Commercial property in the UK is 10% overvalued and there is a 50% chance of a crash that will see values slump by a third in the next five years, according to a measurement released today.
The Property Industry Alliance’s Adjusted Market Value measures how much property is overvalued, and thus the likelihood of a crash in the near future.
It says that when prices are overvalued by 20%, there is a 100% chance of prices falling by 30% in the next five years.
AMV has been designed to stop – or at least warn – lenders continuing to lend at the peak of the cycle, and thus curb some of their losses. It is intended to reduce risks to the UK financial system, and the risk of a catastrophic crash.
Rupert Clarke, chair of the PIA debt group and managing partner at Lipton Rogers said: “The objective is to get lenders to moderate their activity at the end of the cycle. That is the time they usually make the largest number of loans at the highest LTV, at the peak of the valuation market, and therefore lose huge amounts of money and send the financial systems into turmoil.”
Methodology
The methodology behind the measure is technically simple. Using a long-term value model that looks back at real estate values over the past 200 years, it identifies when asset prices rise above the long-term trend, relative to inflation.
In the past, every time values have risen 20% above average, prices have crashed by at least 30% – and it has predicted all former major crashes.
The new early warning system was developed off of a series of research papers undertaken by the PIA, a representative body for all the major trade bodies in the property sector.
Radley & Associates developed the valuation tool, which was chosen ahead of discounted cash flow or mortgage LTV models. IPD/MSCI data is used to establish property values.
What the latest numbers mean is that based on the 10% level of overvaluation, there is a 50% chance of a decline in values of 30%.
Should property pricing continue to accelerate ahead of long-term trends – which at the moment it is likely to do – the likelihood of a crash will increase.
Regulatory
The intention is that the figure, which will be published each quarter, will give advance notice to lenders to curb lending and thus reduce the risk to the financial system.
However, what it done with the notice is another question. Clarke says for the moment they steered clear of recommendations for lenders until the methodology was finished.
“The most obvious use is as a macro indicator of where there where we are in the market, and
when we get to that point, for both regulators and lenders to look at what they are doing and make sure they have anticipated how their lending will respond if there is a major fall,” he says.
However, the Bank of England, which sets regulatory policy, has been involved with the project since conception, and is extremely supportive.
Inevitably, there could be new regulation to reduce LTV’s or increases in capital requirement’s behind loans.
Peter Cosmetatos, chief executive of CREFC Europe, said: “This is about giving regulators and banks a relatively scientific warning system to prevent lenders overextending themselves in a boom, suffering losses that prevent them from lending after a crash when the economy most needs credit.
“Adjusted Market Value isn’t a panacea – it needs to be used alongside other metrics, not least lending data – but its regular publication is a step change in promoting better property lending risk management.”
Inevitably, lenders will also need to have their own internal processes in place to regulate lending, as merely knowing there is a crash coming may not deter who have to lend as part of their job.
Limitations
The model also has limits, and in particular does not work on a sectoral basis – essentially because it can only predict crashes of a certain scale.
Clarke says: “Every time sectors have crashed, its only when all property has crashed and there is a general excess of liquidity right across the whole market, which has boosted values across the whole market.
“Then when the music stops that liquidity had been rapidly withdrawn which exacerbates the major crash of the whole market.”
This means that for those worrying when London values are going to come off, it may not yet help.
Further iterations may aim to look into this, and whether to include other factors, such as the use of transaction linked indices, which takes into account the values assets are trading at, rather than what they are valued at.
Looking ahead
Clarke says the plan now is to consult on the results, work with the BOE and property industry, and look to publish more research and possible recommendations next year.
According to the model, there is still time to construct new regulations and advice: “The vast majority of loans at the end of the last cycle were made after the time it was clear that the market was in danger of crashing,” says Clarke.
With the market still just 10% overvalued, it could mean some years until a high likelihood of a large scale crash.
■ See also Why we need to predict the next real estate crash
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