The availability of debt financing was good throughout 2018, both with regards to bank financing and bond financing, and this trend has continued into 2019. Bond financing has been utilized more and more in the past two years due to the low level of competition between the banks and the relatively high margins on loans. It now looks like things are going to change as the bank margins have fallen for six consecutive quarters; at the same time, we can see an increase in credit margins in the bond market. The spread between bank financing and bond financing has gone from 167 bps to 106 bps since the beginning of 2018.

Financing commercial property

The banks have recently become more restrictive in providing leverage measured by LTV, and the “base case” now stands at 60-65% LTV, while at the same time amortisation structures has become more important given the low yield levels in the market.

During the first part of 2018, interest rates rose sharply, putting pressure on yields, as there was very little head room to be found in interest costs (i.e. yield gap). Through the autumn of 2018 and in 2019, long-term interest rates fell sharply. In the spring of this year, lower interest rate path from the Central Bank of Norway caused a fall, while the recent turmoil related to a trade war, tariffs on car imports from the EU and a hard Brexit have escalated matters. Moreover, bank margins have fallen for six consecutive quarters. The result is reduced pressure on yields. Newsec therefore believes that the yield will remain stable in the coming years and possibly begin to rise when the interest rates once more will be hiked.

Bank financing

UNION’s bank survey for the second quarter shows that the average bank margin for five-year property loans continues to decline. That margin started to fall in Q1 of 2018, which was the first time since the margin began to rise in the autumn of 2015. Hence, this is the sixth consecutive quarter in which margins have fallen. All in all, the bank margin is down 39 basis points since it peaked in Q4 2017. For loans with 65% LTV, the margin is down 7 basis points to 2.06% in the past three months, which is 41 basis points higher than the bottom figure from the second quarter of 2015 when it was 1.65%.

The reduction in margins in the past year has been offset by increased interest rates. For the first quarter this year, however, the average total financing cost fell to 3.95% versus 4.13% for the fourth quarter of 2018. For the second quarter of 2019, the trend levelled out and came in at 3.96%, which is 28 basis points lower than it was one year ago. The total financing costs for a five-year loan is currently 1.12% higher than the lowest point experienced during the first quarter of 2015.

There is also an increased focus on environmentally friendly properties. In the past, the question of whether or not a building had BREEAM EXCELENT certification was not considered particularly important for banks; however, more and more banks are now taking this into account. In a recent bank survey, it was found that such environmentally certification can result in debt financing with some 20 basis points lower margin.

The difference between the bank’s deposit and lending margins continues to be high. Deposit costs for banks increased significantly in the autumn of 2015 as a result of the banks’ risk premiums increasing while capital requirements were simultaneously intensified. Since then, deposit costs have been significantly reduced, while the bank margin remained at a high level due to the rather modest competition between the banks.

The banks’ profits were somewhat reduced in the first quarter, as risk premiums increased, while long-term interest rates remained relatively flat. However, in the second quarter, the banks’ deposit costs fell by 15 basis points, thus the upturn that we saw in deposit costs for first quarter have been somewhat reversed. When bank margins have fallen by 7 basis points in the same period, this means that the banks’ estimated net interest income has increased by 8 basis points.

Competition between the banks and lower deposit costs mean that it is more likely that there will be further reductions in bank margins. However, the higher capital requirements may dampen this potential fall in margins somewhat. On the positive side, many loans have been refinanced on the bond market, which in turn has freed-up capacity at the banks.

Bond financing

The issuance of real estate bonds has increased significantly in recent years. Of the total debt volume for commercial property in Norway of approximately NOK 660 billion, bond financing represents approximately NOK 113 billion (17%). The total outstanding volume in property bonds currently is just over six times higher than it was five years ago.

In 2018, the issuance of new bonds amounted to approx. NOK 26 billion. This is lower than it was the previous year with some NOK 36 billion, but higher than it was in 2016. For 2016, the volume was NOK 24 billion. In the five-year period prior to 2016, the average was NOK 9 billion. These are “plain” bonds that do not include those purchased from the bank by life insurance companies. The reason behind the lower volume in 2018 is a new interpretation of the regulations for life insurance companies, in which this type of investment is not as attractive as first assumed according to SII. In particular, the financing of SPV companies is the hit the hardest, as there was a downturn from NOK 13 billion in 2017, to NOK 7.9 billion in 2018. Furthermore, we see that the non-domestics' share of bond financing is lower than last year, with NOK 6.3 billion in 2018 compared to NOK 7.3 billion in 2017.

The credit margin in the bond market was considerably higher in 2018. However, this has backed off somewhat and is now approx. 20-45 basis points higher than at the beginning of 2018. At the same time, bank financing appears to be relatively more attractive, where as mentioned, the spread between bank financing and bond financing has gone up since the beginning of 2018.

There have been few issuances of “plain” property bonds in recent months. One explanation may be that the companies are waiting for a development in the credit spreads. The larger companies have flexibility with regards to when they may issue new bonds, and thus it would be rational for them to wait, if indeed they believe that the spread differential is temporary and that it will be reduced.

The market has also been more selective with regards to which cases” financeable” for for SPV structures following the Financial Supervisory Authority’s interpretation of the regulations from April 2018. This has also resulted in the credit margin being higher and the bonds terms (tenure) being shorter in such cases, it is therefore natural that bank financing be employed to a greater extent.

The bond markets will probably be “well-functioning” going forward, but the significant growth in outstanding bond volumes will likely be reduced. We will likely see significant levels of refinancing in the coming years. In addition, there is a global fear of turmoil in the major economies that is likely to cause increased credit spreads to a somewhat higher level than we have seen in recent years.

Over the past year, more and more entities have taken advantage of the opportunity to finance themselves in the bond market. In the past there was a "minimum level" of NOK 300 million per bond; however, funding in the bond market is now available for as little as NOK 75 million, demonstrating that it is no longer the case that only the best and largest properties/companies receive loans.

What follow are the largest bond issues for 2017 and 2018:

A large part of the investors for unlisted bonds is comprised of life insurance companies and pension funds, but this was narrowed during 2018. The margin is very vulnerable to their appetite for such bonds, and this demand has now decreased. Several large players have stated that investments in long, unlisted real estate bonds have been put on hold due to the new interpretation of the solvency regulations (SII) and that the return is too low compared to the current margins for these instruments.

The new interpretation of the SII regulation in April means that bonds issued by SPV’s are now treated as “unrated” bonds. This results in a capital commitment of 23.5% for 10 years and 15% for 5 years. For each additional year, 1.2% and 1.7%, respectively, will be added for each year. For example, a seven-year commitment will be 15% + 1.7% × (7 – 5) = 18.4%. Whereas a 12-year commitment will be 23.5% + 1.2% × (12 – 10) = 25.9%.

The result was that real estate bonds did not become as attractive an investment since more capital must be held by life insurance companies and pension funds, thus a large funding source disappeared. However, we also see that they immediately began buying real estate again.

In order to illustrate the problem, we have drawn up a graph in which we have made some assumptions regarding expected return and cost on buffer capital.  As we have seen, the return on property bonds will not be satisfactory when compared with other assets. As the life insurance companies interpreted SII, they had a return of return of 2.8%; however, that figure is now 1.6%. Therefore, all other assets are preferable.