Banks with any real appetite for lending are few and far between and seem justified in their strict conditions and high margins. Yet while developers suffer, many pension funds could benefit. But how long will the new realism last? Richard Lowe investigates

In the pre-credit crunch years, the debt financing market had become highly aggressive, as lenders competed with each other to offer the highest loan-to-value (LTV) ratios and the smallest argins. This was fuelled by the burgeoning commercial mortgage-backed securities (CMBS) industry which, since the onset of the sub-prime crisis, has shrunk into relative insignificance.

Banks and insurance companies willing to lend to real estate developers and investors using their own balance sheets have filled the void left by the absence of CMBS lenders. However, they are not prepared to offer LTVs above 70% and are charging higher prices in the process. Furthermore, although many lenders claim they are active in the market, the number actually willing to finance or at least to quote realistic terms is likely to be much smaller. There is also a growing fear in the industry that this limited lending appetite will be fully sated before the end of the year.

Luca Giangolini, joint head of the corporate finance team at Cushman & Wakefield, which advises investors across Europe on sourcing debt, remembers the pre-credit crunch environment well. "The market in recent years had clearly been very aggressive," he says. "The increasing availability of CMBS debt for income-producing properties had driven down margins to historical lows. LTVs had been increasingly constrained only by interest cover, such that lenders were taking almost equity positions for debt returns. For example, in Germany on some retail assets we'd arranged loans up into the 90s in terms of LTV. That was really fuelled by the cheap money being raised through the CMBS markets."

Giangolini admits it was not a great market for intermediaries. Trying to add value when banks were falling over each other to finance projects was difficult. "We had a steady flow of regular clients but raising debt wasn't difficult," he says. "On income-driven deals you could pick up the phone to five banks and everyone would be offering more or less the same LTVs with perhaps only a five basis point range in price."
Since August 2007, Giangolini and his colleagues have been receiving calls from investors he "would never have dreamed of acting for", namely those who "would have had strong banking relationships that would have seen them through the last three to five years".

Who is actually lending? Savills reported in June that there were 53 lenders with an appetite to lend to new customers, complemented by 16 new players entering the market over the past 12 months. However, the vast majority of these lenders are likely to be open only to non-development financing. Giangolini claims his team has spoken to about 100 lenders, 65% of which, he estimates, claim to be in the market. This seems to be roughly in line with Savills' findings.

William Newsom, head of valuation at Savills, admits that of those 69 lenders cited, only seven "have a genuine appetite to provide development finance". He explains: "Yes, I've identified a large number of lenders who are still in the market but the lenders who are in the market are saying this is no longer a borrowers' market, it is a lenders' market. They can choose the business they do."The business they want to do first and foremost is vanilla investment lending - office blocks with secure income streams, etc.

They will do that because they can get good returns. Why do they have to take on added risk by going into the development arena? It is a question of preferences and priorities."
And Giangolini claims that many lenders that claim to be open for business have little real appetite for financing but still have an interest in being seen to be active.
"If you delve a little deeper, many lenders are only open for business to existing clients," he says. "Others are offering very unattractive terms that would suggest they would rather not lend. Their terms are uncompetitive even in today's market. You see some evidence of lenders offering terms and being open for business but I wonder how much business they are really doing."

Ben Moon, director of investment consulting at Atisreal, paints a similar picture. "In parallel with the domestic mortgage market, the availability of real estate finance has reduced significantly from the summer of last year," he says. "Many banks do not wish to openly admit they are out of the market, although in reality we know they are. They are still prepared to quote terms on things but they are with such unrealistically high margins and arrangement fees that they are not remotely competitive. "Yes, margins have increased, LTVs have reduced and fees have gone up but in some instances banks are quoting such extreme increases in costs they are not effectively in the market."

Has there been an over-reaction on the part of banks? Banks have received criticism for being too cautious with their appetite for financing and strict lending terms, or for taking advantage of the current environment to push up pricing."Every day we get calls saying: ‘I can't believe my bank is only offering me 70% and the margins are out here'. Everyone feels they are being too cautious," Giangolini says. "I can understand borrowers being frustrated and aggrieved, because they see great buying opportunities, but the debt is just not there on the terms they want."

However, most of the frustration is coming from highly geared investors that have perhaps become too accustomed to the recent lending environment or that might have known nothing else. For long-term, lower-geared institutional investors, the changes are less of an issue. In fact, low-geared investors are now in a much better place compared with previous years when they could not compete with their highly leveraged competitors.

