targets and the firming up of green legislation in relation to lending.

With some city dwellers eschewing urban life in favour of country living, we also expect investment in regional offices to continue to grow.

The development cycle

The appetite for development remains high in 2022, but not without its challenges.

COVID-19, Brexit and now Ukraine have created labour shortages and supply chain issues. As a result, we expect lenders will continue to have to amend existing facility agreements to reflect delayed practical completion dates.

Furthermore, rising construction costs because of supply chain issues and the increase in interest rates mean that developers no longer have the pricing certainty they once could rely on when assessing new development projects. In turn, developers will see their profit margins squeezed as the gross development value of assets struggles to keep up with the rising cost of development, making some projects economically unfeasible. As development projects become more expensive and higher risk, the pool of lenders willing to lend against such projects may get smaller.

There will also be the theme of 2021 seen in 2022 with the continuing hardening of the construction insurance market, not helped by the war in Ukraine. This will be seen on several fronts, from the professional indemnity insurance market struggling to provide insurance on an "each and every" claim basis, to the increasing difficulty of how to adequately insure against damage to an existing building whilst works are being carried out.

Despite the obstacles, financial institutions will continue to compete to finance the best (and greenest) development opportunities.

Hotels and leisure - the bounce-back?

For hotels and restaurants that managed to demonstrate their resilience throughout the pandemic without being forced into closure, we predict that the remainder of 2022 will see those assets continuing to recover at pace. In turn, lenders will be able to resume debt service waterfalls and financial covenant monitoring that was previously halted because of the pandemic.

With travel for business and leisure picking up, we expect investors will be on the hunt for hotels in prime locations in the capital and other major cities and for lenders to fund those acquisitions. However, with the slowing down of domestic tourism as consumers return to holidaying abroad, hotels and restaurants in more rural areas may not see the continued interest they experienced in 2020 and 2021.

Tax issues

Following substantial changes to UK real estate taxation in the last few years the tax landscape continues to evolve in 2022.

Residential Property Developer Tax comes into effect from 1 April 2022 and will apply to companies carrying out a wide range of activities (including marketing and management) connected with the development of residential property in the UK. It applies where the company (or a group member or a JV vehicle with which it has a sufficient connection) has a relevant interest in land held as trading stock. The tax is specifically intended to fund cladding remediation costs and is (at least in theory) intended to be temporary, for a period of around 10 years. The scope of the new tax is deliberately wide, and although the tax rate is low at 4%, this is calculated on a broader tax base than corporation tax: in particular, deductions for financing costs are not taken into account. The definition of residential property for these purposes includes land for which planning permission is sought or granted, not only land where actual development has commenced. Taxpayers should already be looking at the potential application of RPDT to existing structures, and when setting up new structures should look at whether there is scope to mitigate or at least simplify application of the tax. In some cases, the group allowance of £25m per accounting period may fully alleviate the potential tax charge, but particular care is required in relation to joint venture structures, where the RPDT rules are particularly complex.

On the tax compliance and administration front, a point for real estate finance lenders and borrowers to keep an eye on is that the time it takes to obtain treaty clearances in respect of UK interest withholding continues to extend, now running at around 4-5 months in many cases (irrespective of whether the lender has a UK treaty passport). In the context of quarterly interest payment dates this means that it will be important to consider whether a long first interest period or mechanism for accrual of interest pending clearance should be included in the finance documents. For the same reasons, borrowers facing a passported lender may also find that they are more often asked to rely on "provisional" treaty clearance to make a gross interest payment on time.