Governance is moving back up the agenda as the credit crunch continues to bite, and more banks are looking to syndicate. Lynn Strongin Dodds reports
Governance is moving back up the agenda as the credit crunch continues to bite, and more banks are looking to syndicate. Lynn Strongin Dodds reports
Whenever there is a crisis, the phrase ‘back to basics' suddenly creeps back into the vernacular, and the credit crunch is no exception. As 2007 came to a close, banks tightened their lending standards and were once again carefully looking at the underlying fundamentals. As a result, the qualities of the property as well as the borrower's credentials are coming in for much closer scrutiny.
Alessandro Bronda, head of property investment strategy at Aberdeen Property Investors, notes, "The commercial banks have become much more stringent in their lending practices. I think this will continue into 2008 as the credit crunch is taking a longer time to unfold. The talk in the UK is no longer about yield compression but how the returns will now be driven by rental income. There will be much more emphasis on how to improve the rent performance from the underlying assets."
Nick Burnell, a partner of Rutley Capital Partners, the real estate private equity business of Knight Frank, agrees, adding, "There will be a greater differentiation between the different markets and the types of properties. I think financing deals in Europe will be easier because the differential between the property yields and borrowing costs is that much greater and there are still quality, institutional grade assets to be found on the continent."
In the US, UK and certain parts of Europe such as Spain, banks had been betting that property prices would defy gravity and continue to rise to unprecedented levels. Many got carried away by the euphoria and followed the herd in chasing market share. After all, risky lending was seen as profitable and few wanted to be left out of the game. Moreover, after the sub-prime crisis exploded in the summer, there was hope that the issue could be dealt with swiftly and sharply. In fact, property lending in the UK continued apace, climbing by £10.5bn (€14.1bn) in the third quarter to a record £186bn, according to figures from the Bank of England.
However, the bulk was lent before the full extent of the sub-prime debacle was revealed. One of the main problems has been with collaterised debt obligations (CDOs) which parcel together different tranches of mortgage backed securities with varying degrees of risk. As the saga has unfolded, the problems have been much worse than expected and this has led to banks moving to the other extreme: they have become seemingly allergic to risk, which has caused liquidity and deal flow to dry up.
Activity in the commercial mortgage backed securities (CMBS) market, which financed about half of the deals in the US and was one of the key drivers of the real estate boom, has also come to a standstill. Issuance plummeted by 84% in October from a record high of $38.5bn (€26.1bn) as problems in the CDO market came to light. In addition, a recent report by Morgan Stanley forecasts a 73% drop in the issuance of new CMBS.
Although emergency action taken by the central banks in the US and Europe has helped to ease the situation, there is still uncertainty in the market. The general consensus is that the prevailing conditions are likely to continue until the second half of 2008. At the end of last year, central banks of the US, the euro-zone, Canada, Switzerland and the UK joined forces and agreed to provide cheap short-term loans to commercial banks.
In addition, the US Federal Reserve announced plans to introduce new regulations for all mortgages as well as an additional layer of safeguards for sub-prime loans - defined as mortgages with an interest rate more than three percentage points higher than the prevailing rate on government securities. The proposed rules would prohibit lenders in the US from extending credit without regard to a borrower's ability to pay, ban so-called no-documentation or low-documentation loans, and require mandatory escrow accounts (placing with a neutral third party) for taxes and insurance.
In the meantime, banks continue to tighten the screws. In the UK, for example, they have lowered their maximum loan-to-value (LTVs) - the ratio between the size of a mortgage and the mortgage lender's valuation of the property - and are demanding a higher income-to-loan ratio. Research from De Montfort University in 2006 showed that the average maximum LTV ratio for lenders into UK prime office buildings was 79.5%, although it was not unusual to see leverage of up to 95% of the value of the property on some commercial deals. Today, LTVs have come down to between 70% and 75%.
Looking ahead, industry participants believe that more equity and senior bank debt will be injected into real estate transactions than in the past four years. Moreover, syndication is expected to come back into favour although few see the end of the securitisation market. Barry Osilaja, director, corporate finance at Jones Lang LaSalle, adds: "Debt has definitely become more expensive. The banks are increasing spreads and reducing LTVs to reflect a higher risk premium. There was a huge weight of debt capital from the securitisation markets but that has now disappeared and is on hold for a while. There are currently only a handful of banks with balance sheet capacity and they tend to be mainly for their relationship clients. Most banks are not stretching themselves and will not underwrite large transactions unless they can syndicate or club in advance."
Michiel Rang, chief executive officer international at ING Real Estate Finance, says: "I think structures will be improved and there will be stronger governance. However, that is not to say that CMBS will disappear. CMBS is still a good financing tool and it will take another six months or so before the market stabilises. In the future, I expect banks will rely on a mix of funding techniques and not just on securitisation to finance a deal."
