Regulation: dealing with debt
Dealing with debt
15 February 2013
Robert Peto assesses the impact of refinancing, regulation and quantitative easing on prospects for commercial property
All those active in commercial real estate (CRE) are aware of the debt statistics. DTZ Research reports Money into Property and Net Debt Funding Gap indicate that:
- In 2008, total debt provided to UK real estate (excluding domestic residential mortgages) by UK and foreign banks, building societies, commercial mortgage-backed securities and covered bonds peaked at £345bn. By the end of 2011 this had reduced by only 6% to £325bn, still 3.65 times the £8bn outstanding in 2000, when capital values as measured by IPD were on average the same as today. Taking into account the increase in the invested stock between 2000 and 2011 there would need to be a further deleveraging of £125bn to return to the same 38% average loan-to-value (LTV) of overall debt to overall invested stock as applied in 2000.
- As at the end of 2011, £173bn of outstanding debt was due for refinancing by the end of 2015. This is at a time when an authoritative survey by De Montfort University indicated that 40% of debt had a LTV of greater than 70% and 20% had LTVs above 100%.
- Over the period 2012-15 and assuming refinancing at 70% LTV against current and forecast capital values, about £46bn of this £173bn will need to be written off by the banks or funded by way of fresh equity/junior debt to make up the 30% shortfall. This gross debt funding gap assumes that the existing lenders will be happy to refinance their entire expiring loans at 70% LTV on today’s values. In practice, many will wish or be forced to shrink their books and therefore additional sources of fresh debt and equity will need to be raised over and above the £46bn.
Whatever can be pinpointed as the fundamental cause of the global financial crisis, the regulators and supervisors certainly did not see it coming, or if they did they failed to abide by the famous maxim of one of the greatest Federal Reserve chairmen, William McChesney Martin Jr during his tenure from 1951 to 1970 that "the duty of a central banker is to take away the punchbowl just as the party is getting started".
Sadly, the manifest supervisory failures of the past are now being compounded by increasing capital reserves, tightening up of regulatory rules and requiring the use of increasingly complex risk assessment methods in the misplaced belief that it is sensible to control complexity with complexity. Basel II did not prevent the financial crisis and Basel III will not prevent the next one; it will only increase the risk that banking supervisors will not be able to see the wood for the trees yet again in the future. It is worthwhile reading the various papers on the subject by Andrew Haldane, Executive Director for Financial Stability at the Bank of England – in particular "The Dog and the Frisbee" written in August 2012.
The perverseness of the behaviour of regulators and supervisors in increasing pressure on banks by raising capital reserve requirements when both the financial sector and the wider economy are in trouble is difficult to rationalise except on the 'something must be done' line of thought, even though it may be wrong. The requirement for increased capital reserves should have been made in 2004-07, not after the horse had bolted.
One aspect of this situation is the increase in the CRE debt funding gap caused by the requirement for extra capital in the banks. The International Monetary Fund in its October 2012 Global Financial Stability Report estimates that European and UK banks will have to increase their deleveraging by just over 7% to maintain required capital ratios. If applied pro rata to real estate lending, then this increases the gross debt funding gap by more than 40% or £13bn (included in the figure of £46bn above).
The perverseness of the behaviour of regulators and supervisors in increasing pressure on banks by raising capital reserve requirements when both the financial sector and the wider economy are in trouble is difficult to rationalise
Other factors are increasing pressure on the real estate debt world. The introduction of slotting is making lending even more expensive, while the deglobalisation of banking with repatriation of capital to assist with their need to concentrate on their home markets is reducing debt availability. There is also the potential for disruption of the derivatives market (especially the swaps market) with the forthcoming implementation of European Market Infrastructure Regulation (EMIR).
EMIR could have far-reaching implications for real estate. The current proposals will require all over-the-counter derivatives to be cleared by a central counterparty with the counterparties being required to post collateral equivalent to the initial and variation margins. This will make swaps more expensive and difficult to manage and discourage the use of gearing. It may also lead to the use of more fixed-rate instruments. The result might be that there is less capital available for deployment into the real estate sector (as funds reduce their appetite for gearing) and that the debt component of this capital will be more expensive.
The occupational side
If the debt side to CRE in the UK is in difficulties, pressure is being exerted on the occupational side. Poor economic outlook and general uncertainty have lead to weak demand resulting in shortening lease lengths (compounded by lease accounting requirements) and weakening rents (outside London). Rising vacancy costs have been compounded by the levying of empty rates. In addition, the looming requirement for all commercial buildings below an ‘E’ Energy Performance Certificate rating to be upgraded before re-letting from 2018 onwards is becoming a serious issue affecting decision-making and pricing.
It could be said that the situation looks bleak, and the confluence of all these factors is clearly being felt outside of London. Values, as measured through IPD, are falling in the regions and this is especially marked for secondary regional office stock and shopping centres. Bearing in mind that the IPD universe reflects more institutional-style property, there is no doubt that the impact on values for poor specification and short-term income properties with vacancies, not likely to be within an IPD portfolio, has been and will continue to be dramatic. This is not just because of falling net income but because such property is virtually unfinanceable. Only cash purchasers, or purchasers with access to corporate level debt, can 'play' in this space and they are demanding double-digit net yields.
Overarching all this is the effect of the loose monetary policy being pursued by the Bank of England through quantitative easing (QE). The Bank now owns £375bn of government debt – one third of the total – through purchases of bonds from the banks and other financial institutions. The debate about the effectiveness of this policy will run and run but one undeniable result is the fall in bond yields. This, combined with the reduction in the bank base rate to historically low levels, has propped up both residential and commercial values.
What has not been achieved is the use of this liquidity by the banks to increase lending to oil the wheels of economic recovery. In this respect it could be argued that QE has failed. There is, in my view, no further need for QE but for the use of more direct transmission mechanisms. The Funding for Lending programme may lead to cheaper financing for borrowers and an increase in lending and although it is too early to be certain I instinctively feel that it has a better chance of helping to kick-start growth.
Infrastructure and housing
What some at RICS have been arguing for is a direct injection of cash into infrastructure, and housing in particular. There is no reason why, rather than QE, the Bank of England cannot print money and buy newly issued housing and/or infrastructure bonds (to the extent that the market will not purchase these). The money raised can be put to work directly in financing more social housing thus stimulating the stressed construction industry and at the same time removing people from waiting lists.
Light at the end of the tunnel?
Despite all this there are some positive aspects:
- The search for yield in a low-interest-rate environment has seen an increasing allocation of capital to the real estate sector in view of its attractive yield. The issue now is the shortage of institutional grade property. This has propped up values for such property.
- There is virtually no new development and in many metropolitan areas there is evidence of a tightness returning for good quality accommodation.
- The value of poor secondary/tertiary property is continuing to fall and the point may shortly be reached where cash investors begin to commit because the returns more than justify the risks.
- There is a growing realisation that intense asset management can produce results in terms of tenant retention and attraction.
- Non-bank lending capacity is rising very quickly provided by insurance companies and a growing band of debt funds. In addition, public Real Estate Investment Trusts are raising significant sums through bond issues at very advantageous coupons. DTZ Research has estimated that in 2012-13 there could be £18bn of funds available for lending, which might reduce the debt funding gap by 75% compared with the estimates made only as recently as May 2012.
The lack of clarity as to the direction of travel politically and economically is without doubt creating uncertainty and therefore indecision. The general feeling that we are not being served well by our politicians and financial regulators reinforces this malaise. But where there are problems there are also opportunities for those willing to seize them.
Robert Peto FRICS is Chairman at DTZ Investment Management and a Past President of RICS
Related competences include: T069