Next generation will push up lending as old guard retreats

Savills’ William Newsom predicts new market entrants will drive increase in liquidity for property

Savills’ UK head of valuation William Newsom’s view of the UK debt finance market is like a revolving door: the favourable lending environment – low interest rates, high property yields, beefy interest rate margins, retreating banks – is “pulling in” new lenders, while increasing regulation (Basel III, slotting) and the mountain of outstanding real estate debt is “pushing out” traditional bank lenders.

Making his annual and 24th ‘Financing property’ presentations this month, Newsom predicted that the rise of a new generation of senior lenders, made up of insurance companies and debt funds, would be enough to support a gradual increase in lending liquidity for UK property, from the £27.5bn in 2011 reported in the latest De Montfort University survey, to £50bn by 2016 (see fig 1, below).

At the same time, the value of extended loans will continue to gradually reduce. Newsom called the transition from old to new lenders “the biggest structural change in property lending over the past 20 years” and said insurance companies and funds would account for a third of new senior lending in future. This would be a four-fold increase from the £4bn-5bn he estimates insurance companies already in the market wrote in new business over the past 12 months.

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Insurance companies already dominate his latest table of organisations that are  able to lend £100m or more per deal (see fig 2, above).

Of 16 lenders on the Savills list, six are insurance companies: AIG, Aviva, AXA, Legal & General, MetLife and M&G. While Aviva has been a consistently successful UK lender for more than 20 years, the others are all new to senior lending since 2008.

Insurers replace German banks

“The list is now dominated by insurance companies, where it used to be by German banks. So in the right circumstances there is plenty of liquidity,” Newsom said.

Newsom described the structural change as “a transition from those with legacy issues to those without… a transition from those subject to heavy regulation to those without, or with less of it.”

The issue of legacy loan books had been extensively discussed over the past few years, he said, but the most significant new challenge for banks is another tightening of regulation.

For UK and German banks it is the introduction of standardised risk weighting models specifically for all property loans what the UK regulator calls slotting – on top of Basel III tier-one capital requirements and risk weighting models.

For the UK lending market this develop-ment was “huge”, Newsom said, because UK and German banks between them dominated the UK lending market. According to the De Montfort report, two-thirds of the £212bn of outstanding debt as of December 2011 was on UK lenders’ books, while last year, UK and German lenders made 76% of the £27.5bn of new senior loans.

Newsom sees Basel III and slotting as a mixed blessing. It will be onerous for UK banks, some of which, he estimated, may be required to hold 2.8 times as much capital. “UK banks need tens of billions of additional capital just to stand still,” he said.

Newsom suggested that implementation of the regulation will have to be phased in, rather than coming in this month as the ‘big bang’ that the Financial Services Authority had originally wanted. At the very least, there would have to be “different speeds for different banks, depending on financial stability”, he added.

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But he also believed regulation will speed up the necessary deleveraging of bank balance sheets. “We see this as a good thing, because it will accelerate the sale of loanbooks and other work-outs. That will accelerate the resolution of legacy issues, which will in turn accelerate sales or active management of individual properties, which is much needed in the market.”

Loan sales to double this year

Newsom predicted that property loan portfolio disposals in the UK and Ireland will double from £4bn last year to £8bn in 2012, and will rise again, to £10bn, in 2013 (see fig 3). “This is in line with expectations, because various stages of market evolution were necessary before loan sales emerged in earnest,” according to Newsom.

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The good news for borrowers was that they could still find senior debt at an all-time low cost of around 4.5% for prime or good secondary properties. The bad news was that anything else was still impossible to finance, while margins on anything except the most prime assets were set to go on rising (see fig 4).

Although senior debt is relatively cheap, borrowers can get less of it with loan-to-value ratios of up to only 50-60%. Borrow-ing at higher LTV levels is expensive and the distinction between senior debt and stretched senior/mezzanine/preferred equity and equity has become blurred, so “raising debt finance is less attractive for property owners”, he said (see fig 5, below).

“For many traditional lenders, their biggest competitors for debt in the middle of the capital stack are those with equity to invest,” Newsom concluded.

Financing Property’s lending market predictions

  • There will be no shortage of new lenders the question is, who will be the performers and at what cost?
  • New lending will rise every year and by 2016 will total £50bn a year, with at least one third coming from new-generation lenders.
  • UK banks are effectively out of the market and any new lending they do will be as part of a wider banking relationship – a continuation of the existing trend.
  • Interest margins will continue to increase except for prime property, where there is great competition to lend and margins will go down.
  • Loan portfolio sales will double this year and remain high for the next six to seven years.

Why have average loan margins increased?

The answer to the above question, says Savills’ William Newson, is partly because there is less competition, other than for very prime assets.

Recent examples of much higher margins on property lending include the senior loan M&G Investments provided for Round Hill Capital’s acquisition of student housing company Nido – a whopping £266m bilateral loan, which was agreed and documented within two weeks. For that, the borrower was rumoured to have had to pay a margin well above 400 basis points.

The handful of lenders that will provide finance for loan portfolio acquisitions – including Royal Bank of Canada, Deutsche Bank, Citi and Bank of America Merrill Lynch, as well as M&G – are charging margins of 500-600bps at low loan-to-value ratios.

Banks’ cost of capital varies greatly and using credit default swap margins as a proxy, Newsom pointed out that the range for the five UK-based clearing banks was from 143.1bps (the lowest) for HSBC, to 407.5bps (the highest) for Santander. Barclays was second cheapest, at 235bps, with Lloyds and RBS at 338bps, as of the end of May.

Banks are also carrying increased overheads for due diligence, credit approval processes and regulatory processes, while  for euro-denominated continental banks lending in the UK, the cost of currency hedging has gone up (see fig 6, below).

“International banks sometimes have
to convert euro deposits into sterling – it depends where the loan is booked,” says Norton Rose partner Duncan Hubbard. “If, for example, a German bank can borrow in the market in sterling here, there is no need, but if the loan is originated in Germany, the bank will have to convert. The issue is if you have to unwind the position.”

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