Vision of a safer debt market calls for new focus on values

It’s a safe bet that responses so far to the seven recommendations in last October’s A vision for real estate finance in the UK report will have been mixed.

The draft report was issued by the ad-hoc Real Estate Finance Group (REFG), which was sponsored by the IPF and chaired by Grosvenor’s finance director Nick Scarles.  It had the laudable but ambitious aim of considering a market structure and regulatory regime that would protect financial markets against property cycles while, at the same time, ensuring adequate debt support for UK real estate across cycles.

The Financial Times’ banking editor Patrick Jenkins was one who found its plea for lighter-touch regulation in relation to commercial real estate loan slotting “self- servingly predictable”. However, he was arrested by recommendation number four, which suggests that regulators should judge the capital requirement of property loans by their long-term sustainable value, rather than market value.

The REFG’s argument goes that there has been an “over-reliance” on loan-to-current-appraised – or market – value, which contributes to the property market over-heating. Lenders will increase the loan-to-value levels at which they are prepared to lend as values rise and reduce them when values fall, the report says.

“As well as allowing riskier lending, it allows existing borrowers to extract equity from existing commercial real estate investments through regearing, making the stock of past lending riskier.” It also makes debt hard to come by in the aftermath of a crash, as happened in the years immediately after 2008.

Breaking the ‘feedback loop’

By contrast, the REFG says that comparing the amount of loans to the long-term sustainable value, or average value of the property through the market cycle, would remove this “feedback loop” between valuations and lending.

This part of the report also caught the attention of the Bank of England, whose support for some of the proposals would be essential if they were to become market practice.

At a dinner to mark the 20th anniversary of the Bank of England Commercial Property Forum last December, Andy Haldane, then the Bank’s director of financial stability, said: “The recommendation that caught my eye related to valuation, which lies at the heart of the pro-cyclical spirals we have seen in the commercial property market.

“Peaky valuations can give the appearance of a safety margin for lenders, causing them to loosen their grip on credit conditions, thus driving valuations still higher… valuations lead lending by around a year, with a correlation coefficient of around 0.75… one way of slowing that pro-cyclical spiral would be to base lending decisions not on spot valuations, but on medium-term or sustainable ones.”

So far, Haldane’s enthusiasm has not been shared by the UK valuation community, which has not been rushing to support the recommendation. The RICS has also been silent so far, although it is putting together a working party to consider the issue of definition and methodology.

The antipathy may be partly because of a misconception that the draft report suggests replacing open-market valuations for lending altogether – which would cut right across valuers’ most hallowed principles. But the report does not recommend this and the REFG, mindful that it may have made a mistake in not stressing this strongly enough, is likely to make its message clearer in the final report, which is in preparation.

With the term ‘valuation’ meaning an open-market valuation to UK valuers, the REFG is likely to change the suggested ‘long- term sustainable valuation’ label.

Robert Peto, DTZ’s former head of valuation and past president of the RICS, raised this issue in last month’s Viewpoint article for Real Estate Capital, where he wrote: “In essence, long-term sustainable value is a calculation of worth and I would strongly recommend that the term is changed to  ‘long-term sustainable worth’ (LTSW).

“My reasoning is that in the English language ‘value’ is synonymous with achievable ‘price’. There may be moments in time when LTSW is the same as price, but given the cyclical nature of economies and property markets, this will be only for short periods”

Value assessments are highly subjective

Peto pointed out that other issues would need to be addressed if the LTSW concept were to be adopted – not least agreeing the basis of the calculation, which sounds as if it is likely to be an even more subjective assessment than market value.

One potential model is the one used in Germany, where practitioners generally take about 85% of market value to arrive at mortgage lending value.

However, there is a view that on the Continent, there is a reluctance to adopt a proper market value assessment, and Peto is also concerned that the widespread adoption of the concept of LTSV will lead to increased smoothing of reported market values “which will reduce transparency and market efficiency”.

The Bank of England is also said to be interested in the Vision report’s recommendation one, which suggests setting up a database of all UK property loans.

The REFG would like this to “be public, in a form that reflects maximum granularity and manipulability of information, so as to enable market participants, academics and potential new entrants to analyse the market… but subject to restrictions as are necessary to maintain public anonymity for individual lenders and borrowers”.

