Tag: Commercial Property

APRA Warns On Commercial Property Exposures

APRA has written to ADI’s today highlighting issues relating to the banks’ commercial property exposures, following a thematic review of commercial property lending over 2016. They say that the risk profile of lending has often been hampered by inadequate data, poor monitoring and incomplete portfolio controls across these portfolios.  They have written to individual lenders with specific requirements. APRA will conduct further work in this area during 2017.

They provided an attachment with more detailed observations from the review and some of APRA’s key expectations in relation to commercial property lending.

Underwriting Standards

Sound credit underwriting standards are fundamental to the safety and soundness of lenders, as well as the stability of the financial system as a whole. This is particularly the case in the area of commercial property lending, which has historically been the source of significant credit losses for the Australian banking industry. It is critical that ADIs maintain appropriate standards through the credit cycle, and are prepared to tighten those standards as circumstances dictate.

APRA has observed a general tightening of underwriting standards, especially for residential development lending, over the past year or so. This has not been uniform, however, and there is a need for ADIs to exercise particular care to ensure that they are not unduly accepting greater risk as other lenders step back.

The review also revealed evidence that some ADIs were justifying a particular underwriting stance based on what the ADI understood to be the criteria applied by another lender. Underwriting standards should be reflective of the ADI’s own risk appetite and not based on a potentially erroneous appreciation of a competitor’s criteria.

A summary of key observations follows:

Income producing investment lending

  • Insufficient constraints on debt size – A key concern is where ADIs have not adjusted the minimum Interest Cover Ratio (ICR), used for debt sizing investment loans, as interest rates have declined. At this point in time, APRA does not intend to prescribe an approach to setting minimum ICRs for debt sizing purposes; however, it does expect ADIs to have thoroughly considered and addressed this risk. ADIs should similarly consider their policies in relation to Loan to Valuation Ratios (LVRs) in light of recent strong asset price growth.
  • Debt yield as a complementary underwriting measure – Debt yield (net operating income to total debt) is used by some overseas banks as a key underwriting measure, but it is not commonly used within the Australian market. This metric, supported by prudent ICR and LVR measures as appropriate, could offer benefits to lenders as it provides a measurement of risk that is independent of the interest rate, amortisation period, and capitalisation rate.
  • Need for greater focus on refinancing risk – A number of ADIs demonstrated only limited analysis of the risk in refinancing a facility at maturity.

Residential Development Lending

  • Sponsors to contribute sufficient equity – A number of ADIs noted an increasing awareness of the use of mezzanine debt / quasi equity from third parties and reliance on material uplifts in land valuations to reduce the size of a sponsor’s contribution of ‘hard equity’. APRA expects ADIs ensure a sufficient level of ‘hard equity’ is at risk from sponsors.
  • Presale quality and coverage – In the past year, some ADIs have tightened underwriting criteria for presales coverage following market concerns with regard to settlement risk. ADIs are now generally requiring qualifying presales equivalent to at least 100 per cent of committed debt and have tightened the proportion of qualifying presales permitted to foreign purchasers. However, there was still scope for improvement in a number of ADIs’ policies on what constituted a qualifying presale, and the thoroughness of analysis of presales achieved for particular transactions was sometimes lacking.
  • Need to consider end product, location and quality – The consideration of potential marketability issues for properties, such as being poorly located, small apartments lacking in amenities and/or suffering from design issues, was not always evidenced in transaction analysis.

Portfolio Controls

A key finding from the thematic review is that many participating ADIs fell well short of expectations regarding portfolio controls for commercial property. This has been in part driven by an underinvestment in information systems, leading to challenges in extracting portfolio data. Ready availability of detailed and reliable transaction level data, appropriately aggregated, is a key component in obtaining a sound and complete understanding of the risk profile of the commercial property portfolio. Deficiencies in data hamper an ADI’s ability to implement and monitor underwriting standards and portfolio controls.

