Opinions on bank(panic)s
The first Black Friday, christened by The Times in 1866, was over the demise one of the largest money lenders in the City of London, Overend Gurney. As recorded in polymathic Walter Bagehot’s book ‘Lombard Street’, the Bank of England, at the time still a private bank but nonetheless lender of last resort, offered emergency loans at cheap rates to other banks but refused assistance to Overend Gurney, thinking the company couldn't be saved, partly, according to Bank of England analysis, “because it entered the lending business with poor lending practices and insufficient risk management.” Auditors at the European Central Bank said last week that the ECB’s officials were too hesitant to use their full powers as the run on the banks ensued earlier this year, and applied regulatory intervention unevenly. “Those with a higher share of non-performing loans were given more time than the others” the report stated. Presently, it is the less solvent banks that received government intervention. We believe that whilst warning signals are still flashing in the CRE sector and bank balance sheets; it is asset selective, lender specific and not globally systemic.
The first-quarter Senior Loan Officer Opinion Survey on Bank Lending Practices published by the Federal Reserve last week revealed that there was a general tightening of standards for all types of CRE loans. This tightening was more pronounced among mid-sized banks compared to larger or other banks. In addition to tighter standards, major and foreign banks both reported weaker demand for loans secured by non-farm non-residential properties, construction and land development loans, and loans secured by multifamily properties. The survey also examined changes in credit policies for major CRE loan categories over the past year. Banks reported significant tightening across all metrics. For construction and land development loans, banks widened loan rate spreads, lowered loan-to-value ratios, and increased debt service coverage ratios. There were significant decreases in maximum loan sizes and market areas served, as well as moderate reductions in the length of interest-only payment periods and maximum loan maturity. Similar adjustments were observed for non-farm non-residential loans and multifamily loans. Foreign banks also reported parallel tightening measures in these loan categories.
Nervousness is rising in Europe too with the European Central Bank’s quarterly Bank Lending Survey (BLS), published on May 2nd indicating that lending standards to companies across the eurozone tightened more than expected in the first quarter of 2023. The net percentage of banks reporting a tightening of their lending criteria stood at 27%, the highest since the eurozone debt crisis in 2011. While there is less alarm regarding CRE in Europe, the ECB remains concerned about the presence of lingering bad CRE loans as an overhang from the GFC. These loans account for a significant portion, up to 30%, of non-performing loans (NPLs) in European banks, although to be taken in perspective, the ECB maintains that it had ultimately achieved its objective, as toxic debts had fallen steadily from more than €1tn eight years ago to below €350bn last year, equal to less than 2% of total loans.
The ECB is also apprehensive about the potential strain that higher interest rates and an anticipated economic downturn may impose on the CRE sector. Consequently, supervisors are intensifying their monitoring of banks' CRE loans and the valuation of underlying collateral. The ECB has been conducting on-site inspections (OSIs) since 2018, targeting 40 banking groups, with additional phases planned for 2022 and 2023. Furthermore, the ECB initiated targeted reviews in 2021 to address emerging CRE-related risks in portfolios related to offices and retail spaces. The assessment of these risks will inform future supervisory activities. The ECB has acknowledged challenges in assessing CRE risks, including market complexity and data gaps.
LaSalle recommends embracing a proactive strategy towards real estate debt amidst the prevailing pressures experienced by all financial institutions, particularly those most susceptible to strain. The crucial question is the extent to which these challenges will extend beyond the most vulnerable entities to create wider panic. This outcome hinges on the intricate interplay between market sentiment, apprehension, and the determination of policymakers to safeguard the banking system. So far, they think that measures implemented to address liquidity concerns have successfully stabilized the situation, with banks like Deutsche being subjected to testing but avoiding forced insolvency. The potential pullback in bank lending activity could increase the significance of private credit, including in the real estate sector. Non-bank lenders funded by sticky capital may play a more prominent role in originating mortgage loans. In terms of equity investments, LaSalle advise careful management of debt maturity schedules in the short term and to diversify sources of debt capital in the medium term.
