Economy in hibernation and cost of financing

This newsletter loosely follows our previously published comment concerning the development of real estate prices in the context of the economic downturn, with a specific focus on the impact on what are called Prime Yields. In this article, we complete our view with the possible development of the cost of the financing of real estate properties and a wide group of industrial enterprises.

Development of the Cost of Financing Real Estate Projects

As we mentioned in our previous newsletter, there are currently no real estate transactions from which it would be possible to estimate the current level of Prime Yields. The situation is also similar as regards the cost of financing real estate properties using senior loan resources. In this case, however, we can use the bond markets, which publish information on the required yield of bonds, as a source of information. In our analysis, we used the Real Estate data published in the Capital IQ database, based on values as of 3 February 2020 and 15 April 2020. We used bonds in the AA- to A- investment category denominated in USD or EUR and, as a second group, bonds in the BBB + to BB- category (this category will include most transactions in the Czech Republic). In our analysis, we use IRS 5Y as the basic interest rate – i.e. a five-year fixation of the rates like PRIBOR or EURIBOR. Where these rates are negative, we use the rate of 0% p.a. As of 3 February 2020, the risk spreads in bonds in the AA- to A- category had a median level of 36 bps – i.e. the bonds offered a yield close to the relevant IRS rates. However, as of 15 April 2020, the median of the risk spreads was at 214 bps. The required performance in such highly creditworthy bonds thus grew by approximately 180 bps. In the case of the very frequent financing in EUR, this development directly corresponds to the increase in the cost of financing from senior sources, while in the case of the less frequent financing in CZK, we can see the positive effects of the central bank’s policies[1], which resulted in the reduction of IRS rates. Five-year funding would thus be more expensive by only 70 bps (however, this would still be more expensive in absolute figures compared to financing in EUR). In the case of the less creditworthy but still reasonably high-quality bond group with a BBB+ to BB- rating, the development between the two dates is only slightly more dynamic, with the risk spreads at the median level growing from 77 bps to 283 bps – i.e. by approx. 200 bps. This development would also correspond to the increase in the cost of financing in EUR; as regards financing in CZK, the cost of external loan resources grew by only 100 bps (financing in CZK would continue to be more expensive than financing in EUR). In recent history, senior loan resources have been the most significant resource of real estate financing, with their share in the value of the real estate normally exceeding 60% of the real estate’s market value. Although bonds are generally considered an instrument bearing a higher risk, the increase in risk spreads even in the high creditworthiness category clearly indicates an increase in Prime Yields and an increase in investors’ demands for capital investments in real estate.

Development of the Cost of Financing Industrial Enterprises

At the same time, we examined the development of bond yields in the category of broadly defined industrial enterprises. Here we first worked with the category of highly creditworthy businesses, with their rating in the AA- to A- category. The median risk spread of these bonds grew from 26 bps to 93 bps – i.e. by approximately 70 bps. As a consequence of the CNB’s policy affecting financing in CZK, the cost of financing in this category decreased slightly, by 40 bps. The development of yields from bonds in a purely speculative group of businesses with the rating grade of BB+ to B- is significantly more dynamic. Enterprises with such a credit quality represent a large group in the context of the Czech Republic. The median risk spread grew from 259 bps to 768 bps – i.e. by approximately 510 bps. The cost of financing in CZK would then grow from 4.41% to 8.43% – i.e. despite the decline in key interest rates, the cost of external resources would almost double. It is again true that the bonds may be affected by lower liquidity and a worse security level compared to senior bank resources. The above development shows how significant the government’s policy aimed at guaranteeing a part of the loan resources within what are called the COVID programmes can be. For a considerable number of businesses with limited financial strength, such an increase in the cost of financing in a situation of falling demand for their products may represent an acceptable option. If you are considering the use of financing with state programme backing, we will be happy to offer our guidance. [1] The 2T repo rate dropped from 2.25% p.a. as of 7 February 2020 to 1.00% p.a. on 27 March 2020