Getting the last stage of the cycle right

Measures to monitor long-term asset value could help prevent boom and bust in real estate finance.

The commercial real estate market is inherently cyclical, but lenders seem slow to react each time the market reaches its peak.

This was demonstrated in grand fashion in the 2008 global financial crisis when banks made huge losses on the unfettered lending which they had made against inflated property values.

However, a steering committee established to examine boom and bust in real estate lending has found that the peaks in the last two cycles were predictable well before they were reached, meaning that lenders could have avoided catastrophic losses, not to mention the impact on the financial system and the wider economy.

The working group from the UK’s Property Industry Alliance Debt Group was set up on the back of recommendations in 2014’s cross-industry A Vision for Real Estate Finance paper, which looked at how to minimise the damage to the financial system from the next property market downturn.

The group has published the first of its findings, on how to best monitor long-term value in the market. After considering three methods, the group recommended ‘adjusted market value’ – essentially measuring current market values against a long-term trend line which reflects inflation-adjusted capital value. Signals of an overvalued market, with a high risk of tumbling property prices, can be garnered from the analysis.

Running the method in retrospect, the group found that it would have predicted the last three property crashes. Based on these findings, it seems like a no-brainer that lending organisations should adopt an AMV analysis into their lending strategies.

Opinions differ as to how long this apparently extended market cycle will last, but most agree that we are now either near the peak, or at it. Although few predict a crash, it is imperative that lenders mitigate for one.

Certainly, lender behaviour at the top of this cycle is very different to last time. Regulation has had a significant effect on how banks finance property, with many traditional lenders capping loan-to-values at a relatively conservative 60 percent to 65 percent and side-stepping riskier sectors of the market.

However, financial markets have time and time again shown memories only last so long. The last crisis was a seismic one, but as time passes and senior market participants retire, there is an increasing danger lending standards will slip.

Competitive pressure also means that the top of the market does not feel like a natural time for lending organisations to apply the brakes. When rival banks and alternative lenders are vying for market share and stakeholders in organisations are pressuring lending teams to maintain activity, it can be difficult to be cautious. This was certainly the case in the years before 2008, when many noted values were sky-high, but no-one wanted to be the first to stop lending.

But with more emphasis on lending discipline this time round, the market is likely to be receptive to the findings of the steering group. At this stage, only preliminary findings have been published, so how exactly the proposed method of evaluating long-term value will be implemented is not yet known.

For starters, it would be wise for real estate finance teams within banks and the alternative lending market to adopt the recommended measures.

A point made by the steering group is that, by creating a lending cliff every 15 to 20 years, lenders can write off all the profits made throughout the cycle. Measures to ensure that debt providers get the end-stage of the cycle right must surely be a good thing.