Many real estate bond issuers will not be able to pay interest, says Jan Topinka, partner at HAVEL & PARTNERS. He explains why bonds will "fall" and what investors should be careful about.
According to HAVEL & PARTNERS analysis, at least 68 bond issues maturing in the next two years are from issuers operating in the real estate sector. You have warned us about the potential problems. Can you give us a closer look at the analysis?
We have reviewed the parameters of all bond issues with prospectus that mature this year and next year. We have left out bank, state and municipal bond issues. Unfortunately, data on issues without a prospectus are not publicly available, but these are small issues up to CZK 25 million, i.e., less significant.
At least 68 of the roughly 140 bond issues maturing in 2023 and 2024 with an estimated volume of approximately CZK 37 billion – out of a total volume of roughly CZK 100 billion – are issued by issuers operating in the real estate sector. This is a significant portion of the entire bond market.
Low demand and expensive resources will lead to difficulties especially for smaller real estate projects financed by bonds instead of issuers' equity capital.
To put it very simply: the Czech real estate market has long been used to approximately 10% annual growth in real estate prices, developers used a 70% loan leverage at about 3%, and often replaced the necessary 30% capital by bonds with a coupon of about 6%.
But the situation has changed. Real estate prices are stagnating or falling. Demand for housing has fallen sharply as the mortgage market has declined. Loan financing is five percentage points more expensive – if it exists at all. Construction costs have skyrocketed. Projects are being delayed or stopped.
Thus, low demand and expensive resources will logically lead to difficulties, especially for smaller real estate projects financed by bonds instead of issuers' equity capital. And problems are already emerging now.
What motivates investors to buy bonds from developers?
To invest in real estate, you need a relatively large amount of money. You can buy an investment apartment in the order of millions of crowns, and you have to take care of it. You can invest in real estate funds, but no one will promise you a predetermined yield.
In contrast, a developer offers you a bond from ten thousand crowns upwards. It looks tempting, after all, he offers a decent fixed yield of 6%, regular interest payments and the distributor tells you that it's a "brick that doesn't lose value". Compared to the negligible interest rates in the bank at the time, it sounded like a good investment, didn't it?
Distribution plays a key role. The developers did not have or did not want to put up their own capital, so they used commissions to motivate intermediaries to sell bonds to retail investors. Such motivated distribution networks were able to push huge volumes of bonds onto inexperienced and naive retail investors.
Why may such issuers face troubles now? What are the most significant influences that affect their solvency?
Let's look at the matter from the perspective of the issuer's financial management. One thing is the interest on the bonds itself. The average of those maturing this year and next year is 5.83% per annum. But beware, you need to consider the total cost of money and also the cash flow side of the matter.
In addition to the interest itself, there are significant distribution costs (up to 8–10% of the volume for very risky issues) and issue preparation and administration costs (typically 2% of the volume). Spread over time, the cost of debt management for a typical three-year bond with 6% interest can be 8–11% per annum.
How will the issuer's cash flow affect ongoing interest payments? Is it common to pay interest on an ongoing basis?
Where the issuer pays interest on an ongoing basis, but his yields depend on the completion of projects, the situation becomes more dramatic – the developer will sell the apartments only at the end, if at all. All issues maturing in 2023 and 2024 pay interest annually or more frequently.
Thus, the issuer has to reserve a part of the yields from the issue at the beginning for the ongoing interest payments and use only the rest in the project. The realisation of project revenues and the maturity of bonds rarely occur at the same time.
The big players, the renowned developers, can handle the problems – they can predict, they can manage cash flow, they have capital. But many, mainly smaller issuers, do not seem to realise the complexity of the situation and overestimate their ability to repay their debts.
All this increases the demand for a return on capital in real estate projects, which must be as high as 15–20% in order to be able to repay the bonds and pay the interest. It is clear that the economic factors described above make it very difficult, to put it mildly, to achieve such return.
In addition, some issuers may have had problems before, but often solved them or are still solving them today by issuing new bond issues and using the yields to repay earlier issues. This was possible in a world of low interest rates, but that ended in 2022. Thus, issuers may have had the problem for some time, but may not be able to repay the current high required yields on new issues.