As with the valuation issue, this is also a challenging idea to sell, in this case to UK lenders: one senior lender in a UK bank told Real Estate Capital: “From where I sit, I don’t want it, and I think it’s a case of ‘be careful what you wish for’. Real estate is just one part of the information going to the Bank… what will they do with it? Are they going to tell us that we’re doing the wrong deals?”

For this to have any chance of happening, there is agreement that the regulator would have to mandate the information’s collection. “It should be sitting with the Bank of England or FCA,” says Hans Vrensen, DTZ’s global head of research. “Now is the time to do it, with all the regulatory changes that are going on. The BoE should do it; isn’t that its job, to help the market come to terms with the risks? But based on informal feedback so far, I’m not convinced it will.”

The scale of the undertaking would be completely new: the Bank of England collects information on new lending and outstanding debt, but it is aggregated at sector level, while the bi-annual UK property lending report produced by De Montfort University, while very valuable, looks back six months, is incomplete and not capable of being analysed. Many details would need to be clarified, for example it is not clear whether overseas banks lending in the UK would be allowed to submit the data as things stand.

UK banks may be disadvantaged

“What about insurance companies and debt funds?” asks one investor. “It could create an uneven playing field where ‘greedy’ borrowers go to other forms of debt than banks. Or it could disadvantage UK banks if overseas banks aren’t in it too.”

Specialist practitioners in any area will always identify the problems, as the REFG is no doubt very aware. People can see the difficulties, even if they see the value.

Peto for one is not convinced that all the recommendations are necessary. The most important point, he believes, is “a beefed up” recommendation two: that a group of experts advises the regulator on market trends and inflection points to forewarn of market stress – and, crucially, that the regulator be prepared to act on the information.

The REFG’s next step is to publish a fuller report, probably in May. Being written by Peter Cosmetatos, chief executive of the Commercial Real Estate Finance Council Europe and a member of the REFG, it is likely to be closer to 50 pages than the 11-page draft, though still at ‘Vision’ level.

At this point responsibility for the recommendations looks likely to switch to industry bodies such as the IPF, British Property Federation, RICS and CREFC Europe – if their lender, investor and valuer members are convinced that its recommendations are essential, not necessarily to prevent another property-debt-led crash, but to mitigate its severity. They have the resources, expertise and accountability.

Meanwhile, since Bank of England governor Mark Carney’s March reshuffle  of his team, Andy Haldane has been given an expanded role as chief economist and Spencer Dale is now head of financial stability. The UK property lending community will be looking for more signs of support for their Vision from Dale and his colleagues.

Vision’s recommendations: seven key steps towards market stability

Information about the market

1. Mandate a public database of all UK commercial real estate loans, whether originated or held by UK regulated banks or other market participants.

2. Set up a committee of experts, some with property lending and others with macro-economic expertise, to interpret property’s position within the cycle and  the wider economic environment.
Aim:To ensure that lenders and regulators have the information they need to understand the risks being taken.


3. Introduce an accredited ‘commercial real estate lender qualification’ for all property lenders.

Reducing pro – cyclicality

4. Link regulatory commercial real estate lending capital requirements to a property’s long-term sustainable loan-to-value ratio, rather than appraised (market value) LTV. Aim: To ensure the build-up of adequate regulatory capital as the market rises, so that lenders have enough regulatory capital after a property market crash, plus to dampen credit growth during a boom.

5.Introduce lower capital requirements for low-risk commercial real estate lending greater differentiation of capital requirements (slotting in the UK) between loans.
Aim: to remove UK regulated lenders’ disincentive to make low-risk loans and to increase safe lending supportive of the property market after a crash.

6. Have regard to levels of diversity of lenders and seek to reduce barriers to entry when taking regulatory decisions.
Aim: To promote lender diversity to cushion the market from a change in strategy by any individual or group of lenders.

7. such as sector and cyclical capital buffers, incrementally as the market rises above  its full cycle average, irrespective of views about whether a crash is anticipated or considered unlikely.                                                                                                                                                                                                                      Aim: To ensure the economy can manage a property market crash whenever objective criteria indicate one is possible; minimise the belief that “it’s different this time”.