On November 25, 2021, the Central Bank of Ireland (Central Bank) issued consultation paper 145 (Consultation Paper) to industry on a proposal to introduce macroprudential limits on leverage and provide regulatory guidance to reduce liquidity mismatch risk in AIFMD1 compliant property funds which are licensed in Ireland and invest more than 50% directly or indirectly in Irish property.
After a period of analysis of the impact of the Irish property sector, including property funds, on the overall financial stability of the Irish economy, the Central Bank has issued a Note on financial stability in February 2021 in which it was noted “that the investment of property funds in Irish commercial property has brought risks as well as rewards, which supports the need to explore possible macroprudential policy interventions”.
In recent years there has been a significant growth in the use of Irish licensed investment funds for the purpose of investing in Irish commercial property (CRE). The Central Bank noted that, given its systemic importance, any unexpected or significant instability in the Irish CRE market is likely to have negative consequences and macroeconomic effects for the wider Irish economy.
In order to address potential risks to longer-term financial stability and to ensure that the sector is better able to absorb, rather than amplify, adverse shocks in future periods of stress, the Central Bank has now published the consultation document containing its proposals around the introduction of macroprudential policy interventions in this sector. The Central Bank is of the view that this “will in turn better equip the sector to continue to serve its purpose as a valuable and sustainable source of funding for economic activity”. In particular, the Central Bank has identified and focused on two main potential sources of financial vulnerability, namely inadequate leverage and liquidity in licensed property funds in Ireland, which it believes complement existing regulatory requirements.
Proposed measures to tackle leverage in certain Irish property funds
As part of its analysis of the Irish property sector, the Central Bank identified in the consultation paper that:
- leverage levels vary widely across Irish property funds;
- a cohort of real estate funds have high levels of leverage; and
- the average value of total loans to the value of total assets of Irish property funds is around 46% – however, there are significant differences across the sector in Ireland and the Irish average exceeds the whole of the property fund sector in Europe.
These factors create the risk that highly leveraged real estate funds will breach their lending covenants (including leverage thresholds), leading to voluntary or compulsory asset sales in an illiquid market, amplifying tensions in the CRE market and creating greater market instability.
Relevant Irish property funds
The leverage limit (defined below) would apply to all Irish real estate alternative investment funds (AIFs) which invest more than 50% directly or indirectly in Irish real estate assets (real estate funds).
New real estate funds will be required to comply with the leverage limit upon authorisation, while the Central Bank proposes to provide a three-year transition period for existing real estate funds whose leverage levels are above the proposed leverage limit to ensure that these funds have the necessary time to adapt. their portfolio in a gradual and orderly manner.
Proposed leverage limit
As detailed in the consultation paper, and similar to leverage limits for real estate funds in place in other countries, the Central Bank is now proposing to introduce a 50% limit on the ratio of real estate funds’ total loans to their total assets (or its equivalent applying the AIFMD or commitment gross methodologies) (the leverage limit).
The leverage limit will apply to all types of loans, including affiliated party and shareholder loans, with a view to reducing the potential for regulatory arbitrage by increasing leverage through affiliated entities unregulated.
Leverage limits will be determined by the Central Bank based on each real estate fund’s regular regulatory reporting of asset and liability values. Real estate funds with leverage levels close to or above the leverage limit would be assigned a leverage limit by the Central Bank, which would also be notified to ESMA2.
Given the wide variation in real estate fund leverage levels, the Central Bank says it will carefully consider feedback from stakeholders “on the proposed calibration of the limit.” In addition, it is proposed that the Central Bank have the power to temporarily remove or tighten leverage limits, when it deems appropriate.
Proposed measures to address the liquidity mismatch in certain Irish property funds
Following its analysis of Irish property funds, the Central Bank “observed a significant variation in the redemption conditions of Irish property funds, which cannot be entirely explained by differences in the liquidity of their assets”. The Central Bank is of the view that the liquidity mismatch is evident for a significant subset of Irish property funds and that additional regulatory guidance (the guidance) is required which will be specific to property funds but which may have a more general value for other types of AIFs when interpreting regulatory requirements for liquidity risk management.
Proposed guidance on liquidity management
Despite the existing regulatory requirement for Irish licensed AIFs, including property funds, to align their redemption policies with their investment policies and strategies and the liquidity profile of their investments, the Central Bank is of the view that additional regulatory guidance should be introduced for Real Estate Funds on aligning their redemption conditions with the liquidity of their assets.
Details of the draft guidelines are presented in Annex 1 of the consultation document and include the following key proposals:
- Irish property funds must generally be licensed as closed-end or open-end funds with limited liquidity.
- The board of the alternative investment fund manager (AIFM) (as well as the board of the real estate fund, if applicable) should review and document the most appropriate structure/liquidity status for the fund real estate, taking into account the asset class(es), the availability of a secondary market and whether redemptions could be satisfied without the need to dispose of large portions of the portfolio held by the real estate fund.
- Redemption policies should be reviewed to ensure that they match the liquidity profile of the assets of open-end real estate funds with limited liquidity.
- AIF managers should consider the liquidity of real estate assets under normal and stressed market conditions when considering the redemption terms of real estate funds.
- Liquidity management tools (LMT), complementary to the redemption policy and aligned with the liquidity profile of the assets of a real estate fund, should be made available to the manager to enable him to manage the liquidity risk, if applicable. LMTs should not be overused, however. Please also see our publication on the European Commission’s proposed reforms of the AIFMD, which include new proposals regarding the use of LMTs in AIFs.
- With regard to liquidity periods for open-end funds, the Guidelines propose that:
- Real estate funds should have appropriately balanced liquidity periods that include extended notification periods for redemption requests and settlement periods for paying redemption funds to investors.
- Real estate funds must allow for a liquidity period of at least 12 months, taking into account the nature of the assets held. The Central Bank notes that this “will help to ensure that the redemption terms of the real estate fund align with the liquidity of the assets held in normal and exceptional circumstances, and in a manner consistent with the fair treatment of investors.
- Real estate funds that cannot dispose of assets within the minimum liquidity period should consider implementing longer liquidity periods.