On November 25, 2021, the Central Bank of Ireland (Central Bank) released a Consultation Paper 145 (Consultation Document) to industry on a proposal to: (1) introduce macroprudential limits on the leverage and (2) provide regulatory guidance to reduce the potential for liquidity mismatches in the AIFMD compliant real estate funds authorized in Ireland and investing more than 50% directly or indirectly in Irish real estate.
After a period of analysis of the impact of the Irish real estate sector, including real estate funds, on the overall financial stability of the Irish economy, the Central Bank issued a Financial Stability Note in February 2021 in which it was noted “that the investment of real estate funds in Irish commercial real estate has entailed risks as well as rewards, which justifies the need to explore possible macroprudential policy interventions”.
Over the past few years there has been a significant growth in the use of licensed Irish investment funds for Irish Commercial Real Estate (CRE) investment purposes. The Central Bank noted that, given its systemic importance, any unexpected and / or significant instability in the Irish CRE market has the potential to create negative consequences and / or macroeconomic effects for the Irish economy as a whole. .
In order to address potential longer-term financial stability risks and ensure that the sector is better able to absorb, rather than amplify, adverse shocks in times of future stress, the Central Bank has now published the consultation document with its proposals for the introduction of macroprudential policy interventions in this sector. The Central Bank is of the opinion that this “in turn, will better equip the sector to continue to serve its purpose as a valuable and sustainable source of financing for economic activity. “In particular, the Central Bank has identified and focused on two key potential sources of financial vulnerability, namely leverage and liquidity mismatch in licensed real estate funds in Ireland, which it believes will come complement existing regulatory requirements.
B. Measures proposed to combat leverage in certain Irish real estate funds
As part of its analysis of the Irish real estate sector, the Central Bank identified in the consultation document that:
- there is a significant variation in debt levels between Irish real estate funds;
- a cohort of real estate funds have high debt levels; and
- the average value of total loans compared to the value of total assets of Irish real estate funds is around 46%; however, there are significant differences across the industry in Ireland and the Irish average exceeds the entire real estate fund industry across Europe.
These factors create the risk that highly leveraged real estate funds will not meet their lending commitments (including leverage thresholds), resulting in voluntary or compulsory sales of assets in an illiquid market, resulting in amplification tensions in the CRE market and greater market instability.
Irish property funds affected
The leverage limit (defined below) would be apply to all real estate alternative investment funds authorized in Ireland, who invest more than 50% directly or indirectly in Irish real estate assets (real estate funds).
New real estate funds will have to respect the leverage limit when authorizing, while the Central Bank offers to provide a three-year transition period for existing real estate funds with leverage levels above the proposed leverage limit in order to ensure that these funds have sufficient time to adjust their portfolios in a gradual and orderly manner.
Proposed leverage limit
As detailed in the consultation document, and similar to leverage limits for real estate funds in place in other countries, the Central Bank now proposes to introduce a limit of 50% on the ratio of total loans of real estate funds to their total assets (or its equivalent by applying the gross or commitment methodologies of the AIFMD) (Leverage limit).
The leverage limit will be apply to all types of loans, including loans from affiliated parties and shareholders, with a view to reducing the potential for regulatory arbitrage by increasing leverage through unregulated affiliated entities.
Leverage limits will be determined by the Central Bank on the basis of the regular regulatory reports of each real estate fund on the values of assets and liabilities. Real estate funds with leverage levels near or above the leverage limit would be issued with a leverage limit by the Central Bank, which would also be notified to ESMA.
Given the significant variation in leverage levels in real estate funds, the Central Bank states that it will take into account stakeholder comments “on the proposed calibration of the limit carefully”. In addition, it is proposed that the Central Bank have the power to remove or temporarily tighten leverage limits, when it deems it appropriate.
C. Measures proposed to address the liquidity mismatch in some Irish real estate funds
Following its analysis of Irish real estate funds, the Central Bank has “observed a significant variation in the repayment terms of Irish real estate funds, which cannot be fully explained by differences in the liquidity of their assets”. The Central Bank is of the view that the liquidity asymmetry is evident for a significant subset of Irish real estate funds and that additional regulatory guidance (Guidance) is needed, which will be specific to real estate funds, but which may be of value. more general for other types of AIFs when interpreting regulatory requirements for liquidity risk management.
Guidance on liquidity management
Despite the existing regulatory requirement for Irish authorized AIFs, including real estate funds, to align their repayment policies with their investment policies and strategies and the liquidity profile of their investments, the Central Bank is of the opinion that ‘It is appropriate to introduce additional regulatory guidance for Real Estate Funds to align their repayment terms with the liquidity of their assets.
The details of the draft guidance are presented in Annex 1 of the consultation document and include the following key proposals:
- Irish real estate funds should generally be licensed as closed-end or open-ended funds with limited liquidity.
- The board of directors of the alternative investment fund manager (AIFM) (as well as the board of directors of the real estate fund, if applicable) should review and document the most appropriate structure / state of liquidity for the fund. real estate, taking into account the asset class (s)), the availability of a secondary market and whether redemptions could be satisfied without it being necessary to dispose of a large part of the portfolio held by the real estate fund.
- Redemption policies should be reviewed to ensure that they align with the asset liquidity profile of open-ended and liquidity-limited real estate funds.
- AIFMs should take into account the liquidity of real estate assets under normal and strained market conditions when considering repayment terms for real estate funds.
- Liquidity management tools (LMT), complementary to the reimbursement policy and aligned with the liquidity profile of the assets of a real estate fund, should be available to the manager to enable him to manage liquidity risk, optionally. However, one should not rely too much on LMTs. Please also refer to our publication on the Reforms Proposed by the European Commission for AIFMD, which includes new proposals regarding the use of LMTs in AIFs.
- With regard to liquidity times, the Guide suggests that:
- Real estate funds should have appropriately balanced liquidity terms that include extended notification periods for redemption requests and settlement periods for the payment of redemption amounts to investors.
- Real estate funds should allow for a liquidity period of at least 12 months, taking into account the nature of the assets held. The Central Bank notes that it will “help ensure that the real estate fund’s repayment terms align with the liquidity of the assets held under normal and exceptional circumstances, and in a manner consistent with the fair treatment of investors. “
- Real estate funds that cannot sell their assets within the minimum liquidity period should consider implementing longer liquidity periods.
The Central Bank is seeking opinions (with supporting evidence, if applicable) on the consultation document from all relevant stakeholders by Friday, February 18, 2022. If you are offering to make a submission and wish to discuss, please do not. do not hesitate to contact us.