The demands of stricter regulation and the need to deal with existing problem loans is squeezing bank lending. Paul Leatherdale explains
Anyone involved in the real estate market will know only too well that over the last 18 months or so, we have witnessed dramatic problems on a global scale that very few could have foreseen in the heady days of the early to mid decade.
One of the many lessons that have been learned is that the international financial markets are highly inter-connected in many different ways. The ill-fated ‘disintermediation' by leading investment banks playing pass the parcel (or was it Russian roulette?), spreading the risk of ill-considered and imprudent US sub-prime residential lending around the international investment community, caused problems in many other asset classes and an overall withdrawal of liquidity from the market. Investors and banks counterparties realised that the value of their assets had fallen, though liabilities on the other side of the balance sheet had not.
To illustrate the scale of the problem, by mid-2009 the UK banking sector's overall exposure to commercial property was estimated to be around £280bn (€320bn), but UK commercial property values had fallen approximately 45% from the market peak. This, coupled with other problems arising from the economic crisis, created enormous pressure on bank capital and balance sheets. UK banks alone have had to raise over £130bn of equity.
In addition, the regulatory requirements on the amount of capital banks have to hold are being tightened to ensure that they have enough capital cushion to protect against future crises. This will mean that loan pricing generally will have to increase so that banks can maintain the return on equity required by their shareholders.
This new capital has come at a high price. Not only has it cost more in economic terms, but many banks have removed their senior management who were held responsible for getting them into trouble. Indeed, in a number of organisations, a safe pair of hands and a risk-averse nature is now deemed much more valuable than someone with more entrepreneurial ambitions. This, coupled with the other factors discussed below, will naturally reduce the appetite of banks to lend in large volumes and maintain as sizeable an exposure to the UK property market as they had pre-crisis. Indeed, some banks have stated that they will no longer be involved in any new real estate financing at all.
Both asset valuations and covenant structures are back to much more conservative levels than we have seen for many years. Loan to value ratios have dropped to around 60-65% from 80-85%, and senior debt pricing has moved to higher levels (eg, loan margins closer to 200bps, rather than below 100bps). Arguably now is a good time to be making new loans. But we are not seeing a lot of new lending activity at present.
Banks are simply over-exposed to real estate risk, and are having to dedicate a great amount of management time and effort to sort out the problems in their existing loan books. The Asset Protection Scheme put in place by the UK government undoubtedly provided important reassurance and stability to the market at a time of great nervousness. But it only really serves to defer the realisation of the problem and limits the overall P&L hit that participating banks would suffer. The loans and underlying assets still have to be worked out.
Banks with large exposures to UK property built up over the boom years of the cycle themselves acknowledge that they have effectively become property companies in their own right. They need to have a long-term perspective when considering their recovery strategies.
Until the impaired loan portfolios are properly dealt with (or at least substantially reduced in size), banks with large exposures to UK property will find that their credit ratings will be negatively affected. In turn their ability to raise competitively priced funding, which they can then lend on to finance new business or even to refinance maturing loans, will be constrained. This will also act as a brake on the pace of market recovery.
In addition, we can already see a tsunami on the horizon, in the form of an estimated £300bn-plus of maturing commercial mortgage-backed securities (CMBS) issues in Europe within the next four years. This is in addition to maturing bank loans.
Another trend limiting the availability of property finance is that some international banks are concentrating on their core or domestic markets. For example, some of the German Landesbanks (owned by regional governments) have reduced their international business, or ceased it altogether.
Another key driver of the boom was the ability of banks to manage their risk asset and capital positions, by accessing the wider investment markets through securitising the loans they had underwritten via CMBS structures, pfandbrief and covered bond markets. While there is some increasing activity in these areas, the available liquidity is relatively modest compared to the market requirements.
So we can draw the conclusion from these factors that the days of the cheap credit that fuelled the boom have long gone. The risk premia applied by lenders and investors alike in assessing new business opportunities will mean that only strong, conservatively structured transactions with strong counterparties and property fundamentals will be attractive to the market.
Secondary assets on a stand-alone basis will struggle to find any appetite from banks. Unless there are equity sponsors involved, which have deep enough pockets to provide banks with acceptable contingent support, it is difficult to see much bank activity returning in this area until general economic conditions improve and concerns about tenant covenant and counterparty risk abate.
As always, these pressures and problems will create opportunities for those with available capital and a clear vision of where value can be obtained and risk prudently assessed. But do not expect 2010 to be anything other than a long, hard slog for the banks to work their way back towards normality. And until they do, sourcing new funding will be a challenge and the overall climate will be decidedly cool.