Industry leaders propose measures to avoid future lending cliffs

Preliminary findings outline that lending organisations should put into place tools which identify when the market is overheating.

The peaks in the last two real estate cycles were predictable and lenders could have avoided massive losses if long-term asset values had been adequately monitored, a group of senior industry figures has concluded.

The preliminary findings of a two-year initiative set up following 2014’s cross-industry A Vision for Real Estate Finance report outline that lending organisations should put into place tools which identify when the market is overheating, through ongoing analysis of long-term value in the market.

The research was undertaken by the debt group within the Property Industry Alliance – a group of industry bodies including the Investment Property Forum and Commercial Real Estate Finance Council Europe – with the aim of reducing the risks of boom and bust in the commercial real estate lending market.

After considering three different approaches to monitoring long-term value, the group concluded that an analysis of ‘adjusted market value’ is the most effective method. The debt group considered three alternative methodologies; adjusted market value, investment value and mortgage lending value, compared to market value.

The adjusted market value approach is derived from comparing current market value, as reflected in an appropriate capital value index, to a long-term trend line, drawn through an inflation-adjusted capital value index such as the Investment Property Database’s All-Property Capital Value Index. The method weighs up whether values are rising above levels where, historically, crashes have taken place before.

The analysis showed that when the IPD index is more than 20 percent above the long-term trend – as it was most recently in Q2 2004, three years before the crash – the likelihood of a 35 percent or greater fall in the real value of that index within five years is very high.

Such an approach would have allowed lenders and regulators adequate time to moderate exposure to the sector and ensure they were better-positioned to manage the subsequent downturn, the report said.

“This long-term value research is a game changing breakthrough for the proactive management of end of cycle systemic risk,” said Rupert Clarke, the former CEO of Hermes, who chaired the research group.

“The vital next step is to make sure lenders, regulators and all the lending stakeholders grasp the nettle and resolutely hard wire long-term value techniques into their risk management framework,” Clarke added.

Further research and analysis is required, although the initial findings of the paper provide lenders and regulators with the ability to identify and make steps to mitigate their exposure to the next real estate market crash, the report added.

The overleveraged UK commercial property market reached the end of a bull run in Q2 2017, and values dropped by 42 percent over the following two years.

“UK commercial property lenders were looking at huge potential losses, with Lloyds/HBOS and RBS being bailed out by the UK taxpayer in October 2008. The UK economy today still bears the financial fallout and scars,” the report’s authors said.

De Montfort University research shows that although the property market started falling rapidly in mid-2007, property lenders carried on making new loans, with bank loans outstanding eventually reaching a peak of £255 billion in 2008, £24 billion higher than at the end of 2007 and £107 billion higher than at the end of 2004.

“Any metric that can be shown to give reliable advance warning that a major fall in property prices is likely could play an essential role in helping lenders manage cycle risk and avoid some of the errors of the past,” added Peter Cosmetatos, chief executive of the CREFC Europe.

“From a regulatory point of view, we believe that it is particularly important to avoid unnecessarily distorting competition across different types of lenders subject to different regulatory and capital frameworks,” Cosmetatos added.

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