by Tim Asson
From 1987 to November 1990 bank lending to property companies increased from £10bn to over £38.9bn. During the past 12 months property prices have fallen for the first time in 15 years and the Gulf war has served only to heighten fears of a full-scale recession and property crash similar to 1974. Furthermore, many foreign banks are experiencing economic difficulties at home. There have been significant slides on the stock markets in Japan and Sweden, and the USA is experiencing problems. It is in this context that many banks are now seriously examining their exposure to the UK property market and considering their options.
The two traditional sources of finance in the property market are the institutions and the banks. Over the past five years there has been a significant shift towards bank debt, largely as a result of declining institutional investment during a period of increased development activity. Furthermore, the latter half of the 1980s witnessed a significant increase in the number of foreign banks represented in the market, their involvement often being a direct consequence of foreign investment activity. This is particularly the case of the Scandinavian and Japanese banks who, along with the Americans, dominate the representation from overseas.
The shift from debt to equity financing, combined with increased demand from a booming property market, resulted in increasingly competitive and sophisticated operations. Banks keen to lend money have developed a number of tools and techniques enabling them to do so, despite borrowers being already highly geared and high interest rates prevailing. Movements in interest rates can be insured against by the use of caps and collars, while the highly geared property company has been able to borrow off balance sheet, often on a non- or limited-recourse basis. As a result, total bank lending stood at £38.9bn in November 1990, representing an annualised rate of approximately 20%. This is substantially below the annual growth figures of 50% in 1988 and 60% in 1989, although there is still commitment in the pipeline and some estimates indicate that property borrowing could grow by a further £16bn to a total of £55bn.
The rate of growth of bank lending has been such that as far back as 1987 the Bank of England warned that a careful watch was needed on property lending. In August 1989 Lloyds Bank published a report expressing concern at the increase in total bank lending, particularly bearing in mind the increased amount of off-balance sheet and non-recourse debt. This was followed in November by a statement from the Governor of the Bank of England, Robin Leigh-Pemberton, in an attempt to curb the banking community’s exposure in respect of short-term lending on highly geared property developments.
The most recent evidence is that bank lending has slowed significantly during the past 12 months, although it is debateable whether this is as a direct result of the Bank of England’s warnings. It is more likely attributable to the general cooling-off in the economy and the downturn in the commercial property market. However, with outstanding loans approaching £40bn, banks are now major players in the UK property market. Furthermore, many banks who engaged in short-term property lending are now faced with longer-term commitments as borrowers either default or refinance.
In the light of the present position, two key questions arise. First, bearing in mind the current level of bank debt and falling property values, what action should banks take on their existing loan book, much of which was underwritten at the height of the market? Second, should banks continue to increase their exposure to property?
Existing bank lending
With regard to existing bank lending, falling capital values combined with the practice of rolling up interest shortfall have serious implications on loan-to-value ratios. While senior debt is often restricted to between 60% and 75% of value, the use of mezzanine finance and commercial mortgage insurance have enabled borrowers to finance up to 95% of value. With valuations in excess of purchase price (not an unusual phenomenon in a rapidly rising market) it is possible to borrow in excess of 100% of purchase price leaving the borrower with no exposure to risk.
Many loans now reaching maturity were taken out at the height of the market. Some investors, not wishing to realise a loss, are seeking to refinance and are being faced accordingly with the cold reality of updated valuation advice. With the levelling-off of rental growth, yields have moved out, and where there are vacancies letting voids must be extended. In some areas — particularly the secondary and fringe locations — capital values have fallen significantly, leaving senior debt exposed in some instances.
To date, many banks have pursued a policy whereby they have waited for problems to arise rather than calling for updated valuation advice on what may become problem loans. After all, what is the point in seeking a valuation at the bottom of the market and rocking the boat, particularly in instances where interest repayments are being met and an upturn in the market is possibly imminent? However, for a number of reasons, any significant improvement in the property market must be considered medium term at the very least.
While entry into the ERM has permitted a reduction in interest rates, a trend which is likely to continue up until the next General Election, in the longer term the fight against inflation can be successful only if UK businesses become more competitive. High wage settlements will erode competitiveness, thus creating redundancies and a contraction of the business community. This will have serious implications on the amount of take-up in a market where, in many areas, supply has been substantially increased by the development boom of the late 1980s. Accordingly, my practice consider it likely that rental growth in many areas will be restricted in the medium term, which will lead to continuing high yields (and low property values) despite possible falling interest rates.
Should banks therefore be pro-active in identifying problems within their own loan books and take appropriate action to minimise their exposure to risk? Such action is not limited merely to revaluations. For instance, the credit worthiness of borrowers could be reappraised, and where developments are nearing completion detailed and informative researches as to take-up could reveal potential cash-flow problems. If decisive action is taken at an early stage problems can often be contained before they develop into crises. Rather than developers holding out for unrealistic prices in order to maximise profit and eventually going into receivership as rolled-up interest outstrips capital value, a negotiated sale or refinancing package at a realistic figure could assist both the developer and the bank.
Alternatively, bearing in mind the extent to which bank debt underwrites the market at present, should banks hang on and wait for an upturn? A proliferation of discounted or forced sales could drag down market values, reducing the value of existing loan books further and merely serving to exacerbate the situation. By taking such a stance banks could well threaten the stability of the whole market.
