The UK’s commercial property market hardly has a record as a beacon of stability. But we shouldn’t be fatalistic.
Yes, the cycle is a force of human nature.
But resilience to it can be nurtured. The time to start is when the market is on the up.
And if we are going to have any success, we, the Bank of England; you, the industry; and us, together, need to step up and act.
We need to avoid the pattern of financing conditions going from conservative to careless and then to closed, all too rapidly.
Through stress testing, we are making sure banks are able to withstand severe stresses. And by withstand, I don’t just mean survive. I mean they can continue to lend.
We have to nurture more than the resilience of the banking system. Property companies must have resilient balance sheets too. Overgearing of the property industry has been a major driver of instability in the past, making it vulnerable to the slightest change in sentiment.
We know that the dominance of major UK lenders in financing property has almost halved since the crisis.
While that diversity should be welcome – it should be a source of strength – it can be a source of weakness if it simply moves gearing into a shadow on our radar screen.
I welcome the efforts to build a database of commercial real estate loans to make a dataset that will be run and managed for the public good, while respecting commercial confidentiality. It can give the property industry, and us, the information we need to manage the risk of loosening underwriting standards.
But still more is needed to nurture a resilient market environment. You can become overgeared even when strict underwriting standards apply.
We have seen in the past how a change in sentiment can drive commercial property prices up even without the prospect of improvement in the cash flows that the property will generate.
That creates headroom for those already in the market to borrow more without breaching their loan-to-value standards. And the use of that headroom drives prices up further.
A pernicious spiral of sentiment and debt begins. Valuations and debt increase sharply relative to the cash flows that support them.
When the music stops, the process goes into reverse. As valuations fall, borrowers are left struggling to service loans that are greater than the value of the property.
Fire sales begin. Sentiment deteriorates. And market valuations collapse.
The proposal of the cross-industry Vision for Real Estate Finance, led by Nick Scarles of Grosvenor, was that everyone – lenders, borrowers and regulators – should define appropriate levels of debt not relative to market prices but relative to cash flows capitalised at long-term, cycle-neutral, rates.
The industry proposal is music to our ears. If you apply it, it will stop debt running away unsustainably in the good times. And it will cushion the bad times. It’s countercyclical, mirroring the way capital requirements for banks will now operate.
In a matter of months, the Bank of England will start reporting market-wide indicators of valuations and gearing based on cash flows capitalised at cycle-neutral rates. It will help you to measure the risks. And risk that is measured can be managed, by you and by us.
These measures are not a panacea. They cannot guarantee occupancy rates or rents for you. But had they been used to guide your decisions and our policy, they would have made a difference in the run-up to the crisis.
If we continue to work together, there is a real prospect of nurturing a market that keeps up with the cycles of human nature. But nature will fight back. The drivers of cycles will evolve. History may rhyme, but it rarely repeats.
Just look in this cycle at the rapid inflows of finance to commercial property from retail investors in open-ended funds. More than 6% of the stock of commercial real estate finance is now held in these funds, and is growing rapidly.
Open-ended property funds now have 80% more assets under management than they did on the eve of the crisis.
So the growing importance of funds offering short-notice redemption and investing not just in property but in other potentially illiquid markets too, is a focus of regulators in the UK and internationally.
The Bank of England, along with the Financial Conduct Authority, is looking at the ways these funds might contribute to broader instability.
By working together, our nurturing of resilience can keep up with nature’s inevitable fight back.
Alex Brazier, executive director, financial stability strategy & risk, Bank of England
