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Systemic risk in lease rental discounting market

Rating agency Fitch Ratings has warned that failure to understand the inherent risks of lease rental discounting (LRD) loans may leave market participants exposed to stress in the commercial rental market in the event of an economic downturn.
"In many cases, the pricing of LRD loans suggests that these are perceived by some lenders to be in the high investment grade. However, given their strong credit and operational linkages with sub-investment grade real estate corporate owners, the credit profile of such LRD loans is expected to be weaker," said Fitch director (structured finance), Deep Mukherjee.
However, he added that as of now there is no risk per se in this market but it could pose problems if rentals start falling in line with the present downturn.
LRD is a method to obtain finances from banks or other lending institutions, and is an agreement between the borrower /the developer who owns the premises, the tenant who takes it on rent/lease and the bank or financial institution that extends the funds. In other words, under this, the developer pledges his future rentals to a bank that gives him a loan.
A major clause in an LRD loan repayment is that the rent is directly deposited with the lender and not with the borrower, as rent is considered as fixed income over the rent/lease period.
The borrower gets the loan on the basis of the rent to be collected over the lease period. As such, LRD loans have a lower risk profile than other real estate loans. The bank, before sanctioning the loan, discounts all future rents depending on the lock-in periods, the profile of the tenant and other factors. The bank also assess the growth prospects, road infrastructure, law and order, water and power supply, medical facilities and presence of industries in a city to arrive at true value of the property.

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