De Fault Is In The Stars

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Yeah, a really bad pun, but we specialise in such. So what recently caught our eye here in our dark scribbler’s pit was a recent news report about the travails of certain U.S. private equity groups. If you work at the private equity groups Lone Star and Oaktree Capital you’re busily kicking yourself, as the Financial Times reported here

Shopping centres breach loan terms after stores fail

Now it couldn’t have happened to a nicer group of people, really. Really.

The story is as follows. These private equity groups alongside others saw an opportunity to buy into commercial property in the UK in the period 2012 – 2014 when there was a previous downturn in the high street. Encouraged no doubt by the upward only clauses in rents but ignoring the disruption being caused by the shift to online, something that our Editor-In-Chief has commented on here, these “stars” (or if you prefer “masters of the universe”) saw an opportunity to get in there, buy cheap, and leverage up their investments with a lot of borrowing. Masterful strategy. It’s supposed to be that proverbial no brainer of a deal. Buy cheap, borrow, and watch a steady pile of loot come home as the value of their investment appreciates fast aided by that debt providing a nice degree of leverage. What’s not to like?

What could go wrong, you ask yourself? What really?

But leverage while it might turn a pedestrian return into a racing Ferrari on the way up has that little downside to sink in a vacuum like the feather dropped from that high tower.*

Blitzed by the carnage on the UK high street, the valuations of the shopping centres bought by our intrepid private equity gurus have gone down like that feather. According to a short report available from Bisnow here, the valuation of the underlying properties owned by Oaktree have fallen 18%, raising the loan-to-value ratio to 78% against a covenanted ratio of 75%. This breaches an all-important condition of that debt financing. Ops! Or excrementum as Tim is want to say.

To understand the current distress in the retail commercial property sector, Oaktree’s portfolio, which it bought for £260 million in August 2012, had the equity valued at around £100 million. The latest valuation puts it at £85 million. And the next one?

To give you an idea just how bad it all is, Oaktree tried to sell off their portfolio with an 8% yield, which is how they failed to sell it in 2017. According to the Bisnow account, the yield is now 12%. That’s some spread over long term gilts and reflects huge uncertainty on future valuations.

We can see where this is going, can’t we.

This is what Moody’s had to say about the sector, as reported in the FT article: “…the higher leverage combined with a decline in value on the underlying property will result in higher loan defaults upon refinancing and greater loss severities.” That “greater loss severities” is you lose your shirt, equity holders.

Lenders, who have no upside when things go well don’t really want to be in on the downside when things don’t. Best to pull the plug once red lines have been breached and get those assets sold off and the loan repaid. And too bad for the owners. They had their chance to play with their hired Ferrari. Pity it crashed, eh?

You see, the reason is, the more the property declines in value, the greater the temptation by Oaktree to play games at the expense of the lenders. These in turn aren’t fools—hence the loan-to-value covenant in the loan agreement. If left to themselves, Oaktree might reduce the value of the portfolio by skimping on maintenance and other value destroying activities, such as offering rent holidays to new tenants or below market rents. All to allow Oaktree time to delay the inevitable bust and potentially to suck out as much of their investment as possible.

Nah! Best to let the owners go. As the FT reported, a commercial real estate agent commented that “banks become more stressed when interest cover is a problem.” Given the information we have from the articles, the loan to Oaktree’s properties is about £160 million or so and the rental income from these is currently £9.5 million per year—but not all of that can go towards debt service interest if the properties are to be properly maintained. Say maintenance costs £4 million that leaves £5.5 million, implying about 4% interest service. To complicate matters and to put the heebie-jeebies up the lenders, there are 131 tenants with an average lease length of 5 years, so about 25 will be up for renewal this year. How many do you think might be in the position to accept a rent increase or not to demand a rent reduction?

Yeah. Go to the top of the class if you said all would be seeking a rent reduction or no increase as a minimum for signing on again. And the same number next year. You can see where this is headed. All during a period when the high street is being savaged by the inroads being made by online. It ain’t looking good.

Whoosh!

That sound you can hear is water rushing out as the plug is pulled. Not just in this particular bath but elsewhere. The FT reports that RDI Reit (also from the U.S. of A.) has agreed a standstill agreement until October 2019 on £144.7 million of debt against four shopping centres that have exceeded their loan-to-value ratio of 85%.

It’s not good news for Lone Star and Oakwood is it?

As lender, you want to be the first seller in what is now a distressed industry, not the last. And lend them more money? You crazy?

 

* — See this video demonstrating the dropping a feather and a lead ball in a vacuum here with unexpected results.

 

You can now visit Tony’s creative writing website here and read about his latest book, The Sorcerer’s Lackey, an amusing little tale about an innocent abroad sent on a suicidal mission by his sorcerous master. A little poke at the fantasy genre. Go on! You’re interested in reading it, aren’t you?