Bank governor says equity, not debt, is pushing up values

The governor of the Bank of England singled out equity rather than debt as the main factor driving up real estate values in a key speech earlier this week.

Addressing the Committee on Economic and Monetary Affairs (ECON) in Brussels on Monday 7 December in his capacity as the first vice chair of the European Systemic Risk Board (ESRB), Bank of England governor Mark Carney told MEPs that the real estate sector is being watched, but that regulators are not poised to intervene at this stage.

“Commercial real estate values have moved quite notably in a number of jurisdictions,” Carney said, before singling out the UK. “The degree of leverage in the system and the leveraged exposure of UK-based institutions has not moved in tandem with those valuations. In other words, there has been a lot of foreign equity come into the market.”

Carney went on to say that the ESRB is monitoring the market, including publicly-traded retail funds which have seen big inflows, to ensure it is not a “potential amplification channel of financial instability”. He added that no action is being taken in the UK at this stage, but that from an ESRB perspective, monitoring the situation “makes sense”.

In the CRE banking sector, the bank’s scrutiny has been welcomed. John Feeney, global head of CRE at Lloyds Bank, told Real Estate Capital that regulators’ attention is a positive for the market.

“It is absolutely right that regulators across Europe should be monitoring the commercial property market closely,” said Feeney. “Real estate is, and always will be, a cyclical asset class and as values continue to rise there is natural inclination to temper any exuberance with more caution.”

Feeney added that the post-crisis efforts of regulators including the Bank of England, as well as the efforts of the major lenders, have done a lot to redress the structural weaknesses seen in the last cycle: “Crucially, this has seen a shift in risk with the greater burden now on the equity side, which is where it should be, rather than debt.”

Real estate was also held up to scrutiny earlier this month in the December Financial Stability Report published by the Bank of England’s Financial Policy Committee (FPC), which passes on its concerns to the Prudential Regulation Authority (PRA). The FPC listed the UK commercial real estate market among other factors which have the potential to pose a risk to economic stability.

“The FPC continues to monitor closely developments in the UK commercial real estate market. Prices in the UK commercial real estate market have risen significantly and the funding of investments is becoming riskier,” the report said.

While the Bank emphasised the role of foreign equity in driving up property values, it added that the use of leverage especially in London has increased “a little” during the past year or so. Like Carney, the report also highlighted strong inflows into open-ended funds, which now have more assets under management than in 2007 and hold around 5 percent of total UK stock.

Exposures of the major banks remain substantial, the Bank warned, averaging around 50 percent of their CET1 at the end of 2014. While the UK commercial real estate market is generally fair-valued, some areas of the market, such as prime West End of London offices, look overvalued.

In addition, the report warned: “A severe downturn in the commercial real estate market could reduce the ability of some firms to access bank finance, given their use of commercial real estate as collateral.”

Peter Cosmetatos, CEO of the Commercial Real Estate Finance Council (CREFC) Europe, welcomed Carney’s comments on commercial property and noted that the sector was not flagged as a current risk. However, Cosmetatos warned that regulators’ “understandable” focus on commercial property risk is rarely balanced by an appropriate recognition of its positive role in the economy.

“The flow of credit to the commercial real estate industry is what allows it to make an incredibly important contribution to the economy, especially for new and growing businesses that need to rent space,” said Cosmetatos. “But all too often, regulators see only the risks. The asset class is still tainted because of the financial crisis.”

“Mark Carney is absolutely right that we need to build resilience in financial markets through diversification, and to encourage the pairing of long-term investors with long-term assets, including through the capital markets,” he continued. “We’ve been making the same points for years, specifically in relation to commercial real estate – but regulatory silos often mean those positive goals are not pursued for commercial real estate.”

Cosmetatos agreed with Carney’s emphasis on the role of foreign equity capital in pushing up UK commercial property values: “So far, it hasn’t been debt driving values; the banks are being pretty disciplined on LTVs.”

The December Financial Stability Report also gave particular focus to the buy-to-let residential sector as a potential risk. It said that the outstanding stock of buy-to-let lending is growing by an average 5.9 percent per year compared to 0.3% growth in lending to owner occupiers. Some smaller lenders have loosened lending policies, for instance by raising LTV thresholds.

“The FPC will monitor developments in buy-to-let activity closely following the tax changes to the buy-to-let market announced by the Chancellor in the Budget and Autumn Statement,” the report added.