In the direct market, an increase in the cost of capital is expected to lead to a decrease in prices. At a recent SPR event, Peter from Green Street examined credit spreads to get a more comprehensive understanding of the cost of debt. Currently, real estate prices are approximately 25% lower compared to 2022, and indicators suggest that the cost of capital is satisfactory at present. However, Papadakos expressed a belief that private markets could potentially experience a further decline of 10%, resulting in a total decrease of 30% in the private real estate market.
AEW has maintained its estimate of the debt funding gap for the period of 2023-2025 at around €51 billion, which accounts for approximately 22% of the total originations from 2018 to 2020. Their estimate of the gap stands at 60% of the corresponding gap observed after the GFC with 46% of this combined gap related to Germany, 25% to the UK and 29% to France. Timewise, they estimate a funding gap of €17bn, €21bn, and €14bn in 2023, 2024 and 2025, respectively.
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They are not alarmed about the position in the EU, with average CET1 ratios at 15.3% in Q4 2022 well above the average guidance for 2022 of around 10.5%, although the ratio of underperforming (so-called stage 2) loans deteriorated in 2022 to 9.5% in Q4. This increase was not accompanied by a step-up in provisioning coverage ratios, signalling potentially higher loan losses ahead. Losses for the 2018-2020 loan vintages are estimated to be around 3.2% of the original loan amount, which aligns with historical European CMBS losses. These losses primarily occur in retail loans, assuming a refinance threshold of 75% LTV and enforcement-related costs equivalent to 25% of the collateral value.
In a recent note, UBS also concluded that current fundamentals do not warrant a repeat of the 2008 GFC. Their covered banks have only 6.5% of commercial property loan exposure. Even if current exposures trigger similar to GFC write-offs at 9-12%, losses will remain in line with reserves.
According to the Bayes Lending Survey, there is support for repositioning and asset improvement; however, this comes at a considerable cost. The all-in loan interest charged on opportunistic and repositioning assets varies between 5.5% and 7.5%. The survey also reveals that loan pricing varies significantly based on the size of the loan. Smaller loans under €5m tend to have higher interest rates. Additionally, borrowers need to be aware of local lenders, as 92% of banks only provide loans within their domestic market. Only 8% of banks engage in lending across Europe without external subsidiaries or branches. In contrast, 38% of debt funds pursue a strategy that involves lending in multiple countries.
PGIM highlights the impact of regulatory constraints on banks and credit factors that have worsened the funding gap. The finalization of Basel III is the most recent regulatory change that has consistently raised capital requirements for real estate loans, resulting in an estimated reduction of over €125bn in lending capacity within the banking system. Credit factors have also played a role, as higher interest rates have led to stricter debt service coverage ratios. This has been a primary driver behind lower LTV loans and, consequently, lower advance rates. With long-term interest rates projected to remain elevated in Europe, there will be less available capital in the system for property acquisition and refinancing.
Consequently, financing solutions will increasingly need to come from other market participants. While banks currently dominate European lending markets, holding over 85% of all real estate loans compared to the more diversified sources of capital in the United States, they are more constrained than ever in their lending capacity. Alternative lenders have entered the European real estate credit markets since the GFC and have become an integral part of the funding market. However, there is a clear need for significant growth in private debt to meet the demand in the coming decade and beyond.
Spec Advisory's blog suggests that the current market conditions, characterized by high interest rates and low real estate spreads, present an opportune moment to invest in real estate debt. Their analysis indicates that senior debt exhibits similarities to fixed income investments, offering a low average 5-year IRR and minimal volatility. On the other hand, real estate equity leveraged at 70% is highly volatile and tends to yield weaker results when spreads fall below 300bps. In contrast, mezzanine debt demonstrates robust returns, which are relatively independent of the level of spread. Mezzanine debt aligns its returns and risks more closely with the underlying real estate portfolio, and these returns remain elevated even when spreads are low. Overall, Spec Advisory suggests that investing in mezzanine debt in the current market environment can provide favourable outcomes.
There are valid concerns that the tightening of lending standards will put significant strain on the CRE sector, and that there is a need for alternative financing sources. However, as Brookfield Corporation stated, concerns about a potential commercial real estate meltdown are exaggerated, with distress limited to older office properties that were already facing challenges for example. UBS’s long time advertising slogan was, “Here today, here tomorrow,” this will be true for most banks.