A summary of key observations follows:

  • Availability of transaction data lacking – The identification, recording, tracking and reporting of key transaction characteristics, in a manner which can be readily aggregated, is fundamental to sound risk management. These transaction characteristics include asset type, geographic location, construction contractor and developer concentrations and key underwriting metrics such as ICR, debt yield, loan-to-development costs (LDC), presales to debt cover and LVR. Analysis of these transaction drivers helps an ADI to understand its risk profile at different stages of the cycle. A large number of ADIs were unable to readily provide reasonably basic portfolio information to APRA as part of this review.
  • Portfolio limits can be improved – APRA expects that ADIs with commercial property exposures should manage not only the risk of individual loans but also consider build-ups in risk at the portfolio level. A deeper understanding of the portfolio can be particularly helpful for the Board and senior management in setting and monitoring portfolio limits, and adherence to the lender’s risk appetite, as market conditions change. One fundamental management control to prevent a build-up in risk is an overarching sector concentration limit, as per Prudential Standard APS 221 Large exposures. Better practice would be to also have sub-limits to control concentrations in riskier segments of the portfolio, such as lending for development or land. In addition, improvements in data and system capabilities would permit the establishment of a more targeted risk metrics and controls relating to key transaction drivers for the stage of the cycle.
  • Better practice is for deep dives into heightened risk segments – A number of participating ADIs had reacted to perceptions of heightened risk in market segments by undertaking deep dive exercises, targeted stress tests and the provisions of additional targeted reports to key stakeholders. This was particularly noticeable for locations where there was considered to be increased settlement risk and had led, in some cases, to tightened underwriting standards for that segment.Identifying and managing exposures originated outside of standards
  • Inadequate monitoring of exceptions to underwriting standards – Many ADIs fell short of APRA’s expectations with respect to monitoring exceptions to policy and underwriting standards in the commercial property portfolio. This has been a long-standing concern and many ADIs need to improve their capabilities in this area. Inadequate monitoring of policy exceptions/overrides potentially exposes the ADI to a build-up of risk outside of the documented underwriting standards, representing a shift in risk profile beyond the levels formally approved.
  • Insufficient justification for deviation from standards – APRA’s review of transactions with higher risk characteristics, or outside ADI underwriting standards, indicated varying levels of qualitative assessment supporting the taking on of higher risk. Justifying lending decisions on the basis of ‘long-standing relationship’ or ‘good track record’ are insufficient, by themselves, to mitigate higher risk characteristics such as higher leverage or weaker presale cover, especially if these are outside approved underwriting standards.

A $90 Billion Debt Wave Shows Cracks in U.S. Property Boom

From Bloomberg.

A $90 billion wave of maturing commercial mortgages, leftover debt from the 2007 lending boom, is laying bare the weak links in the U.S. real estate market.

It’s getting harder for landlords who rely on borrowed cash to find new loans to pay off the old ones, leading to forecasts for higher delinquencies. Lenders have gotten choosier about which buildings they’ll fund, concerned about overheated prices for properties from hotels to shopping malls, and record values for office buildings in cities such as New York. Rising interest rates and regulatory constraints for banks also are increasing the odds that borrowers will come up short when it’s time to refinance.

“There are a lot more problem loans out there than people think,” said Ray Potter, founder of R3 Funding, a New York-based firm that arranges financing for landlords and investors. “We’re not going to see a huge crash, but there will be more losses than people are expecting.”

The winners and losers of a lopsided real estate recovery will be cemented as the last vestiges of pre-crisis debt clear the system. While Manhattan skyscraper values have surged 50 percent above the 2008 peak, prices for suburban office buildings still languish 4.8 percent below, according to an index from Moody’s Investors Service and Real Capital Analytics Inc. Borrowers holding commercial real estate outside of major metropolitan areas are now feeling the pinch as they attempt to secure fresh financing, Potter said.

 

The delinquency rate for commercial mortgages that have been packaged into bonds is forecast to climb by as much as 2.4 percentage points to 5.75 percent in 2017, reversing several years of declines, as property owners struggle with maturing loans, according to Fitch Ratings. That sets the stage for bondholder losses.

CMBS Record

Banks sold a record $250 billion of commercial mortgage-backed securities to institutional investors in 2007, and lax lending standards enabled landlords across the U.S. to saddle buildings with large piles of debt. When credit markets froze the following year, Wall Street analysts warned of a cataclysm, with $700 billion of commercial mortgages set to mature over the next decade.