A further point to consider is that now that many banks have retreated almost totally from the market and are concentrating on managing their existing loan book, are they sufficiently well informed of current open market conditions to make a decision on the above? In many areas the market is moving rapidly, and up-to-date information is essential in order to make informed decisions on whether one should hold, improve or sell.
There is an obvious need for co-operation between the banks, investors, surveyors and developers if an orderly market is to be maintained. Ignoring the problem or pulling the plug is equally futile, and a middle ground must be found in order to preserve a stable market which, at the end of the day, will benefit all parties. At Nelson Bakewell it is our experience that this cannot be done in every case. However, in many instances well-informed, constructive dialogue has resulted in a solution acceptable to both the bank and the borrower.
New bank lending
Banks who have been prudent (or lucky) in their lending to date may face few problems within their existing book and are able to continue lending. However, many banks have slowed down or are only considering refinancing existing loans; some banks have withdrawn totally from the market. In some instances this is because the loan book size has reached its upper limit and, combined with the downturn in the market, new business is considered imprudent. However, in many cases banks have substantial problems on their existing loans and have chosen to solve those problems before making new commitments. In the case of many foreign banks, current activities are being dictated by domestic credit committees whose perception of the current state of the UK property market is far from favourable. This is particularly the case with the American banks, who also have severe domestic problems with property, and the Japanese banks, who are facing a crisis in property and share values at home and are believed to have made a discrete deal with the Japanese Finance Ministry to reduce lending to UK property companies. As the latter category currently accounts for 10.4% of lending in this area, this will have a substantial effect on the amount of finance available over the next 12 months.
Nevertheless, many banks are continuing to lend, and in a climate of low property values, high yields and reduced competition they are well placed to structure some very lucrative transactions. Furthermore, with average loan-to-value value ratios now approaching 60% on investment property, the bank’s exposure to risk can be minimal. Development situations, with the possible exception of prelets, are proving almost impossible to fund, with increasing importance being placed on cash flow, length of lease and covenant strength.
Future decisions on bank lending must ultimately be affected by the total amount of debt outstanding on UK property, and perceived takeout of that debt. Banks originally entered the market short-term. However, with the rising mountain of debt the future liquidity of the market is questionable and many may find themselves (some already do) with much more long-term commitments as borrowers refinance. While the return of the institutions is regarded by many as a potential solution, the fact remains that the UK institutions have been reducing their property portfolios since the early 1980s. The net level of investment in 1988 was £1.6 bn and in 1989 was £2 bn. For the first six months of 1990 it was £646 m, £490 m of which was committed during the first three months. The present debt burden therefore represents more than 20 years of investment! This contrasts sharply with the ratio of one to two years at the beginning of the 1980s. Nevertheless, as interest rates fall property becomes increasingly attractive to the institutions, who are able to take a longer-term view with large cash reserves. This attractiveness will be heightened by the fact that yield sensitivity to interest rates is regarded as “bi-modal”, yields being more sensitive to an upward than a downward movement in interest rates.
Another important factor influencing take-out will be continued interest from foreign investors. During the past two years Japan, Sweden, USA, The Netherlands, Austria, the Middle East and the Far East have all been represented in the UK market and have tended to concentrate on the larger trophy buildings. While in the short term the activities of many of these groups will be limited by their domestic situations, this trend is indicative of the new global investor who has a wider perception of property investment and is often fully informed on several markets. Despite immediate concerns of oversupply of offices in the City, it must be emphasised that London is one of the world’s financial centres, strategically located in the time zone between Tokyo and Wall Street. Furthermore, with the advent of 1992, the single European market and the possibility of a single European currency this area of the market will be considered in comparison with competing European centres where prime yields are already narrowing.
Whatever the situation, in considering new lending it is imperative that banks are fully advised of the wider aspects of the market. In my practice we are aware that over the past two years instructions from banks have become increasingly detailed and their requirements for reports correspondingly comprehensive. In reporting to a bank a surveyor should now cover rental trends, relevant yield evidence, take-up levels, potential supply in the development pipeline, regional factors affecting the property, and local economic factors such as demographics, unemployment and local employers. Valuation reports which address these issues will enable the lender to form a reasoned and well-balanced judgment of the property risks involved in a particular transaction.
Conclusions
It is now widely recognised that there are many problems with existing loans, and a constructive dialogue between all parties concerned is accordingly essential if an orderly market is to be maintained. In current market conditions many developers will make the transition to becoming investors, and it will be up to banks to find solutions to refinance these situations. Existing loan books should be subject to health checks and appropriate action taken at the earliest possible date where potential problems are identified. However, a co-ordinated approach again is necessary as a run of forced sales will serve only to undermine the wider market.
With regard to new lending, decreased bank activity means less competition for those banks remaining in the market. Furthermore, more cautious loan-to-value ratios and lower property values combine to present the banks with an opportunity of minimising their exposure to risk. As the market recovers (as it surely will) banks will continue to underwrite the market with debt, although it will be interesting to see whether property genuinely prices itself back into the market for institutional and foreign funds.
By taking sensible and well-advised action, banks could be instrumental in helping the property market to recover, which in turn will alleviate some of the problems which they are now facing within their own portfolios. While a flood of forced sales must be avoided, by calling for sales of problem properties at realistic prices, they could help many borrowers who are over-stretched and restore some activity to what has become a very quiet market. Likewise, carefully constructed refinancing packages will not only help the survival of many borrowers but in many instances could also avoid bank losses and costly receiverships.
