In this troubled world, there are far bigger challenges to be tackled than worrying about lending-driven real estate crises.
But, inevitably, life goes on and some way down the long list of things to do to make the world a better place is the need to make boom-time commercial real estate lending less financially and economically disastrous than it has been in the past. This requires a huge collective effort to have any chance of agreeing a way forward and making a difference.
In the UK real estate market, part of that huge collective effort has already been made, resulting in a relatively unprecedented alliance between real estate industry bodies and the financial markets regulator. Not only have they recognised that something needs to change, they also seem determined to implement change.
Just four weeks ago, the Bank of England’s head of financial stability made some remarkable statements in congratulating the real estate industry (in relation to the PIA-led ‘Vision for Real Estate Lending’) on taking the initiative and setting an example of responsibility for the impact we have on the wider economy, a responsibility for others to emulate. He stressed the importance of the industry working in partnership with the Bank to tackle the pro-cyclical boom and bust impact of the existing real estate lending market. Most significantly, not only was the need for a real estate lending database reaffirmed, there was a clear commitment to use a ‘long-term’ valuation measure as a reference point for assessing real estate loans. But what does this mean and why is it so important?
Real estate lending has always been pegged to ‘market’ valuations. This has resulted in excessive lending escalation exacerbating the top of the market cycle and subsequent rapid lending withdrawals exacerbating the bottom of the market cycle. The market collapses, borrowers go bust, banks end up with huge holes in their balance sheets and the UK suffers both directly (in having to prop up the banks) and indirectly (through falling property prices, reduction in credit availability and economic distress). On the other hand, if real estate lending could be pegged to some form of long-term valuation measure, this would dramatically reduce the extremes of both behaviour and outcome.
For example, the German ‘Pfandbrief’ lending regime is underpinned by a long-term valuation mechanism and as a result has not suffered any material lending losses. But the Pfandbrief valuation mechanism only applies to part of German lending activity and is constrained, not acting as a counterbalance at the bottom of the cycle, and as a result Germany still experiences real estate market cyclicality similar to that seen in other countries.
So getting this right is not going to be particularly straightforward for a number of reasons:
- Long-term valuation methodology: At the moment there is no single method that is recognised and used either by property professionals or lenders. Whatever the valuation measure selected, it needs to correctly smooth out the booms and busts, everyone needs to understand and have confidence in it, valuation professionals need to be able to master it quickly, and application and standards need to be monitored by financial stakeholders and the property industry.
- Application: Is the valuation measure going to be optional or will it be mandatory for all regulated lenders? Is it going to be used by the regulator as a guidance tool or to calculate regulatory capital? Will it enable lenders to make higher loan to (market) values at the bottom of the market or only be used to reduce exposures at the top of the market?
- Breadth: Is the regime just going to apply to regulated lenders or to be effective will it need to extend to debt funds, insurance lenders and pension fund lending? And how might offshore lenders be captured? All of this would imply significant co-operation between different industry and international regulatory bodies.
- Deliverability: What barriers will get in the way of implementation and how will they be overcome? How easy will the mechanism be for the valuation industry to adopt, apply and oversee? Will lenders react positively or negatively to what could be seen as further regulatory interference in their credit decisions?
In order to find a way through this maze, the industry has gathered together a group of leading specialist valuers, real estate researchers, lenders, financiers and credit rating agency professionals with experience of the UK and other markets, together with representation from the Bank of England to consider the pros and cons of all the different valuation methodologies and the different ways that they may be applied.
The potential for a solution is now very real. Get it right and the UK real estate lending market and the related property booms and busts will change forever.
Rupert Clarke is chair of the PIA Long Term Sustainable Value working group