The debt metric on real estate’s radar

As global volatility puts the debt exposures of real estate companies under sharp focus, lenders are paying greater attention to a metric that helps determine their ability to service loan facilities.

The Interest Coverage Ratio (ICR) – the ability of a borrower to service the interest on its outstanding debt from the income of the underlying property or portfolio – is now at the forefront of loan structuring considerations.

While the definition can vary between lenders and facilities, simplistically, the ICR formula is asset income divided by interest expense.

In recent months, ICRs have deteriorated significantly while asset incomes (the numerator) have remained stable – a sign that the interest expense (the denominator) is driving the change.

For investors and developers, this means they are unable to leverage their properties as highly as before, which in turn gives them less capital to acquire new assets, launch new developments or refinance existing loans.

“Twelve months ago, ICRs were viewed somewhat as an afterthought for some borrowers as the markets predicted much lower rates for longer, and ICRs were well above minimum acceptable levels,” says Josh Erez, director, debt advisory, JLL Australia.

“But geopolitical and economic instability, and particularly inflation, resulting in higher global interest rates means the commercial real estate industry is undergoing a period of adjustment.”

The ICR is a gauge of the financial strength and creditworthiness of a particular transaction. As one of the major debt covenants of loan facilities, it requires scrutiny and monitoring both initially and during the life of a loan term.

However, with interest rates increasing significantly, investors and owners are being forced to examine their existing debt exposures and future requirements closer than ever before.

“Considering the exponential cost increases, investors coming up to refinance on loan expiry are finding that they may need to de-lever or restructure their positions, or potentially sell assets,” Erez says. “The market is performing a natural rebalancing.”

At the same time, increasing inflation and geopolitical uncertainty is driving wholesale funding costs globally.

In this context, loan serviceability and the appropriate level of leverage is the main conversation borrowers are having with their lenders for new and existing loans.

“In Australia, where I am based, it was once possible to lever up to approximately 60% and even 65% in some circumstances, most transactions are closer to capping out at 55%, with 45-50% increasingly being the new accepted range for core investment assets given the tight yields on some assets,” Erez says.

“Liquidity for debt remains largely strong, but leverage is being tempered through ICRs which should ensure there is a buffer in the system and less likely a chance of a market dislocation should asset values decline materially.”