Ten years ago, I had just extricated myself from almost a decade as a tax lawyer in the City, mostly advising on structured real estate finance deals, and started work as finance policy director at the British Property Federation. The next few years would be dominated – for me as for the UK property industry – by the credit crisis: banks focused on dealing with legacy portfolios of largely unwanted, late-cycle commercial real estate (CRE) loans, rather than on new lending.
Frustrated by a vigorous but uncoordinated regulatory reaction to the GFC, an independent industry group (of which I was a member) produced a report in 2014, A Vision for Real Estate Finance in the UK. Its aim was to show policymakers how to regulate the sector so it could serve the economy without presenting inappropriate risks to financial stability.
Under the aegis of the Property Industry Alliance and with encouragement from the Bank of England, we are slowly making progress in two areas in particular. A new loan-level data repository is in the works to provide better market information (while protecting confidentiality and anonymity). In parallel, long-term value metrics are being developed and tested to make it easier for lenders to understand cycle risk. But it’s worth a fresh look at what’s changed, and what hasn’t, in the UK CRE finance market over the last decade.
Market structure
The structure of the market has been transformed, probably for good. The imposition of the ‘slotting’ approach to risk weighting on the big UK banks reduced their appetite for risk (as well as their competitiveness at the safest end of the market). As they have pulled back, this created space for other lenders. Countless new platforms have emerged, often specialising in particular market niches or strategies, allowing new sources of capital (often institutions more interested in yield than liquidity) to access CRE debt. This new diversity of supply and strategy is good for both borrowers and market resilience, but there are two caveats.
First, by driving a consolidation in what the UK’s big banks will lend against, ‘slotting’ has undoubtedly made access to credit harder for regional, smaller ticket borrowers, and in specialist (but important) areas like build-to-rent. Financial regulation may not be supporting government policy as well as it might.
Secondly, it’s a shame that commercial mortgage-backed securities (CMBS) have struggled to establish themselves as a material part of the market. This matters for two reasons. First, as a public debt product, CMBS offers insights into the market, as well as comparability and liquidity, that simply aren’t available in the private debt fund and syndication markets. Secondly, by learning from the problems revealed by the GFC, CMBS could have emerged a better product for real money investors; instead, those investors are investing in ways that haven’t been road-tested through a major downturn (yet).
New leverage risks?
The latter stages of past CRE cycles have been marked by investors and lenders moving into higher risk activities – development, and new geographical markets, sub-sectors and structures. Other than the increasing importance of operating risk (about which more below), none of those features have been in evidence this time. However, three areas might be worth watching.
First, how much CRE lending exposure is invisible because it is badged as corporate lending? Slotting created an arbitrage whereby the regulatory capital cost of a loan to a real estate investor can be much higher if that loan counts as “specialised lending” (essentially, non-recourse secured lending) than if it is treated as corporate loan (broadly, where loan performance depends on the borrower’s business). Yet, in the case of many CRE borrowers, the difference may not be that meaningful in economic/credit terms.
Linked to that, the emergence of specialist mezzanine lenders (and indeed NPL buyers) has been accompanied by the growth of loan-on-loan finance. There is nothing ominous in this – it is economically similar to the sale of the senior part of a whole loan by a debt fund that only wants to retain the mezzanine. But whereas a sale of the senior would register as CRE exposure in the books of the senior lender, the provider of loan-on-loan finance has security over a loan, not over real estate collateral. The full picture of CRE lending exposure should capture loan-on-loan finance, as well as corporate lending that is in substance CRE-backed.
Finally, the last few years saw an increasing role in the market for international capital. Many acquisitions of prime assets in central London were by cash buyers from Asia, sometimes paying substantially more than was offered by the underbidder. Anecdotally, some such cash buyers were in fact pre-leveraged by lenders in their home jurisdiction. If that’s right, they may behave like leveraged investors, but driven by pressures outside the field of vision of UK regulators and market participants. Unexpected forced sales by such investors into a less liquid market might have a disproportionate impact on sentiment, confidence and values across the wider market.
Changing real estate
Perhaps those thoughts about new risks are scraping the barrel – in broad terms, the market feels relatively stable and lenders relatively disciplined, with nothing like the levels of latent risk of a decade ago. My point is more that we should be alert to new sources or indicators of risk, rather than concentrating only on what went wrong in the past. But arguably the more existential issue for lenders is the way real estate is changing.
Various factors (technology, e-commerce, CVAs, the boom in serviced offices, etc.) are making real estate an ever more operational proposition. Asset management and the ability to maintain and replace income are becoming more important skills for property owners than securing long leases to strong covenants. That has knock-on implications for lenders who should be wary of underwriting by reference to leases in place.
The next decade promises to be even more interesting than the last one.
