Credit Risks on UK Commercial Property Lending

APRO705 Lending and Risk Strategies

Emefa Anthony-Sikpah

7th December 2011

CONTENTS

I. The story so far

II. The risks to be considered

III. Risk strategy: Forbearance

IV. Conclusion

THE STORY SO FAR...

CRE exposure remains high

The pre-crisis increase in debt in the

corporate sector was primarily used to

raise leverage for CRE companies

CRE lending reached £250bn between

2008 and 2009 to decline by 3% in 2010

to circa £243bn

Real estate lending in the UK accounts

for circa 50% of total exposure of UK

banks to non-financial firms

Sharp falls in property prices have led to

a rise in write-offs on lending but they

remain below levels witnessed during

the recession in the 1990s (graph)

Considerable credit risks remain

Lending to UK Real Estate Activity

Source: Bank of England

Write-offs are expected to rise in the future

Indices of CRE prices fell by more than 40% to 1997 levels between 2007 and 2009

Indices remained at 35% below their peak at December 2010

The quality of banks’ exposure has deteriorated considerably

Total arrears increased from 1.4% (mid-2007) to 7.6% (Sept 2010)

An estimated £34bn of loans are in breach of financial covenant and £20bn in payment default (June 2010)

IPD UK Quarterly Property Index (Sept 2011)

Source: Investment Property Databank

THE RISKS TO BE CONSIDERED

Risks to be considered (1)

Arrears Yields

Commercial property prime and secondary yields

Source: CB Richard Ellis

The value of lender’s collateral has fallen, causing many borrowers to breach their loan-to-value (LTV) covenants

Commercial property arrears

Source: FSA

Total arrears increased from 1.4% (mid-2007) to 7.6% (Sept 2010)

Risks to be considered (2)

Variations in capital values Breach of covenant causes

Commercial property prime and secondary yields

Source: De Montfort University

Almost 50% of breaches are due to “falling below an LTV covenant”.

Capital value changes from trough to January 2011

Source: CB Richard Ellis

Secondary property values fell more than those of primary properties during the market crash and have hardly recovered or fallen further.

WHAT IS BEING DONE?

Survival strategy: Forbearance

What?

Alternative to foreclosure or insolvency where the terms of a loan are renegotiated or relaxed in response to an actual or prospective breach– Loan restructuring– Payment holidays– Switch to interest-only loan

Why?

Reduces expected losses by providing greater flexibility to borrowers in breach

Reduces probability of defaults

Avoids selling collateral at depressed price and incurring a loss

Delays making write-downs until banks’ capital position is stronger

Risks from forbearance

Loan extension exits Change in economic conditions

UK GDP growth profile

Source: ONS, Cambridge Econometrics

Rising prices are not guaranteed. A slower-than-expected recovery could make a strategy of forbearance unviable and losses on loans would result in a reduction in bank’s capital

CRE debt maturity profile at end-2007 and end-2009

Source: De Montfort University

Forbearance is contributing to a concentration of refinancing requirements in the next few years but sources of funding at that time are still uncertain

Conclusion

UK banks’ CRE exposure still poses a considerable amount of risk

Some bank’s have resorted to forbearance to protect their capital position

Forbearance can enhance financial stability but it is a temporary solution

Banks should ensure they fully understand the composition of their loan books and in particular the strength of the cash flows and the borrower’s ability to meet their obligations

The pricing of risk is distorted and lenders need to ensure that their provisioning practices reflect realistic estimates of future cash flows

Bank’s should have a workable exit strategy in place and ensure that it is consistent with realistic market assumptions

QUESTIONS?

SOURCES

Savills research

CBRE research

Investment Property Databank (IPD)

Office of National Statistics (ONS)

Cambridge Econometrics research

Bank of England data

FSA data

De Montfort University research

THANK YOUAnd I hope you enjoyed the goodies.....

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