Earlier this month the Investment Property Forum published its report and recommendations on how to reduce the risk of damage to the financial system from the next commercial real estate crash.
Entitled "A Vision for Real Estate Finance in the UK" and the product of a collaboration between a committee of cross-industry experts (including representatives from the commercial real estate lending industry), the Report sets out a blueprint for regulation in the commercial real estate sector designed to achieve a number of objectives. If implemented (or, indeed, implementable) these objectives would together give advance warning of the approach of a crash by identifying the point of the cycle reached by the market (expansion, slowdown, recession or recovery) and allow steps to be taken to lessen the impact of the impending downturn.
The report accepts that the cyclical nature of the commercial real estate market means that a downturn is inevitable and does not seek to suggest ways of preventing a crash from occurring. Instead it proposes a plan to lessen the impact on the financial system of a commercial real estate market downturn. The recommendations fall into three categories and can be summarised as follows:
1. Information, analysis and expertise
The report recommends the establishment of a loan database to which all lenders in the UK commercial real estate market would be required to submit specified data about each commercial real estate loan that they originate. The database would be used to analyse “point in time” exposure of the debt markets to the real estate sector and to analyse associated risk.
There are many immediate issues which would need to be overcome to implement this recommendation:
- Ensuring compliance – a database is only as good as the data that it captures, so a way would need to be found to compel lenders to submit the relevant data each time a loan is made . A suggestion has been made that a receipt confirming the submission of the data to the database would need to accompany any application to register security, which gives rise to some interesting legal issues;
- Data protection and confidentiality. The proposal is that the database would be widely accessible (possibly even publicly);
- Cost – the cost of submitting historic data on live loans, submitting data on new loans and updating the database to reflect changes to loan terms during their lifetime and early prepayments is likely to be high. This would probably be passed on to the borrower as a lending cost.
The report also recommends the establishment of an appropriately accredited commercial real estate lending qualification (and associated CPD for key members of commercial real estate lending teams and credit functions) to promote a better understanding of commercial real estate lending best practice.
At an individual level the report recommends deferral of remuneration and the possibility of “claw backs more aligned with economic outcomes” (ie the holding back and paying back of bonuses as a deterrent against high risk lending) something that is unlikely win too much support within the banking community.
At institutional level, the Report recommends homogenisation of regulatory capital rules across the commercial real estate lending industry (including insurers, pension funds and shadow banking organisations) and a move away from "slotting" towards a regulatory capital regime which is more closely linked to a long-term measure of collateral value (which seems to be the central theme of the Report).
This is where the Report resonates with noises emanating from the recent LMA Real Estate Finance conference where it was acknowledged that there is a need for long term value measures for risk management purposes to supplement (rather than to replace) market value measures.
The Report suggests that reliance on market value-based LTVs to assess risk is dangerous in a rising market because it exaggerates the cyclical nature of lending, ie as market values rise, LTVs fall creating a false impression of headroom capacity in the lending market, and fuelling increased lending, feeding the cycle and increasing exposure to it.
The proposal, for the purposes of assessing regulatory capital requirements, is to link LTV ratios to the long term value of the underlying asset rather than to its market value at the relevant point in time.
Long term values would act as a relatively static “cycle-insensitive” reference point and would be used to measure long-term risk and therefore to influence decisions on matters like regulatory capital requirements.
The challenge would be to find a way of determining long-term value. This might possibly be by reference to European valuation standards such as the German Verkehrswert valuation standard which is defined, in broad terms, as the average price which could be expected to be obtained for the asset in normal market conditions.
Interestingly the Report does not make any recommendation here for the introduction of mandatory amortisation, which might be another effective tool for managing LTVs across the cycle.
3. A market structured for stability
The Report places great emphasis on diluting risk via diversification of debt types, suppliers, lengths of term, etc so that the withdrawal of banks from the market following a crash does not lead to an immediate credit drought.
We are already seeing a large number of diverse types of lenders entering the market – the big clearers are being complemented by smaller SME lenders, family offices, PE Debt funds, specialist bridging and mezzanine providers and the like providing choice and diversity across the debt stack.
Both the IPF and the LMA acknowledge the need for an effective secondary debt market (though with a degree of caution arising from lessons learned from the 2008 crash) such as CMBS or the Pfandbrief model.
Other recommendations include the encouragement of longer term debt - though with average commercial lease lengths now below six years this may be difficult to achieve other than in situations where there is robust long term underlying income – and transferability of debt to purchasers of the secured property (though KYC and other internal risk management hurdles would need to be overcome).
For anyone with an interest in commercial real estate "A Vision for Real Estate Finance in the UK" is an interesting read and contains some thought-provoking recommendations. The extent to which its recommendations will be supported by the commercial real estate lending industry remains to be seen, however. In an industry that is just getting back to on its feet after six years of market turmoil, the suggestion of further regulation and compliance may be a little hard to stomach.This information is intended as a general discussion surrounding the topics covered and is for guidance purposes only. It does not constitute legal advice and should not be regarded as a substitute for taking legal advice. DWF is not responsible for any activity undertaken based on this information.