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Guide to bank funding
Every Centuria fund takes out a non-recourse loan facility with a major bank, which is designed to help fund acquisitions, and use leverage to improve the income and capital returns to investors. There are a few key aspects of a Loan Facility which investors should be aware of, particularly in terms of the risk which the loan adds to an investment.
“Investors are not required to personally provide security for a loan.”
1. Facility limits and LVRs
The facility limit refers to the total amount of debt the bank is willing to lend under a given facility. It is expressed as a dollar amount, and is related to the value of the underlying assets (the Fund Property). The relationship between the level of debt and the value of the assets is called the Loan to Valuation Ratio (LVR).
The LVR is calculated by dividing the value of the loan by the value of the property.
For example:
| Loan Facility | $5,000,000 |
| Property Valuation | $10,000,000 |
| LVR | 50% |
Every facility has a Loan to Valuation Ratio Covenant, which needs to be maintained as part of the facility agreement. The LVR Covenant requires that the loan is kept below a maximum LVR at all times. This LVR Covenant is normally between 45% and 65% depending on the type of asset. The Bank requires that the LVR covenant is tested at least every 12 months, which requires the Fund to get an external valuation of the property. Valuations are conducted by professional valuers who are approved by the Bank, and are included on the Bank’s panel (panel valuers).
In the event that the LVR Covenant is breached (i.e. the value of the property declines), the Bank will require that the loan is reduced in order to bring it back in line with the covenant. This is achieved either by raising further equity from Investors, committing free cashflow from the property to reducing debt (which results in a suspension of distributions), or a recovery in the property valuation.
2. Interest cover ratio (ICR)
Facilities taken out by Centuria funds are “Interest Only” facilities. This means that the Fund is only required to pay the interest cost of the loan, with the principal being repaid when the facility ends (either by the sale of the property or refinancing with another Bank).
The Interest Cover Ratio (ICR) defines the number of times the income from a property covers the annual interest payable on a facility. This is a critical measure for the financier, as it expresses the ability of the fund to meet its interest payments. Every facility has an ICR Covenant, which requires that the income from the property not fall below a given ICR. The covenants range from 1.15 to 2 times, depending on the facility and risk to income.
For example:
| Net property income | $1,500,000 |
| Interest cost | $750,000 |
| ICR | 2.0 times |
A breach of the ICR Covenant can occur if, for example, a large number of tenants vacate a property at the same time, or if a property has a single tenant and this tenant leaves. In the case of a breach of an ICR Covenant, the Bank will generally require that extra funds are placed on deposit to cover the difference between the actual income from the property and the ICR Covenant. It will also often result in the Bank requiring that the Fund cease paying distributions to investors until the income from the property is improved.
We are required to report on the LVR and ICR Covenant at least every 12 months, and in some cases every six months. This is completed by submitting a Compliance Certificate, which is signed by the Directors of Centuria.
3. Facility terms
When we enter into a new Facility, we will normally seek to line up the term of the facility with the term of the trust. The term of the Facility is normally between 3-5 years. We will seek the maximum facility that the Bank will offer, as this prevents us having to refinance a facility which incurs re-finance costs to the Fund.
4. Interest costs
The interest payable by a Fund is determined by two factors – the base rate and the bank margin.
Base Rate – in simple terms the base rate is the “cost of money”, and is derived using the inter-bank lending rate, known as “BBSY”. This is a floating rate which re-prices daily.
In order to reduce the risk of this rate increasing, we will fix the base rate payable for a term, generally in line with the term of the loan or the term of the trust. This is known as “hedging”.
Bank Margin – the bank margin is essentially the profit to the bank from lending to the Fund. The margin differs based on the risk of the underlying property. There has been significant
movement in margins since 2007, with rates going from a range of 0.6-1.0% to a range of 2.5-3.0%. The financial crisis saw banks react by increasing margins, in line with the (perception of) increased risk of loans. The margin is fixed for the term of the loan, unless there is a facility review, triggered by a breach of covenant (LVR or ICR as discussed above).
It is our view that the “natural” margin for Centuria-style funds is a range of 1.25-1.5%, and we anticipate that as the market normalises, we will see margins return to these levels.
5. Loan security
We only enter into non-recourse facilities. A non-recourse facility means the loan is only secured by the assets of the Fund (i.e. the underlying property). Investors are not required to personally provide security for a loan.