On November 25, 2021, the Central Bank issued a consultation paper on the introduction of measures designed to address financial stability issues resulting from the identified liquidity mismatch and excessive levels of leverage in real estate funds, including:
- a limit of 50% of the loan / value leverage for eligible alternative investment funds authorized by the Central Bank (QIAIF) invest more than 50% directly or indirectly in Irish real estate assets (Real estate funds). All loans, including affiliate and shareholder loans, would be included in the on-balance sheet debt limit that would be applied by Central Bank notice under Irish AIFM regulations to real estate funds reporting levels of debt close to or above the 50% limit and, as such, all real estate funds would, de facto, be subject to the limit. Existing real estate funds would benefit from a three-year transition period from the finalization of the debt limit to ensure compliance; and
- guidance on the liquidity schedule for real estate funds, including a planned minimum period of 12 months between the repayment deadline and the settlement date for real estate funds structured as open-ended with limited liquidity. The guidelines would apply to new real estate funds from the authorization and existing real estate funds would have to make the necessary changes to take into account the guidelines as soon as possible.
As highlighted earlier (here), the Central Bank, along with other regulators, legislators and standard-setters, has increasingly focused on the need for a macroprudential framework for funds. Following its 2020 in-depth survey of the real estate fund industry (Thorough investigation) (addressed here and below), the Central Bank has identified financial stability issues resulting from the sector’s high exposure to Irish real estate assets and financial vulnerabilities in the form of liquidity mismatches and high levels of leverage of funds.
The Central Bank considers liquidity asymmetry in funds (i.e. when the frequency of a fund’s transaction does not match the liquidity of the underlying assets) as a potential source of financial vulnerability because it may force the funds to receive large redemption requests which may not be satisfied. liquid assets, to sell assets in a short period of time leading to dislocated prices and spillover effects on the real economy.
The liquidity periods (i.e. the time between the deadline for the redemption request and the redemption settlement date) for real estate funds range from 7 to more than 1,200 days, with 58% of funds (representing around € 13.6 billion in real estate assets) with deadlines of less than 200 days. Fund managers responding to the Deep Dive survey estimated that it takes an average of 180-213 days to sell a property in normal economic times and 420 days in difficult economic times. The Central Bank is therefore concerned about the “Significant liquidity imbalances in the majority of the funds surveyed” estimating that, based on the survey results, only 17% of real estate assets are held in funds that would avoid liquidity imbalances in stressed market conditions by having a liquidity lead time of 400 days or more.
The Central Bank notes that the risk of liquidity mismatch in real estate funds can be mitigated by factors such as the level of liquid assets held (typically 5% of assets), infrequent transactions (most are liquid funds closed or limited) and a limited investor base. (65% of real estate assets are held in single investor funds). However, it remains concerned about the ability of the funds studied to process large redemption requests, as the results highlight that the majority of real estate funds apply liquidity deadlines of less than 200 days. And while single-investor funds may not, due to the lack of first-mover advantage dynamics, be as sensitive to the risks of liquidity mismatches, the central bank is concerned about the possibility of a indirect liquidity mismatch risk given that approximately one fifth of these funds are financial institutions with multiple underlying investors.
High levels of leverage
The Central Bank considers higher levels of leverage in real estate funds to be problematic as they can have an amplifying effect on lowering equity returns in bear markets and, in its results of the in-depth investigation, several indicated. sources concluding that the overall leverage has a negative impact on The real estate fund returns.
The Deep Dive survey found that a significant portion of funds (67% unique investors and 41% multiinvestors) have leverage levels above 50%. Although these levels are above the European average, the Central Bank acknowledges that this is in part due to the significant presence of shareholder and affiliate loans in Irish real estate funds. However, even when affiliate loans are excluded from leverage measures, Irish real estate funds hold higher leverage than their European counterparts. And while most of the funds studied have a single investor, the Central Bank does not consider that this necessarily affects the increased vulnerability of being heavily in debt, as a single investor may always seek to sell the fund’s assets, whether by because of its own leverage. right or not, under tight market conditions and thus triggering downward pressure on prices.
The Central Bank has identified a cohort of real estate funds that exhibit both liquidity mismatch and higher leverage. In total, 35 Real Estate Funds, representing € 5.2bn of real estate assets (i.e. around 1.3 times the average annual volume of CRE 2014-2019 investment transactions) both have liquidity maturities of less than 180 days and a leverage greater than 50%. These funds are considered “Particularly vulnerable to an external shock or sudden economic downturn”.
The consultation on financial stability measures in points 1 and 2 above is open until February 18, 2022 and the Central Bank requests that the respondents provide the reasons for the answers given and that the suggested changes be substantiated, to the extent of the possible, by evidence that will support the consideration of the issues by the Central Bank. raised. The Central Bank intends to provide feedback after the close of the consultation period, but no deadline for feedback or publication of finalized measures has yet been indicated.