Relationship banking alone is no longer sufficient to get the finance the commercial real estate sector needs. Ric Lewis and Ian Laming explain

There is a misconception in the European real estate investment market. Many seem to believe that the government support and loose monetary conditions extended to the banking sector will result in the financial taps being turned on again, giving access to the capital needed to lubricate those deals which require a liberal dose of finance and a friendly boom-time banker to get them off the ground.

The reality is a little less rosy. Government and central bank intervention was palliative care, not a solution. The financial system still needs fixing. Bank balance sheets are not fully recovered and tougher tier 1 capital requirements will ensure that commercial real estate is a long way down the pecking order for lending when financial order is restored.
Banking relationships have changed at many different levels. For one, many people have shifted on both sides of the real estate/banking fence and unfamiliar voices are on the end of the phone lines. Also, the banks simply don't have the capital to finance and refinance deals currently. Maybe one in 10 assets will get done, and probably even fewer on the terms the market is hoping for.

There have been attempts to maintain the aura of relationship banking, but many borrowers are now experiencing ‘slow death by termicide' with a succession of term sheets for financing and refinancing that will not be acceptable to those who bother to read the small print.

If investors want to understand the dilemma the banks face, they should read two key recent reports by the Bank of England and the Bank of International Settlements in Basel on the future stability of the banking system. They make bleak reading for real estate financing.

Let's use the UK banking sector as a proxy for the pressure many international banks are now experiencing. Since the financial crisis broke, UK banks have raised £127bn (€146bn) to boost their balance sheets. No mean feat, as this takes their tier 1 capital ratios back up to their long-term average position. This ‘turnaround' position is, however, falsely reassuring. It assumes that future losses on refinancing will revert to historic trend. Over the next five years the UK banking sector has to refinance roughly £1trn of debt. If there is any glitch in this refinancing process, losses have the potential, once again, to seriously erode bank capital.

Meanwhile banking regulators are aggressively looking at what constitutes tier 1 capital, and particularly the quality of those assets. For tier 1, the authorities are steering heavily towards the view that ‘if it isn't common equity, it ain't going to be good enough'. If we look at the UK banks in risk weighting terms, around a third of the their balance sheets are in securitised and derivative assets, and the regulators are looking at more stringent risk weights and write-offs to be attached to those assets. It all adds up to a sobering fact: much more tier 1 capital will be required. This could require UK banks to add between £30bn and £40bn of incremental capital to their books.

In the particular realm of commercial real estate, UK banks have an estimated £250bn potential exposure. They have already taken a £10bn charge against this exposure, but S&P estimates the need for between £23bn and £37bn in additional write-downs. And while the leverage of the banks has shrunk from around 40x equity to around 20x, they are still phenomenally extended, relative to where they should operate. This is no secret and the regulator is watching.

With conditions like this, it's very difficult to see the level of credit outstanding to the real estate sector going up any time soon, regardless of the strength of investor/banker relationship.

These numbers also raise serious questions over the popular notion that the banks are going to be the source of a flood of distressed property deals disgorged from their broken balance sheets. With changes to their tier I capital base, and risk-weighting adjustments coming down the pipe at them, why would any half-sane banker volunteer for additional impairment?

What does this mean on the street? Well, it probably means any real estate deals the banks consider are going to have to be clearly profitable. But with the musical chairs at the banks, there are, understandably, fewer people than at any time in the last 10 years who feel confident enough to make the right call on what constitutes a good business plan in the current shaky economic environment - and there is no such thing as a risk-free real estate lending situation.

Given the distressed nature of a large number of assets, there are many business plans which need some creativity. Here, we see only the deepest of relationships and the longest of track records as able to consistently access credit at sensible terms. Another problem is servicing a deal of any size. Size used not to matter much and financing was readily available at below €500m. Now the upper limit is closer to €100m and, even at this level, many banks still want lending consortia to co-underwrite the credit risk with them.

Sadly, this may mean there are many markets that will be unable to attract financing for a considerable period. Even though there may be some very attractive investment strategies, it is possible that the baby may have been thrown out with the bathwater for the time being. Only those with great relationships and track record will have access to the capital they need at rates that make any economic sense.

The important thing about the relationship with a bank is knowing that there is someone who will understand the business proposition and work alongside you as a true partner. The worst case scenario is dealing with a faceless and unhelpful banker hiding behind his committees and institutional process and showing no flexibility in rapidly changing times. That is the embodiment of the myth of relationship banking.

An investor's relationship with its bank has the potential to be one of the most significant competitive advantages in ensuring investment performance in the next few years. But partnerships and relationships are two-sided affairs. Most of our industry is holding its breath and hoping that the banking industry can quietly repair its internal damage so it will once again be able to focus on fostering and growing its external relationships, allowing them to grow in scale, depth, and flexibility. In that way we might eradicate the myth and return to an era of sensible, rewarding relationship banking.

Ric Lewis is CEO and Ian Laming is COO at Tristan Capital Partners.