UK banks face pressure to overhaul their approach to commercial real estate lending, as new research suggests ‘behavioural’ patterns contributed to heavy losses for stakeholders in the run up to the recession.
Collectively, UK banks failed to generate any returns from real estate during the last lending cycle (1992-2008), as well as the previous two cycles: a period spanning more than 50 years, according to a report by Rupert Clarke, former Hermes chief executive and chair of the Property Industry Alliance debt group.
Commercial property lending produced profits of £7bn during the last cycle but these were dwarfed by £19.3bn of write-offs, mainly from loans made towards the end of the cycle.
The research suggests that loan-to-value ratios were not adjusted to reflect increasing risks as property market values rose significantly towards the end of the cycle.
Historically, banks have considered real estate lending as ‘safe’. As such, many of their divisions have been heavily exposed to property. Bad commercial real estate loans were a large part of the reason HBOS and RBS needed bailouts a decade ago.
Clarke said: “When banks are getting more enthused about the markets and growing profits, real estate is an area where they can deploy capital in large amounts.
“It looks very attractive and it is one area they seem to have a tendency to expand in at the end of the cycle.
“Real estate is Achilles heel for financial systems throughout the world – an increasing number of banking systems have real estate at the heart of their lending risk.”
In the majority of banks, there is no end-of-cycle strategy in place at all and, as a result, they are very exposed to the risk of losses at the end of the next major cycle
The report identified four key behavioural reasons behind lending organisational failures: peer pressures or the fear of reducing market activity ‘too early’; organisational inertia; short-term horizons and failing to look at the big picture; and a lack of clear end-of-cycle commercial real estate lending strategies.
Clarke has called on banks to put more formal strategies in place to avoid taking too much risk on real estate loans.
He said: “Banks need to have a clear view of the real estate cycle. They need to track some clear macro indicators that indicate it’s about the right time to moderate risk – most banks do this in part but generally the discipline is not hardwired enough.
“However, in the majority of banks, there is no end-of-cycle strategy in place at all and, as a result, they are very exposed to the risk of losses at the end of the next major cycle.
“The regulator could insist banks have clear, sustainable commercial real estate lending strategies that anticipate and manage end-of-cycle behaviours. This is also an obvious question for shareholders to ask the banks they invest in.”
“Organisations, and those that run them and invest in them, need to be confident that commercial real estate lending activities are sustainable and that appropriate governance is in place.
See also: Rising demand for flexible lending
“It’s vital lending activities are not only well managed and successful in the short term but robust and sustainable throughout all stages of the lending cycle.
“Investors, banks and regulators need strategies in place to address specific challenges around lending during the latter part of property cycles. Without such measures, future cycles will continue to see shareholder capital eroded and economic stability undermined.”
Peter Cosmetatos, chief executive of lenders’ trade body CREFC Europe, said: “In such a highly cyclical market as commercial real estate, those joining the party late in the cycle are most obviously at risk, skewing the profitability picture for the market as a whole.
“Having said that, any lender would be wise to have a strategy for managing the peak of the cycle, and both regulators and investors should want to understand and support such strategies.”
Saker Nusseibeh, chief executive of Hermes Investment Management, said: “Sustainable investing demands that boards, investors and shareholders have strategies that deliver value over the long term.
“The findings of this groundbreaking report make it clear that all the stakeholders in commercial real estate lending, both in the UK and internationally, need to commit to putting in place strategies and governance that fully recognise the lessons from the past.”
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