Central Bank of Ireland introduces real estate fund leverage limit

On 24 November 2022, the Central Bank of Ireland (the Central Bank) published its Macroprudential Policy Framework for Irish Property Funds (the Policy), introducing new limits on leverage and Guidance to limit liquidity mismatch in property funds.

This follows ESMA’s formal advice the same day, which confirmed that ESMA considered the leverage limit proposal which the Central Bank had notified to it was “appropriate to address the concerns relating to the stability and integrity of the financial system”.

What has the Central Bank proposed?

The Policy introduces a limit of 60% to the ratio debt over total assets of in scope funds as an authorisation condition under Regulation 26 and, where appropriate, Regulation 9 of the Irish AIFM Regulations.

The limit applies to Irish funds which have at least 50% of their assets under management (AuM) directly or indirectly invested in physical Irish property assets (Irish real estate funds).

In the context of ESMA’s Guidelines on Article 25 of the AIFMD (the ESMA Guidelines), this is equivalent to

• a 150% limit to the financial leverage ratio (measured as the value of borrowings as percentage of NAV) and
• a 250% limit to the gross leverage (measured using the gross method for calculating the exposure of the AIF),
  where funds do not have recourse to another source of leverage. While the proposed limit applies to borrowing, in principle, synthetic leverage could allow funds to reach higher levels of leverage.

What does Simmons think?

We are pleased that the Central Bank’s final policy document takes account of industry feedback to its consultation paper on the introduction of a leverage limit - a 60% leverage limit is more realistic for Irish real estate deals than the originally proposed 50%, while the 5 year transition period is welcome.

It is also interesting to note that the Central Bank made use of the provision under Article 25(3) of the AIFMD to obtain ESMA’s view on proceeding in this manner and that it is referring to the leverage limit as its first macroprudential policy measure for non-banks. As the Central Bank has made reference to the introduction of macroprudential measures for some time, it will be interesting to see what other measures it plans to introduce.

Timing and transitional period

From 24 November 2022, the Central Bank will only authorise new property funds with leverage below the 60% limit.

There will, though, be a five year implementation period for existing funds – this will last until 24 November 2027. However, the Central Bank has stated that it expects funds to make “gradual and orderly progress” over this period to lower leverage levels and funds should be mindful that ESMA has specifically advised the Central Bank to encourage Irish real estate funds “not to take advantage of the implementation period to delay unnecessarily their compliance with the leverage limits”.

Exemptions

There is an exemption from the limit for funds which invest at least eighty per cent of AuM in social housing provided that:

• the social housing fund holds long term leases
• the income is guaranteed and
• the debt has no LTV covenants or repayment-on-demand features associated with it.

In addition, Irish real estate funds which are involved in development activities will be allowed to use a different methodological framework for the calculation of leverage, since the proposed leverage calculation of total debt to total assets is predicated on the value of completed (investment) assets and does not account for the cost-based valuation of development assets.

During the duration of the development phase, such funds would be able to apply a margin to the development assets, which will work as an estimate of the final value upon completion of a development project. This will account for the difference between costs of development and final valuation, and will be provided by the Central Bank. Based on ‘a range of data sources’, though, the Central Bank has initially set the margin at 20%.

Central Bank Guidance

The Central Bank’s publication includes Guidance on the application of Regulation 18 of the Irish AIFM Regulations with regard to the minimum liquidity timeframe expected for property funds.

This includes the Central bank’s expectations that property funds

• will generally have a minimum liquidity timeframe of at least 12 months, taking into account the nature of the assets held
• which are authorised on or after 24 November 2022 will adhere to the Guidance from inception.
  Existing funds will have 18 months in which to take appropriate actions in response to the Guidance.

Why has the Central Bank introduced the leverage limit?

The Central Bank’s notification to ESMA follows its public consultation in November 2021, in which it proposed a leverage limit of 50% total debt to total assets (although, in light of feedback, that has now been raised to 60%).

The Central Bank’s analysis had shown that a cohort of Irish real estate funds have elevated levels of leverage and that Irish real estate funds have, on average, higher levels of leverage than their equivalents in Europe, with some being exposed to liquidity mismatches.

ESMA’s own assessment found that, at the end of 2021, 22% of Irish real estate funds employed leverage on a substantial basis with the majority of these being Commercial Real Estate (CRE) funds. This was significantly above the average level of leverage for EU real estate funds, where only 5% of all real estate funds were substantially leveraged.

When looking at funds which use leverage on a substantial basis, Irish real estate funds were also found to have a higher leverage ratio than other equivalent EU real estate funds - 50% of relevant Irish real estate funds reported leverage above 677% of their NAV as against 433% for other EU real estate funds.

In addition, the Central Bank reported that Irish real estate funds were also exposed to liquidity mismatches for approximately 40% of their assets – the ESMA Guidelines note that liquidity mismatches can increase the risk of fire sales, in particular in stressed market conditions.

The high level of leverage reported by a part of Irish real estate funds combined with their large market footprint on the CRE market, magnifies the potential of such funds to amplify shocks across this market, while liquidity mismatches for a subset of these funds increases the risk of disorderly deleveraging in stressed market conditions.

As a result, ESMA has agreed that the Central Bank’s proposals are appropriate to address the risks identified.