The background to slotting – the replacement of lenders’ internal risk-based property lending models with the FSA’s standardised risk assessment model – is a familiar one and the latest developments are discussed elsewhere in this issue of Real Estate Capital.
But in the past year we have found that analyses of what slotting actually is have stopped short of what its application will mean for a market that extends to borrowers and properties beyond central London and into the regions – to the bulk of the UK commercial property market. The plight of regional property companies has been challenging and is to become ever more so.
In the regions, underlying property fundamentals have struggled to overcome the ‘flight to quality’, which has driven lenders into a shallow market of prime commercial and residential property in London and the south east. This seems unlikely to change in the near future.
Even before slotting, competition within banks for scarce and increasingly expensive resources had grown. To make the case for lending with their credit and capital allocation committees, relation-ship managers have to deliver the right kind of customer profile: longevity; ready access to equity; a reasonable approach to ratios and pricing (meaning an acceptance that the world has changed); and a greater share of customers’ wallets – ie the ability to sell products other than senior debt and swaps.
Slotting will intensify the squeeze on capital and make the underlying relationship between banks and lenders more important. Many property companies will overcome that obstacle, but more will not. The case for supporting many regional property companies other than those perceived to be the best will become ever more challenging.
The need for increased allocation of risk- weighted assets will affect lenders’ appetites and lead them to ask: ‘Does this borrower represent the best use of our capital?’ Or: ‘What price does this increasingly rare commodity, our debt, justify?’
None of this should come as a surprise to those who have watched real estate finance markets outside London over recent years. However, some lenders have noted that slotting also produces a counter-intuitive reaction that could produce some surprising consequences.
The bluntness of the mechanism means that the spread within a slot that drives the allocation of risk-weighted assets, and the qualitative difference between the bottom of a higher slot and the top of the next, lower one, might mean that lenders look at lower slots to generate the required returns.
The argument is that the better the deal, the better the slot – but even ‘better’ deals consume capital and risk-weighted assets. Slotting can produce margins the market cannot justify, making bank debt look relatively expensive compared with the increasing supplies of inexpensive equity, long money supplied on thinner margins by non-bank lenders, or foreign investors exploiting a foreign exchange arbitrage.
It is argued that if a lender cannot make its returns in the desired market and slot, it will drop into a riskier market and less attractive slot. Development finance could be an improving market where there is less competition and more chance of making the required return. One benefit of development finance is that the allocated capital (and risk-weighted asset) is returned and available for use far earlier than the ‘safer’ investment deal, where capital may be tied up for much longer and produces a more attractive margin.
Superficially, this is an attractive argument and certainly there were more development finance negotiations before summer. These factors have definitely led UK property lenders to look again at their strategies.However, market fundamentals, the quality of borrowers and the emphasis on underlying relationships trump any suggestion that lenders will take greater risks because slotting models make their debt more expensive.
Gerry Mulholland is head of real estate finance at Pinsent Masons