Ongoing regulatory changes are likely to create further opportunities for unregulated capital
Spring is here, and with it, a more upbeat assessment of the prospects for real estate than the Sturm und Drang that prevailed at the start of 2016.
But in the post-financial crisis world, it is a regulator’s job to be gloomy. Investors and lenders who believe in the risk of a downturn are unlikely to be as bearish as the scenario just published by the Bank of England which underlies its latest round of stress tests for the UK’s seven most significant banks.
Under the stress scenario for commercial real estate (CRE) lending, values in Europe’s largest property market are assumed to fall 42 percent in aggregate and by an even more extreme 49 percent for prime assets. According to CBRE, which published a very good note on asset risk and stress testing on 4 April, this would translate into half of outstanding loans secured on prime properties, at LTVs down to as low as 60 percent, tipping into default.
The Bank’s main concern around CRE, as described in the last Financial Stability Report published in December 2015, is the effect on UK values of a possible sudden reduction in liquidity from overseas investors.
Meanwhile, as reported in this column last week, other regulators are also keeping a beady eye on bank CRE loan books and their ability to withstand shocks. Non-UK banks not yet subject to standardised risk assessment models for their lending (slotting in the UK) feared this might be about to change. And it is. The Basel Committee on Banking Supervision proposes to require banks to adopt a standard risk assessment model for their specialised lending (the category which includes real estate), rather than banks using their own IRB (internal ratings-based) models.
Assuming this goes through, it will have a further knock-on effect on the evolving relationship between heavily-regulated bank lenders and unregulated capital investing in debt, such as debt funds. The number of new CRE debt fund managers launching into the market may have slowed down to almost nothing, but that is not because opportunities to lend are drying up (notwithstanding lower levels of investment transactions so far this year).
Quite the contrary. For the managers which have established decent track records since they appeared on the scene after the financial crisis, there are opportunities to lend on deals which the banks can no longer finance, as well as to participate in financings alongside banks, sometimes in the portion of the capital stack where banks can’t go. On the latter point, banks which would once have kept all their loans on balance sheet are increasingly managing their book much more intensively and debt funds are an important part of that. Look no further than the German banks’ 2015 results published over the last few weeks, with their talk of targets to re-shape and syndicate sizeable portions of their books going forward.
One European debt fund manager commented that in the latest Basel regulation, they see a new opportunity coming down the track. Three years into real estate lending, this firm manages a debt fund and managed accounts, and seeks returns in the 10-13 percent ballpark.
So far they have lent mainly in the UK but expect to lend more in other European markets in future, as European banks become more, not less, restricted in their ability to lend. “We believe that what has happened to UK banks will come in France and in Germany. Those banks have not yet been affected to date in the way UK banks have and we see this a medium-term opportunity”. They are unlikely to be the only debt fund which sees more regulation leading to more business.