Eleanor Jukes, Property Analyst
Sign up for our weekly Newsletter and receive the latest ETF and ETC news.
Click here to register for your free copy
For professional investors and advisers only. This document is not suitable for retail clients.
However, lending practices have recently come under renewed focus from regulators as they seek to maintain stability in the financial system. The introduction of the Basel reforms sought to reduce the probability and severity of future fiscal crises, including prudential requirements to strengthen the quality and quantity of capital and risk coverage by credit institutions.
Alongside Basel III, the Financial Services Authority (FSA) has placed greater scrutiny on the internal models used by banks when calculating their risk-weighted capital in lending to ‘specialised’ income producing assets, such as commercial property. Losses on commercial real estate (credit risks) are very volatile, and thus difficult to model, which engendered increased concern that banks were not setting aside enough regulatory capital to cover these risks or owning up to substantial losses.
Since 2007, the FSA has sought to impose a definitive method of calculating risk on loans to these assets, a process known as ‘slotting’. In January 2013 it was confirmed that all UK banks must conform to the slotting methodology, unless they can demonstrate that the risk levels of their holdings are accurate and conservative. Under this new directive, all current and future performing property loans are to be assigned to one of four categories (‘strong’, ‘good’, ‘satisfactory’ and ‘weak’), with risks weights attached to each ranging from 50% to 250%. These weights then determine how much capital is to be held against potential losses on each loan. Prior to this, banks could choose between assigning a 100% weight to all commercial property loans or using their own risk models, which invariably assigned lower risk weights and thus smaller capital requirements.
The FSA has shied away from public announcements on deadlines or results of their investigations in order to give banks time to go through their loan books. Having been given a reasonable amount of time to understand the guidelines, we believe that many banks are already in the process of realigning their internal models as this must be completed by the summer. Their main issue remains the prospect of ‘zombie’ property loans, where interest payments can be met but where there is little chance of full repayment of capital.
The effect of higher regulation and greater reserve requirements will be increased costs for both the banks and borrowers. Indeed, the FSA initially estimated that slotting could lead to £1bn-£3bn of additional equity capital requirements. For those banks that continue to offer debt finance, lending spreads are likely to widen as the return on equity for commercial property loans is currently so low. Anecdotally, banks are questioning the practicality and cost of lending to assets in the heavier risk-weighted buckets, whilst it is thought that the new models will place greater emphasis on interest rate covers rather than loan-to-value ratios. A greater focus on the rental income stream being generated by the property compared to its fundamentals could result in an even greater divergence between demand for stable, long-let property compared to value-add opportunities. In addition, bank deleveraging of property assets, which has been relatively steady to date, could increase, potentially leading to a further depression in values at the distressed end of the market.
This latest evolution in financial regulation will inevitably lead banks to review their lending exposure to commercial property. Given the difficulty of finding the additional equity required and the lower returns on capital, it is perhaps unavoidable that slotting will further restrict banks’ ability and appetite to lend. Yet, whilst slotting may make lending to commercial property more expensive, the funding environment for these assets will change but not disappear. Slotting regulation only applies to UK banks; alternative sources of finance, such as debt funds, insurance companies and German lenders, are expected to move in to fill the funding gap. However, there are questions over the cost of capital from these sources along with the relatively unregulated nature of opportunistic funds, and that to date, lending from insurance companies has been reasonably modest.
Looking towards the future, the scale of the reduction in lending volumes and increased financial regulation suggests this is a structural, rather than cyclical, change. If slotting is a precursor to macro-prudential regulation, which is being rolled out in the UK under the auspices of the Financial Policy Committee at the Bank of England, this intervention will not be a one off. In the short term, the worst case scenario is that slotting could result in some destabilisation of the investment market as more distressed properties are put for sale, capital values fall further and lending is restricted to prime properties only. In the medium term, however, this directive could act to limit the aggressive lending that drove the building and lending booms that have characterised previous cycles, and thus encourage stability.
For professional investors and advisors only. This document is not suitable for retail clients.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Property Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions.
Any forecasts in this document should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors.
Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested.
Issued by Schroder Property Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1188240 England.
Authorised and regulated by the Financial Services Authority.
Source: ETFWorld – Schroders
Subscribe to Our Newsletter
