UK commercial real estate values are currently 10% above long-term average (once inflation is stripped out), giving a 50% risk of prices falling by 30% within the next five years, according to a new metric launched to sound an early warning for overvaluation.
The risk rises to 100% if values hit 20% above average, according to the risk metric set up by the Property Industry Alliance Debt Working Group to warn lenders when commercial real estate values are above the long-term trend.
The move is designed to allow regulators to rein in lending when the market gets too frothy - while helping banks better understand the risks they take at various points in the property cycle. By adopting the Adjusted Market Value (AMV) metric, lenders can act to cut exposures and avoid a crash in values, such as the one witnessed in 2008.
In particular, the property industry hopes that the Bank of England can pull regulatory levers to cut lending as a proportion of market value when those values rise avoiding a repeat of 2007.
'Our ambition is that all lenders - banks, funds and debt funds – hard-wire this methodology into their risk metrics, become more cautious when it starts to hit amber and take decisive action when it moves into red,' said Rupert Clarke, chair of the PIA debt group and managing partner at Lipton Rogers. 'At the moment the vast majority of lenders have no clear action plans to prevent themselves from being sucked in the CRE lending “black hole”, lending too much against overvalued properties at the end of the CRE cycle.'
Peter Cosmetatos, chief executive of CREFC Europe, which represents property lenders, said: 'This is about giving regulators and banks a relatively scientific warning system to prevent lenders overextending themselves in a boom, suffering losses that prevent them from lending after a crash when the economy most needs credit. Adjusted Market Value isn't a panacea - it needs to be used alongside other metrics, not least lending data - but its regular publication is a step change in promoting better property lending risk management.'
Rupert Clarke added: 'The reasons we need this metric are that lenders and regulators consistently fail to recognise the risks at the end of the cycle, allowing their loan activity to spiral as property becomes increasingly overvalued, resulting in huge losses and the risk of financial meltdown.'
Vicious circle as price increases spur lending
Lending activity usually rapidly increases towards the end of a property cycle. CRE values sore, and as lending grows too, this amplifies risk. Because lenders are incentivized to lend money, the majority of losses are linked to end of cycle loans.
De Montfort University’s research showed that after lending a record breaking £82 bn in 2006, 89% of CRE lenders planned to increase their new lending activity in 2007. All last cycle CMBS write-offs related to issues between 2005-7, according to Fitch.
Led by the Property Industry Alliance (PIA), a collection of trade bodies representing investors, developers, surveyors and lenders, the risk analytics consultancy, Radley & Associates, has developed AMV to show the percentage by which prices are above or below their long-term historical trend level based on all types of property and establish the probabilities of such overvaluations leading to major falls in values.
