On the 25 November, 2021, the Central Bank of Ireland (Central Bank) issued a consultation paper 145 (Consultation Paper) to industry in relation to a proposal to: (1) introduce macroprudential limits on leverage and (2) provide regulatory guidance to reduce the potential for liquidity mis-matches in AIFMD[1] compliant property funds, which are Irish-authorised and investing over 50% directly or indirectly in Irish property.
A. Background
Following a period of analysis of the impact of the Irish real estate sector, including property funds, on the overall financial stability of the Irish economy, the Central Bank issued a Financial Stability Note in February 2021 in which it was noted “that property funds’ investment in Irish commercial real estate has brought risks as well as benefits, which supports the need to explore possible macroprudential policy interventions”.
Over recent years, there has been significant growth in the use of Irish authorised investment funds for the purposes of investing in Irish commercial real estate (CRE). The Central Bank has noted that, given its systemic importance, any unexpected and/or significant instability in the Irish CRE market has the potential to create adverse consequences and/or macroeconomic effects for the wider Irish economy.
With the aim of addressing potential financial stability risks in the longer term and to ensure that the sector is better able to absorb, rather than amplify, adverse shocks in future times of stress, the Central Bank has now issued the Consultation Paper with its proposals around the introduction of macroprudential policy interventions in this sector. The Central Bank is of the view that this “in turn will better equip the sector to continue to serve its purpose as a valuable and sustainable source of funding for economic activity.” In particular, the Central Bank has identified and focussed upon two key potential sources of financial vulnerability, namely, leverage and liquidity mismatch in Irish-authorised property funds, which it believes will complement existing regulatory requirements.
B. Proposed measures to address leverage in certain Irish Property Funds
As part of its analysis of the Irish property sector, the Central Bank has identified in the Consultation Paper that:
- there is significant variation in leverage levels across Irish property funds;
- a cohort of property funds have elevated levels of leverage; and
- the average value of total loans to the value of total assets in Irish property funds is approximately 46%; however there are significant differences across the sector in Ireland and the Irish average exceeds the whole property fund sector across Europe.
These factors create the risk that highly-leveraged property funds may breach their loan covenants (including leverage thresholds), resulting in voluntary or compulsory asset sales in an illiquid market resulting in the amplification of stress in the CRE market and wider market instability.
Impacted Irish Property Funds
The Leverage Limit (defined below) would apply to all authorised property alternative investment funds (AIFs) in Ireland, which invest over 50% directly or indirectly in Irish property assets (Property Funds).
New Property Funds will be required to adhere to the Leverage Limit upon authorisation, whilst the Central Bank proposes to provide a three-year transition period for existing Property Funds with leverage levels above the proposed Leverage Limit to ensure that those funds have appropriate time to adjust their portfolio in a gradual and orderly manner.
Proposed Leverage Limit
As detailed in the Consultation Paper, and similar to leverage limits for Property Funds in place in other countries, the Central Bank now proposes to introduce a 50% limit on the ratio of Property Funds’ total loans to their total assets (or its equivalent applying the AIFMD gross or commitment methodologies) (Leverage Limit).
The Leverage Limit will apply to all types of loans, including loans from affiliated parties and shareholders, with a view to reducing the potential for regulatory arbitrage by increasing leverage through unregulated affiliated entities.
Leverage Limits will be determined by the Central Bank based on each Property Fund’s regular regulatory reporting of asset and liability values. Property Funds with levels of leverage close to, or above the Leverage Limit would be issued with a Leverage Limit by the Central Bank, which would also be notified to ESMA.
Given the significant variation in leverage levels in Property Funds, the Central Bank states that it will consider feedback from stakeholders “on the proposed calibration of the limit carefully”. In addition, it is proposed that the Central Bank will have the power to temporarily remove or tighten the Leverage Limits, where it deems appropriate.
C. Proposed measures to address liquidity mismatch in certain Irish Property Funds
Following its analysis of Irish property funds, the Central Bank has “observed significant variation in the redemption terms of Irish property funds, which cannot be explained fully by differences in the liquidity of their assets”. The Central Bank is of the view that liquidity mismatch is evident for a significant subset of Irish property funds and that additional regulatory guidance (Guidance) is required, which will be specific to Property Funds, but which may have more general value to other types of AIFs when interpreting regulatory requirements on liquidity risk management.
Proposed Guidance on Liquidity Management
Despite existing regulatory requirement for Irish authorised AIFs, including Property Funds, to align their redemption policies with their investment policies and strategies and the liquidity profile of their investments, the Central Bank is of the view that it is appropriate to introduce the additional regulatory Guidance for Property Funds on aligning their redemption terms with the liquidity of their assets.
Detail of the draft Guidance is set out in Annex 1 to the Consultation Paper and includes the following key proposals:
- Irish Property Funds should typically be authorised as either closed-ended or open ended with limited liquidity.
- The board of the alternative investment fund manager (AIFM) (and also the board of the Property Fund, where appropriate) should consider and document the structure/liquidity status that is most appropriate for the Property Fund, taking into consideration the asset class(es), the availability of a secondary market and whether redemptions could be satisfied without the need to dispose of large portions of the portfolio held by the Property Fund.
- Redemption policies should be reviewed to ensure that they align with the liquidity profile of the assets for open-ended with limited liquidity Property Funds.
- AIFMs must take into account the liquidity of real estate assets under both normal and stressed market conditions when considering redemption terms for Property Funds.
- Liquidity management tools (LMTs), which are complementary to the redemption policy and align with the liquidity profile of a Property Fund’s assets, should be available to the AIFM to permit it to manage liquidity risk, where appropriate. LMTs should, however, not be excessively relied upon. Please also refer to our publication on the European Commission’s proposed reforms of AIFMD, which include new proposals around the use of LMTs in AIFs.
- In relation to liquidity timeframes, the Guidance proposes that:
- Property Funds should have appropriately balanced liquidity timeframes which include lengthened notification periods for redemption requests and settlement periods for the payment of redemption monies to investors.
- Property Funds should provide for a liquidity timeframe of at least 12 months, taking into account the nature of the assets held. The Central Bank notes that this will “assist in ensuring that the redemption terms of the property fund align with the liquidity of the assets held in both normal and exceptional circumstances, and in a manner consistent with the fair treatment of investors.”
- Property Funds that cannot dispose of assets within the minimum liquidity timeframe should consider having longer liquidity timeframes in place.
Next Steps
The Central Bank is seeking views (with supporting evidence, where appropriate) on the consultation paper from all relevant stakeholders on or before Friday, 18 February 2022. If you are proposing to make a submission and wish to discuss, please do not hesitate to contact us.
[1] Directive 2011/61/EU.
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