"If you relate it to the fund market, what has the impact been? At the core end not that much, because you can you still borrow 40-50%," Giangolini says. "The impact has been that margins have probably gone out 50 basis points. The overall cost of funding has gone up a bit but there is no issue in terms of availability of debt." Rory Morrison, fund manager at Invesco Real Estate, believes the relationship between real estate fund managers and lenders has not changed dramatically over the past 12 months - at least not for institutional funds with sustainable levels of gearing.

"Fund managers and the products they represent tend to be less highly geared than some of the more private, individually focused vehicles or transactions," he says. "It is not funds that were ever running at 90% LTV, certainly not in the institutional space. As a result, the relationships with fund managers have actually provided some comfort for the banks, because we tend to be at the lower risk end of the spectrum. For the more highly geared, short-term investors, I think the relationships are very different right now."

Where the real estate fund industry has been affected by the changes in the financing market is in the opportunistic space where they seek to leverage development at over 70%. Recent INREV figures show that opportunity funds had a very low ratio of capital raised to capital invested in 2007. A possible implication here is that this difficulty in investing capital was partly linked to funds not being able to source the required levels of debt.

But Morrison does not believe that banks are being overly cautious or too strict with their lending conditions. "They are being more cautious but that is understandable when you look at the volatility and the challenges both in their own banking market and in the real estate market," he says. "Anyone would expect somebody to be looking a little bit harder and asking tougher questions. I don't think personally it is overly cautious, I think it is a natural reaction to volatile markets."

Giangolini agrees: "The banks are not being too cautious, they are just pricing risk as they see fit; it is a free market. No doubt as property markets improve and the cycle reaches the bottom, terms will become more aggressive." Moon points out that many banks are probably sitting on what little money they can lend, because they want to concentrate on working with customers they can trust and have worked with consistently in the past. Such customers might not require financing at the moment but might well return to the market when conditions improve."What these banks don't want to do is say to their very best customers: ‘sorry, we are no longer open to business to lend to you, even though you have never had a default or we have never had a problem with you'. They don't want competitors taking their business," Moon explains.

Will we see a return to sustainable practices or is this a short-term blip?
It could be argued that in not providing the level of financing many investors are calling for, banks are playing their part in holding back a real estate recovery. However, the counter-argument is that today's lending conditions are far more sustainable than those of the preceding years and healthier for the industry.

"Lending money to investors at 90% LTV and higher is the bit that is not sustainable and was what fuelled some of the disconnect we saw in the market," Morrison says. "The kind of approach they are taking currently is more normal if you look over the long term. LTVs of 60-70% LTVs and margins of 80 basis points upwards are, when you look back at the history of bank lending, not out of kilter with what is normal. I would argue that 12 months ago the market was more out of sync to some extent than what we are seeing today."

But how will the lending market develop over the next 12-24 months? Are the current conditions here to stay for the medium or long term or will banks have the appetite to reinstate a more aggressive lending market once they clean up their balance sheets or economic and market outlooks improve? The global credit crunch as a whole continues to outlive industry forecasts on what seems like a rolling six-month basis. Predictions of its demise are regularly put back and the current consensus seems to be first quarter of 2009. But perhaps even this is being optimistic.

Giangolini admits it is difficult to foresee and wonders what would need to happen for lending conditions to improve. "I suppose some of the investment banks clearing their balance sheets and selling some of the loans they couldn't distribute through the CMBS markets will help," he says. "But if there still isn't any liquidity in CMBS, will they really want to move back into the market? I don't know.

"Values settling would certainly help. When people know that there isn't significant downside risk on values, that should help LTVs but it is hard to say that in six months' time everything will be fine. Everyone talks about a recovery in the first quarter of 2009 but the reality is we will probably not see a sudden improvement at any time. What is more likely is the market will recover gradually over a sustained period of time."

Newsom points out somewhat ominously that development lending as an activity was something "which more or less died for the whole of the 1990s". He explains that the aggressive development lending, particularly by Japanese banks, in the late 1980s helped fuel the unsustainable development of that period. The over-development caused immense problems," he says. "Lenders were not prepared to lend against development for a long time after that downturn."Newsom expects the lending market to bounce back more quickly this time. But, he says: "It is going to be difficult to raise development debt for quite a prolonged period, perhaps three or four years."