Lenders' profits hit by property value declines, BoE warns

The sharp decline in commercial property values in the UK has dragged down the profits of the country's most active real estate lenders, the Bank of England has cautioned in its latest Financial Stability Report. The central bank said the 16% fall in commercial property values since last June had raised risk of losses on the UK's £174bn (EUR 224bn) outstanding commercial real estate loan book to 'material' values. 'Falls in property values erode the equity buffer with which borrowers can withstand financial shocks, implying higher losses on commercial property loans in the event of default,' the report said. 'At the same time, lower collateral values could result in commercial property companies finding it difficult to refinance existing loans, which may increase the probability of default.'

The BoE said the rapid property correction had led to some loan-to-value covenant breaches although it had not yet seen an increase in loan default rates. According to a survey the central bank compiled with De Montfort University, if the commercial property loan default rate were to hit a baseline estimate of 1.5%, the UK's main property lenders could face a total implied write-off of £800mln, or 3% of pretax profits. In the currently unlikely scenario that the default rate climbed to 10%, the implied write-off would be £5.1bn, or 19% of pretax profits.

The report said some UK banks could also suffer additional losses as a result of the shutdown of Commercial Mortgage Backed Securities (CMBS). At end-2007, UK banks held about £16bn of highly rated CMBS, which would now be worth about 90-95% of par based on current secondary market pricing, suggesting an implied mark-to-market loss of up to £1.6bn.

The BoE report said that while the risk from both commercial property loans and CMBS were 'material', it added that the risk to commercial banks from either of these commercial property channels were not seen as critical overall. 'The effect on UK banks would be greater, however, if an increase in default rates on commercial property lending coincided with a general deterioration in the health of the corporate sector, as it did in the early 1990s.'