The law of unintended consequences
The property industry faces a confluence of regulatory changes, including Basel III, ‘slotting’ and shadow banking legislation. Lynn Strongin Dodds reports
Although the current raft of regulation aims to make the UK and European investment world a safer place, there is no doubt that Basel III, ‘slotting’, loan-to-value (LTV) and loan-to-income (LTI) caps, and shadow banking legislation will produce a number of unintended consequences. For real estate, it will, at the very least, put even greater pressure on a retrenching European banking industry. New entrants might help the situation, but un-financeable secondary and tertiary properties will be particularly hard hit.
There was a glimmer of hope following the recently announced delay of full Basel III implementation to 2019 and the relaxation of the so-called liquidity coverage ratio to include highly rated residential mortgage-backed securities (RMBS) and corporate bonds. However, market participants do not expect to see any major changes to current bank lending patterns or a kick-start of the moribund RMBS market in Europe. The effect will be far greater in the US where these assets run into the trillions of dollars.
As Heleen Rietdijk, senior manager, regulatory risk consulting at KPMG, says: “I don’t think it will have any new additional impact. Banks may have been given additional time but, in the end, the result will be the same and they will have no choice but to put more capital aside, allocated to this specific type of clients and industry.”
David Brown, partner in real estate and investment at Deloitte, adds that “it is not just one piece of regulation but an accumulation of pieces that is [affecting] and will affect a bank’s appetite to lend to commercial real estate”. He continues: “Slotting and Basel III will further constrain their balance sheets and they will have to pick and choose more carefully where they want to invest. There will be winners and losers and, given the volatility of commercial real estate, this could be placed on the back foot versus other sectors such as SMEs [small to medium enterprises].”
Robert Stassen, head of European capital markets research at Jones Lang LaSalle, agrees. “Although the final details are still being decided for many of these regulations, the capital requirements will be higher for secondary assets, which are already suffering,” he says. “If they do lend on non-core assets then they will increase the margins in order to reduce the risk. This is not just because of Basel III but also slotting, which is not completely new. But the question today is: how strict will they be? National regimes, including the Financial Services Authority [FSA], each have their own version.”
A recent report, ‘The Slotting Approach to IPRE Risk Weighted Capital’, published by Investment Property Databank (IPD) warns that slotting could “significantly exacerbate” economic risks by forcing banks to rid themselves of unsustainable property loans. This in turn would “further depress” the property market, creating a “vicious cycle of further losses in loans secured by commercial property”.
Under the FSA rules, commercial real estate loans will be divided into four risk weights ranging from 50% to 250%. Banks must hold a progressively higher amount of capital for each category as the level of risk increases. Previously, they had the options of either assigning a 100% weight to all commercial property loans or using their own internal models. The majority chose the latter because it enabled them to hold less capital. But now they will have no choice but to abide by the new laws unless they can prove that their own models are accurate and conservative.
The other regulations expected to have a negative impact on UK real estate, especially residential, are the LTV/LTI caps. The subject has been under discussion since the crisis, but the caps became a reality when the UK Treasury included them in a consultation launched late last year regarding the tools it would hand to the new regulator, the Financial Policy Committee (FPC). Former cabinet secretary Lord O’Donnell also stirred debate when he called for the UK to follow Canada’s example and put in place stringent limits on borrowing, with a guide of 80% LTV.
“The problem with caps is how they are used,” says David Skinner, investment strategy and research director at Aviva Investors. “They have to take into account the cyclicality of property. If they are applied for example, on a dynamic basis during the life of a loan, then borrowers may need to put in new capital at exactly the time property values are falling. They may not be able to do this, which is why caps need to be applied sensibly and take these factors into consideration.”
With banks taking a backseat, attention has been focused on non-bank players but they, too, will not escape unscathed. The final rules for Solvency II are still being hammered out for insurers, while the clampdown on shadow banking might make it more difficult for real estate debt funds to finance distressed opportunities. Last year, the Financial Stability Board (FSB), the global body which co-ordinates national financial regulation, published recommendations for a tighter oversight of the $67trn shadow banking sector, although many debt funds baulked at being grouped under the heading.
“Shadow banking is a good example of regulation that is not directly targeted at real estate but may well be applied to the sector,” says Rob Martin, director of research at Legal & General Property. “In the round, it is about credit intermediation that falls outside of banking, which arguably includes real estate debt funds. The FSB is currently consulting with market participants on the detail of the rules. The hope is that they will evolve in such a way that they do not hamper the operation of real estate debt funds. These have the capacity to act as a significant conduit for passing institutional debt capital to borrowers and assisting the deleveraging of the banking sector.”
Graham Barnes, senior director, corporate finance at CBRE, also believes that the real estate debt sector will develop other solutions. “I do not think we will see just one model, but it will evolve over time. Capital is Darwinian and models will adapt with the changing circumstances. Regulation will not kill the sector. For example, look at the US after its savings and loans crisis in the early 1990s. That gave birth to the CMBS market and I am sure we will see different intermediators between supply and demand in the future.”