There is plenty of capital willing to invest in real estate but banks will need to proactive to facilitate it say Jose Luis Pellicer and Nigel Allsopp
Even the fiercest free-marketeer should now admit that the worst global financial crisis since the Great Depression has been dealt with superbly by both governments and central banks. Without their intervention, the global banking system could easily have collapsed. The banking bailout, aggressive interest rate setting and monetary injections buoyed up bank profits in 2009 and 2010. This has given banks the time and resources to wash their faces and rebuild much-needed capital. Nevertheless, there is still quite a lot of dirt in the banks' balance sheets that needs to be thoroughly washed away before aid is withdrawn. Indeed, the gap between what would be available for refinancing and the actual refinancing need is quite substantial - capital is therefore needed. Yet, there is plenty of it looking for property right now. The question is therefore, how should the industry fund the gap?
It is easy to forget that the banking system is totally based on the good faith of depositors. Euro-zone banks' cash holdings represent less than 10% of deposits. If faith were lost, and every depositor wanted their money back, episodes like the 2001 Argentine bank closure, subsequent economic collapse and mass emigration would follow. Fortunately, faith was indeed restored: banks made billions in 2009 thanks to low funding rates, high liquidity (from central banks), low competition (many banks had gone bankrupt) and still some risk aversion in the system (and thus high margins and wide bid-offer spreads). Goldman Sachs posted $19bn (€14.3bn), JP Morgan $16bn, Deutsche Bank $5.2bn and Barclays $4.5bn.
Furthermore, asset prices began to rise, partly because of low interest rates - when rates are low, demand for risky assets increases. The Bank of England estimates that 20% of the recent stock price rally has been entirely due to the effect of lower discount rates on asset pricing models. The picture therefore looks bright - profitable banks, rising asset prices, money markets functioning again, confidence restored. Mission accomplished, then?
Err… no. Profits in 2009/10 are just a ‘flow' variable on the back of very extraordinary measures. Now it is time to deal with the stock. But these measures are about to be withdrawn. The European Central Bank is already announcing that it will gradually remove non-standard operations (the purchase of covered bonds); furthermore, the yield curve reflects the fact that three-month Euribor and Libor rates in December 2010 will be at 1.6% and 1.9% approximately (compared with 0.65% and 0.66% respectively right now). Once public support is withdrawn - bankers are on their own, with profits being driven by both, current balance sheets and general economic development.
A worrying feature of the banking sector is the legacy of bad loans, mainly in the commercial real estate sector. When a bank has a substantial amount of bad loans, it will either have to make provisions (an expense for P&L purposes), or restructure (and take on an immediate loss), or take control of the asset (and hire some specialist labour to deal with it, another cost). In all examples, the bank is likely to have to put aside more regulatory capital, thus denting any new lending activity - in other words, a legacy of bad loans implies lower revenue, higher costs and thus lower profits. This will become apparent once measures are withdrawn.
There is little data on the magnitude of the problem at a European level. Yet it is not hard to estimate by making some assumptions on loan-to-value ratios, volume of transactions, volume of debt and loss of real estate capital values in Europe since 2005. Applying a similar exercise, DTZ has come up with an estimate of the funding gap, ie, the differential of the monetary amount of the loans to be refinanced in 2010 and 2011, and the value that will be refinanced at current valuations and LTVs. This funding gap can add up to €156bn in their most pessimistic scenario. Capital is thus needed.
When thinking of real estate investment, it is useful to think in terms of ‘four quadrants', ie, private equity, public equity, private debt and public debt. As argued above, there is a funding gap in the private debt market. Yet there is plenty of liquidity both in public and private equity sectors and (possibly) in public debt.
The recent violent positive repricing of European real estate is typically attributed to lack of supply, with few property owners willing to put their real estate on the market. The volume of transactions is near 2005 levels, yet this has not stopped pricing reaching quasi-boom levels for prime property and increasingly for good secondary - investors are moving up the risk curve because of lack of product. In other words, there is plenty of equity capital looking for too few properties in Europe. DTZ estimates this to amount to roughly €120bn.
Furthermore, this repricing can also apply to public real estate, with REIT share prices having increased by 63% between March 2009 and March 2010. Also, there has been a resurgence in bond issuance of non-financial corporations in the euro-zone, according to the ECB, with net issuance per month exceeding €10bn in 2009, well above issuance during the boom.
This may suggest that there could be capital to fund the gap, at least partially. But will the capital be sufficient (for which one can only provide a qualitative answer) and how will it find its way to the market? A possible answer to the latter question is debt for equity swaps - banks agree with borrowers to take ownership/partial ownership of the assets or to act as a conduit for an eventual portfolio sale (including a combination of good and bad assets). This option was taken on by the Spanish property companies Metrovacesa and Colonial - their lenders took control of the companies in exchange for the cancellation of part of their loans (a debt for equity swap).
Another form of debt for equity swap would be the creation of property companies (listed or unlisted), with shared ownership by the bank and the borrower, but also funded publicly or privately though a placement, IPO or rights issue. A third option is the issuance of covered bonds. These are different to CMBS in that they are not divided into different seniority levels, but just simple senior paper secured on real estate cash flows.
The policy of extending loans should be over soon; banks need to be proactive in dealing with their balance sheet and finding a means to fund the gap. The capital is available to fund real estate; it is up to banks to facilitate it.
Nigel Allsopp, associate at AEW, also contributed to this article
Jose Luis Pellicer is associate director at AEW