The Bank of England’s concern about ‘stretched’ commercial property values serves as a reminder for real estate lenders to remain vigilant.
One of the starkest findings in the Bank of England’s latest biannual Financial Stability Report was that commercial real estate in the UK could be overvalued.
Alongside some corporate bonds, the Bank highlighted CRE values as a potential cause for concern. The report, which was published this week, said that valuations in some segments of the UK CRE sector appear “stretched”.
The Bank said low risk-free interest rates point to pessimistic growth expectations and high perceived tail risks, and, although some CRE asset values factor in the low long-term interest rates, the Bank’s point is that they do not reflect the uncertain outlook implied.
Current CRE prices lie at the top end of the range of sustainable valuations, consistent with persistently low rental yields, the report showed. If rental yields returned to their historical averages, it would suggest that current prices are above estimated sustainable valuation levels. Property values are therefore vulnerable to repricing, which could come through an increase in interest rates, or adjusted growth expectations.
Overall, the Bank reported a relatively steady economic environment (“standard” in its terminology), but warned there are “pockets of risk” that warrant vigilance – including consumer credit and easier lending conditions for residential mortgages. “Lenders may be placing undue weight on the recent performance of loans in benign conditions,” the report stated.
It also highlighted potential risks that have not crystallised, including the impact of the UK’s exit from the European Union and financial vulnerabilities in China.
Across the whole picture, the Bank is clearly concerned that the UK’s major banks need to further bolster themselves against potential losses on their lending. The headline from the report was that the Bank has increased the countercyclical capital buffer from the zero percent set after the Brexit vote to 0.5 percent, with a warning that the November report will order a rise to 1 percent – effectively adding £11.4 billion (€13 billion) to the major UK banks’ reserves over the next 18 months.
The report is essential reading for those in the business of lending to commercial real estate assets in the UK market, many of which are already adopting a conservative approach to their lending in terms of leverage.
UK banks have made great efforts to reduce their exposure to commercial property. They have more than halved their stock of CRE lending since the global financial crisis, from around £160 billion at the end of 2008, to around £77 billion at the end of last year. Banks are generally restrained when it comes to leverage, with 60 percent to 65 percent seen as the limit by many.
However, some lenders are winning property lending business by doing deals traditional banks do not have the appetite for – moving up the risk curve and at higher loan-to-value ratios. The Bank’s report should, therefore, serve as a reminder across the market of the risks to be considered.
The report did highlight that certain parts of the market, such as offices in London’s West End, look particularly highly valued, and that the picture is far from uniform across the whole market, which allows lenders of varying types to take considered risks.
But as the report makes clear, lenders need to remember that today’s benign lending conditions will not last forever.