The sharp fall in five-year swaps has depressed forecast returns for UK senior debt
CBRE’s latest quarterly UK Debt Prospects report says the “nose-dive” of almost 60 basis points in the five-year swap rate at the beginning of the year had “completely eclipsed” a slight rise in lending margins, resulting in a fall in gross returns to 3.3 percent per annum for loans made in Q1 2016 compared to Q4 2015’s 3.7 percent.
The report says senior lending margins rose by an estimated 13 bps in Q1 2016 (10 bps for prime, 15 bps for secondary), to an average 2.1 percent. In Q4 2015 margins were flat following a 5 bps uptick in Q3.
Dominic Smith, head of real estate debt analytics at CBRE, said the sharp correction in swaps was due to weak economic data and the dove-ish comments made by Bank of England governor Mark Carney about likely timing of future rises in the bank rate.
“At the start of the year people were thinking that the base rate was probably going to rise this year. And then we had data, and the Bank of England commenting that this wasn’t going to happen in 2016, so the five-year swap rate came right down.”
On a risk-adjusted basis, which takes probability of default and loss into account, returns also declined, from 3.6 percent per annum in Q4 2015 to 3.2 percent in Q1 2016.
Forecast gross mezzanine returns declined to 8.2 percent (8.7 percent, Q4 2015) and 7.4 percent risk-adjusted (8.2 percent), also mainly due to the fall in swap rates.
The key measure for UK banks, however, the return on risk-weighted assets (RoRWA) under slotting, improved. This is because it is a function of margin and fees alone, not interest rate. On a RoRWA basis, gross and risk-adjusted returns inched up by 10 bps, to 3.1 and 3.2 percent respectively, assuming strong slotting treatment.
The report notes that senior debt is still performing well on a relative return basis, with the premium over gilts at 2.4 percent.
Senior debt performs best in a downturn
CBRE’s central forecast for property values for the next five years from Q1 2016 is a rise of 11.5 percent (2.2 percent per annum), and in that scenario, senior 65 percent LTV loans have a probability of default of just 0.5 percent.
Default rates would pick up if these forecasts turn out to be overly bullish or if market sentiment starts to decline again. The latest Bank of England stress test scenario is for a very bearish 42 percent crash in values, bottoming out in mid 2017 and translating to an aggregate fall of 30 percent over the Q4 2015/2020 five years. “So it remains to be seen whether current assumptions around default and loss will prove too optimistic”, CBRE’s report says.
“If you compare the different forms of property investment in a downturn of 30 percent”, Smith said, “with ungeared equity, income return compensates for the capital value fall and you end up with a return around about 0. If you’re highly geared you’ll get wiped out. But senior lending at 50-60 percent LTV will make a risk-adjusted return of 1 or 2 percent. So if you believe in the risk of a downturn and you want real estate return of some form you should be in debt, not equity.”