Insurance companies and pension funds need a proper performance index if they are to fill the financing gap in Europe. Malcolm Frodsham reveals the latest work by IPD in this area
Basel III and Solvency II regulations are having a significant impact on the lending landscape for commercial real estate. Hefty regulatory capital charges have made real estate lending more expensive for banks, while insurers are worried that the projected Solvency II capital requirements will make investing in direct real estate less attractive than in the past - particularly in some continental European markets.
At the same time, some interpretations of the projected Solvency II capital framework imply that the new regime will make it relatively more attractive for insurers to lend on real estate. The extent to which insurance companies might be able to partially fill the void created by the deleveraging of bank real estate loan books is now a serious question for the financing of an industry desperate for debt funding.
Investment Property Databank (IPD) has been meeting with insurance companies to establish which insurers are actively lending on commercial real estate, or are planning to lend. Our discussions to date have revealed that relatively few are intending a major shift into mortgage provision, and many of these are still focusing on building the necessary internal procedures, staffing and infrastructure to monitor such exposures.
One difficulty faced by entrants to the market is the absence of relevant and reliable risk metrics for the commercial real estate (CRE) mortgages these insurers wish to hold. The provision of quantitative information on the risks of investing is needed to encourage the increase in lending capacity, which is of such great importance to the industry as a whole.
IPD is undertaking a preliminary survey to ask insurance companies what data they require regarding the risk characteristics of CRE mortgage exposures. If there is an industry appetite to gather this information, IPD can develop a service that pools loan data to create an anonymised CRE mortgage data resource on risk and return characteristics in a similar manner to the IPD portfolio analysis service (PAS).
The PAS service already provides insurance companies with over 25 years of real estate returns, spanning several cycles, allowing an estimate of their value-at-risk from direct real estate investments - essential for the new Solvency II requirements. A PAS service for lenders pooling their balance-sheet loans would create a complementary index of returns from private real estate debt. This index would provide empirical evidence of the volatility of real estate debt returns and the correlations of these returns to other investments - the key inputs to Solvency II.
Any service developed would not just provide data for risk measurement, but also a risk management platform for a real estate loan portfolio similar to that developed at IPD for banks in response to the latest crisis. These services have helped banks gain visibility on their collateral, a process that has revealed previously unknown concentration risks within their loan books. Indeed most of our efforts to date have been in helping banks organise their loan and collateral data in order to allow a visualisation of the key metrics. This, in turn, allows for a drilling down into the data, giving those managing the portfolio a fuller understanding of the bank's exposures.
This visibility is allowing the banks to manage their portfolios in much the same way as an investor. Currently this means managing the contraction of the loan book. The systems put into place will provide a legacy to prevent a repeat of past mistakes and, hopefully, avert new mistakes that could arise in the next cycle.
Creating a CRE mortgage index requires specialist analytical techniques. In order to calculate a regular index of returns for commercial real estate mortgages, valuations are required for each of the loans. Such values are difficult to calculate using directly comparable data, so some form of valuation model is required. To date the best known long-term example of a CRE mortgage performance index is the Giliberto-Levy index in the US. The index was created by Michael Giliberto and John Levy in 1993 as the first index to measure performance of investments in the US commercial mortgage industry. It is now published in conjunction with IPD each quarter.
At the time of writing, we are forming a user group to develop the most relevant methodology for such an index for the UK market - assuming a sufficient pool of lenders can be identified.
IPD data has also been important in the internal analysis that banks have been undertaking to understand how the crisis affected their CRE loan exposures and is currently being harnessed to develop subsequent exit strategies.
It is no secret that lenders were caught out by market risk in the first wave of the financial crisis - and that the fall in values had a considerable impact on loan-to-value (LTV) ratios. In fact, taking the IPD UK all-property numbers, an average fall of 42.4% turned an 80% LTV into a 140% breach of covenant. The range in returns was relatively narrow, from -33.8% on standard shops in the south east, to -46.7% on retail warehouses.
The subsequent recovery in values has alleviated some of the distress, but as it was predominantly focused on London and a few key sectors, it has only allowed investors to work out their distressed loans around these areas.
All-property values have so far recovered to 30% below their peak, but this varies considerably across the country. While the London's West End has seen values return to within 19% of pre-crash levels (meaning an 80% LTV at the peak of the market is now back to below an average 100% LTV), values in regional offices are still 39% below their peak (meaning an 80% LTV is now 130% LTV).
Quantifying and understanding these risks will be the key to the success of the new risk-based regulatory framework. If the risk of lending to real estate is correctly priced, capital will be more efficiently allocated and risks can be managed. The objective here is to help prevent yet another financial crisis with its roots in real estate speculation.
Regardless, sectors and regions are not the only exposures that IPD has been measuring. The major tenant defaults have revealed the impacts of concentration risks, and how they can accrue on individual covenants - covenants that may be matched by exposure elsewhere within the bank.
The IPD Rental Information Service (IRIS) has been measuring this exposure in investor portfolios for many years, and now measures such concentration risks within bank loan books as well. Systems and data standards, once implemented, make it easier for banks to identify their exposures to company insolvency, or distress in particular industries and even particular countries.
The IRIS not only reveals tenant concentration risks but also exposures to lease lengths. The recent cycle has hammered home the importance of income security to asset value preservation in a downturn.
This year is set to be a difficult one for the UK commercial property market. A desperate scarcity of debt means insurance companies and pension funds are needed as lenders, but they need a proper performance index to understand the risks and limitations of such a move. At IPD we are committed to constructing such a framework.
Malcolm Frodsham is director of research at IPD
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