Have base rate cuts changed outlook for property finance?

Another cut in base rate but what does that mean for property finance? The MPC voted for another 0.5% interest rate this week but does this really change anything for property companies in search of funding? Bernard Frazer, Partner at Red Chilli Structured Finance, believes not. With base rates now at a historical low and the prospect that they will remain there for the foreseeable future, there may naturally be an expectation that this will lead to cheaper and, in time, easier credit. That is unlikely to be the case in the near future and lower base rates are not unlikely to be the answer to the funding woes of the property industry.

No immediate relief for property investors

Over the last few months, it quickly became clear that banks were not going to pass on rate cuts in full and, in the current economic climate, why should they? Beyond the pressing need of banks having to recapitalise (and some of that effort will obviously come from greater profitability), they are faced with an unprecedented imbalance between supply of funds and demand. That affects them both ways. Not only can they afford to charge higher margins on projects they choose to fund (much demand) but also they have to pay high interest to their depositors in order to protect their capital base (not enough supply). So the short of it is that recent (and future) cuts in base rates are unlikely to change the cost of lending on their own.
The real issue of course is availability of credit. Borrowers are not precious about pricing; they just want to be able to borrow. Leaving aside the broader macroeconomics, the fundamental problem in the funding industry has been the brutal contraction of credit. In 2007, the reported funding gap was £740bn meaning that banks lent £740bn more than they had on deposit. The difference was of course absorbed by the now defunct CMBS markets and the reverse is currently happening where banks engage in negative lending, i.e. they lend less than they have on deposit as they endeavour to recapitalise themselves.

Liquidity, liquidity, liquidity

While the government’s move in October 2008 to inject capital into a number of banks was necessary to stem the panic that had engulfed the markets and to avoid further runs on UK banks, it did not address the liquidity issue. Banks were inclined to trust each other again but that did not change the fact that the property market was in the doldrums with values declining left, right and centre significantly undermining the underlying security of their existing loans and therefore their capital. While they were licking their wounds and figuring out how to work through some of their more critical issues, banks were always going to be unlikely to consider lending on new projects. The economic background, dire business climate and deteriorating property and job markets all conspired to exacerbate the banks’ reluctance to engage in any new lending. Critically, this has led the broad economy in general and the property industry in particular into a downward spiral which nothing seems to be able to break. Ironically, property has not looked so cheap in a long time and the spread between interest rates and yields has not been that healthy for years. Although the repeated cuts in base rates have failed to kick-start new lending, they have set the tone for low long- term interest rates and the swap markets have slowly begun to reflect this.

Commercial property has not looked so attractive in a long time

With 5 year swaps at 3% and commercial yields between 8% and 10%, a great deal of cash rich investors are very keen to get back into the market. With such spreads, lenders could afford to charge silly margins and get away with it. A 2.5% margin (3 times what a lender would have charged 18 months ago) would still only cost a borrower 5.5% against an income of almost twice as much. At a gearing of 70%, the lender would have the comfort of a 2 to 2.5 interest cover ratio, a dream ratio not so long ago. In essence, a fundamentally sound deal for any lender.

So, in the face of such safe deals and with much demand from property investors, why are deals not happening? The answer is capitalisation and psychology. Capitalisation because banks cannot lend the capital they do not have, psychology because negative expectations have a nasty habit of being self fulfilling. In other words, the expectations of further declines in property prices mean that property prices will decline further. So what can be done to break this vicious cycle?

While it was expected there would a painful adjustment in the property markets, there is now widespread belief that values have dropped to a level which is economically attractive and that, negative sentiment notwithstanding, now would be a good time to get back in the market. The only reason one might not would be the expectation of further declines fuelled by the lack of liquidity.

A solution to the property funding woes?

There is every reason to believe that renewed liquidity from lenders would almost certainly kick-start activity in the property markets, help prices stabilise and ultimately pick up. The question is what can the government do to restore liquidity? One obvious solution would be for the government to underwrite new loans made on property investments by guaranteeing their principals (possibly jointly with lenders) and allowing them to be securitised. This solution suggested by Sir James Crosby in his Autumn report is particularly suited to the property sector as key lending criteria could easily be set (e.g. max LTV, min ICR) and the underlying securities are arguably safer than that of corporate bonds.

It is easy to see why a UK government-backed loan on property at 70% LTV paying, say, 2% over swaps would find buyers in the CMBS markets given the strength of the numbers (the generous ICR would provide ample comfort and plenty of room for solid amortisation). Lenders could charge an additional margin (say 50bps) to be paid into a general insurance pot to cater for possible defaults and the deals would still stack up from the investor’s perspective. Lenders’ balance sheets would not be affected as debt would be securitised but their recapitalisation efforts would be boosted through increased profitability. Best of all, the government would not actually have to fork out any cash but simply underwrite the risk. Naturally, such a scheme would include residential mortgages.

Broader availability of such credit would almost certainly reinvigorate the commercial and residential property markets, buyers would flock back and there is every chance that negative sentiment would be reversed with values firming up thanks to the renewed activity. In time, it is likely that the stabilisation and eventual pick up in the markets would see the government off risk and ultimately the tax payer no worse off.

This is clearly not the silver bullet to all our economic woes and the property industry cannot be considered in a vacuum. It is however one the industries worst affected by the credit crunch and arguably the one that offers the best security for any reasonable loan. It is also undeniable that it affects the mass psyche probably more than any other, particularly where residential property is concerned. There is a strong case for implementing the type of measure recommended by Sir James Crosby, and to implement it very soon.

Bernard Frazer is a Partner at Red Chilli Structured Finance, an independent property finance advisory firm specialising in arranging funding for property projects in the UK and all over Europe.

Other Resources

• Bank of England
• British Bankers’ Association BBA
• swapratesonline.com

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