Case 023Real assets and private marketsHard
A real estate debt sleeve holds EUR 600 million of loans on Northern European offices, Southern European retail and Gulf logistics. Stress interest rates up 100 basis points and cap rates up 75. Which loans breach a 70% loan to value or a 1.5 times interest cover covenant?
1The situation
The Aldmark Real Estate Debt Sleeve holds three floating-rate senior loans, EUR 600 million in all, each with covenants of a maximum 70% loan to value and a minimum 1.5 times interest cover, measured on net operating income.
Northern Europe offices: loan EUR 250 million at 55% loan to value, property valued at a 4.50% cap rate, interest at a base rate of 3.0% plus a margin of 2.00%.
Southern Europe retail: loan EUR 200 million at 65% loan to value, property valued at a 6.50% cap rate, interest at a base rate of 3.0% plus a margin of 3.25%.
Gulf logistics: loan EUR 150 million at 50% loan to value, property valued at a 7.50% cap rate, interest at a base rate of 3.0% plus a margin of 3.00%.
The committee wants a stress in which base rates rise 100 basis points and cap rates rise 75 basis points on every property, with net operating income unchanged.
2Your task
Which loans breach which covenant, why, and which region's debt looks most attractive after the stress?
Quick check
Which covenant does the Northern Europe office loan break under the stress?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Southern European retail fails both covenants, Northern European offices fail interest cover only, and Gulf logistics passes both. Cap rate rises cut values and push up loan to value; rate rises lift interest and cut interest cover. Retail starts closest to both lines and ends at 72.5% and 1.38 times. Offices keep value headroom but earn too little on a low cap rate, falling to 1.36 times. Logistics, with the highest income against its loan, is the most attractive.
Step 1Which stress hits which covenant?
Keep the two channels apart. A higher cap rate lowers the property's value for the same income, so it moves loan to value; a higher interest rate raises the interest bill on a floating loan, so it moves interest cover. A home owner feels the same two pressures: falling house prices eat into equity, and rising EMIs eat into monthly income, and either can break the bank's rules on its own. The cap rateNet operating income divided by property value. A rise in the cap rate means a lower value for the same income. and the loan rate are the two inputs to watch.
Step 2What happens to each loan?
Offices: income of EUR 20.5 million on a 4.5% cap rate; the value falls 14.3% and loan to value rises to 64.2%, still inside 70%. But interest rises from EUR 12.5 million to EUR 15.0 million, so interest cover falls from 1.64 to 1.36 times, a breach. Retail: loan to value rises from 65% to 72.5% and interest cover falls from 1.60 to 1.38 times, breaching both. Logistics: 55.0% and 2.14 times, comfortably inside.
| Loan | LTV before | LTV after | ICR before | ICR after | Debt yield | Paydown to cure, EUR m |
|---|---|---|---|---|---|---|
| Northern Europe offices | 55.0% | 64.2% | 1.64x | 1.36x | 8.2% | 22.7 |
| Southern Europe retail | 65.0% | 72.5% | 1.60x | 1.38x | 10.0% | 16.1 |
| Gulf logistics | 50.0% | 55.0% | 2.50x | 2.14x | 15.0% | 0.0 |
Step 3What does the position map add?
It shows headroom in both directions at once, and which way each loan travels. Every loan moves down and to the right, but retail starts in the corner nearest both lines, so it is the weakest loan and the first to fail both. Debt yield, income divided by loan, is a useful third measure because it depends on neither the valuer's cap rate nor the rate curve: 8.2% for offices, 10.0% for retail and 15.0% for logistics.
Step 4Which region's debt is most attractive, and what would you prioritise?
Logistics, on these numbers, because it has the most income per euro lent and room on both covenants. Rank real estate debt by how much of the stress it can absorb, not by the margin it pays: retail pays the highest margin and is the first to fail. For the office loan the fix is cheap: an interest rate cap or a hedging requirement protects cover without new equity. For retail, ask the sponsor for a cure of about EUR 16 million or a cash sweep. The other risks to prioritise are lease expiry, tenant concentration, refinancing at maturity and, for the Gulf loan, currency and local legal enforcement, which this stress ignores.
Where candidates lose it
Candidates apply both shocks to one number, usually loan to value, and miss that the office loan fails on income, not value. Keeping the channels apart, cap rates to value and rates to interest, is the point of the question.
The second miss is ranking loans by margin. The highest margin sits on the riskiest loan, and a stress test is how you see that before it defaults.
What the interviewer asks next
- The office loan has an interest rate cap at 5.5%. Does it still breach?
- How would you stress net operating income as well, and which loan is most exposed to a vacancy rise?
- Why might a lender prefer a debt yield covenant to a loan to value covenant?
- The retail sponsor offers a guarantee instead of a paydown. How do you judge it?
Asked at PIMCO, Real Estate, Munich, 2024 (Wall Street Oasis): You're evaluating exposure to EMEA real estate debt across the portfolio given shifts in eurozone interest rates.
Company names and figures are illustrative.