What else is specific about real estate bonds?
It is a project model that is demanding for cash flow management. You need a lot of money for construction. Until the real estate is built and sold or rented, you simply don't have the money. But bonds have a predetermined maturity, it's still debt!
Everybody has problems. The big players, the renowned developers can handle them – they can predict, they can manage cash flow, they have capital. However, according to our findings, many, mainly smaller issuers, do not seem to realise the complexity of the situation and overestimate their ability to repay their debts. Or they do not care anymore...
How should issuers proceed if they begin to suspect future financial difficulties?
At the beginning there is a simple algorithm. Are you sure you'll repay the bonds? Are you? Do the math again. Make a detailed and realistic cash flow plan. Do you still think you will be able to repay? If so, great, repeat the exercise regularly. If it doesn't work out, take a breath, acknowledge the problem and start solving it. Take the insolvency test. Don't stick your head in the sand, don't expect it to "work out". Communicate with investors.
With timely solutions, much can be saved and damage can be limited. Sell something, extend maturities, get an investor... the possibilities are many. But if you let the matter go into insolvency, you will lose control. You will face forced asset sales at discount prices, indiscriminate raids by debt collection predators and usually the interest of law enforcement authorities. And your investors will go away empty-handed.
If an issuer has a problem and wants to solve it honestly, we can help effectively. We help find and implement solutions not only to the satisfaction of our clients but also to the satisfaction of their creditors. We have been involved in several very successful reorganisations and insolvencies with high proceeds for creditors. We do not represent rogues and crooks.
What should retail investors be most careful about when buying real estate corporate bonds?
First of all, they need to realise that it is by nature a risky investment and approach it accordingly. I'm not talking about the big established players, but the smaller or "unknown" issuers. Don't give in to distributor’s pressure, take your time, don't be ashamed to ask... Successful investors don't invest in what they don't understand.
What options do investors have to verify issuers?
There are a number of verification options, most of the data is freely available online. The history of the issuer and its shareholders, accounting statements of the issuer and its group dating a few years back, nature and status of projects financed, negative media reports. Don’t rely on “shiny” websites and distributors’ sweet talk.
Read the emission terms. Are the bonds secured? Is the issuer willing to commit to limit indebtedness, to maintain the amount of equity capital or the project value to debt ratio? Unusually high interest rates, pressure from the distributor, big plans for the future versus short history, emphasis on "guaranteed yield", swearing by the CNB approval, unclear purpose of using the money from the bonds... These are indications that you should pay attention.
And be careful! Approval of the prospectus by the Czech National Bank does not mean that the issuer is financially sound and will repay the bonds properly. The CNB only monitors whether the prospectus contains the necessary information – it is then always up to the investor to evaluate it.
Even if the issuer is a big-name company, a specific project can get into problems. How can an investor catch such problems early?
Creditors should pay attention to the warning signs and not wait passively "for maturity", it will often be too late. The most frequent signs are postponement of interest payments, silence in communication or, on the contrary, unusually brisk communication by issuers, loud sales campaigns for the issuance of new bonds and the intensive offering of new bonds to existing creditors, often in conjunction with the unavailability of their accounting statements.
Is the issuer obliged to redeem the bond before maturity at the investor's request? Do they usually use early repayment clauses or the right to demand redemption?
No, he isn’t. The vast majority of bond issue terms do not give the investor a right of redemption or early repayment. You can't escape early.
Will the proposed amendment from the Ministry of Finance help in the area of risky corporate bonds in general in relation to retail investors?
It will help, but it is far from saving the situation. Moreover, it applies only to the so-called below-limit bonds (below CZK 25 million), for which the investor will have to be provided with information about the issuer, its management and plans, including financial statements for the last two years. However, everyone will have to evaluate this information by themselves. The most problematic, in my opinion, is rather the combination of the lack of financial literacy of retail investors, their naivety and greed, combined with intensive distribution.
This interview was published on the Peníze.cz website
Jan Topinka specialises in banking, finance and capital markets. He focuses on debt financing on both the creditor and debtor side, financial services regulation, and capital market transactions. Previously, Jan worked for five years in various legal positions at the Czech Securities Commission.