“At the depths of the panic, it was just that: panic,” said Manus Clancy, a managing director at Trepp LLC, a firm that tracks commercial-mortgage debt. “That made people’s future expectations extremely bearish. Extremely low interest rates over the last four or five years have forgiven a lot of sins.”

The CMBS market roared back after an 16-month shutdown, and lenders plowed into real estate as an antidote to skimpy returns for other investments. The cheap loans helped propel property values to record highs in big cities such as New York and San Francisco, alleviating concerns about the mountain of debt coming due.

Credit for property owners has once again become scarce in some pockets. Borrowing costs jumped following the surprise election of President Donald Trump, and Wall Street firms are being more cautious as new regulations kick in requiring them to hold a stake in the mortgages they sell off. Other lenders are scaling back on commitments to property types and locations where problems have gotten harder to ignore.

Struggling Malls

Lenders are taking an increasingly dim view of retail properties — especially malls — as the growth of e-commerce eats into sales at brick-and-mortar stores. Malls tend to have higher loss rates than other property types after a default, increasing the stigma for lenders, according to Lea Overby, an analyst at Morningstar Credit Ratings LLC.

When malls “start to go downhill, if nothing is done to turn the ship around, they plummet,” Overby said. “The fate of some of these malls is very, very uncertain.”

The Sunset Mall in San Angelo, Texas, added a glow-in-the-dark mini golf course in June, part of a nationwide trend of retailers trying to lure customers with experiences they can’t find online. Yet when a $28 million mortgage came due in December, the borrower couldn’t refinance it, according to data compiled by Bloomberg. The debt, part of a bond deal sold by Citigroup Inc. and Deutsche Bank AG in March 2007, was handed off to a firm specializing in troubled loans.

A similar storyline is playing out at a 82,000-square-foot (7,600-square-meter) suburban office complex in Norfolk, Virginia, whose tenants include health-care services firms. The borrower stopped making payments on a $20 million loan that comes due next month and can’t refinance the debt, Bloomberg data show.

Representatives for the owners of the properties didn’t respond to phone calls seeking comment on the loans.

Manhattan Tower

Landlords that own high-profile buildings in big cities are faring better. At 5 Times Square, the Manhattan headquarters for Ernst & Young LLP, the owners are close to securing a five-year loan to pay off $1 billion in debt that comes due in March, according to Scott Rechler, chief executive officer of RXR Realty, which owns 49 percent of the building. RXR acquired its stake in the 39-story tower shortly after the building was sold to real estate investor David Werner for $1.5 billion in 2014.

“We are currently reviewing term sheets from a number of institutions and expect to settle on a lender within a week or so,” Rechler said.

Some borrowers chipped away at the maturity wall by retiring their mortgages early in order to take advantage of ultra-low interest rates. At the same time, landlords with the weakest properties have already defaulted, further reducing the pool of loans that need to be refinanced. The maturity wall has been whittled down to about $90 billion from $250 billion in 2008, according to data from Morningstar. The firm estimates that roughly half of the remaining loans will have difficulty refinancing.

S&P analysts are predicting that about 13 percent of real estate loans coming due will ultimately default, up from 8 percent over the past two years, according to Dennis Sim, a researcher at the firm. That’s their base case, but the default rate could be higher, he said.

“There are a lot of headwinds currently — with the interest-rate increase, with the new administration coming in, and also risk retention,” Sim said. “Those three wild-card factors could also play a role in how some of the better-performing loans are able to refinance or not.”

‘Rising risks’ for banks in commercial property

Higher vacancy rates for office properties combined with growing settlement risks for newly-built residential apartments add up to a credit negative for Australia’s major banks, says Moody’s Investors Service via InvestorDaily.

Payment-Pic

A new report by Moody’s Investors Service has concluded that the risks from commercial real estate are rising for the big four banks, but they remain “manageable”.

After a hiatus in the years following the global financial crisis, Australia’s major banks have been steadily growing their exposures by 5 per cent or more each year from December 2013 onwards.

There are two major risks in the commercial property sector, according to Moody’s.

First, there are higher vacancy rates in office properties in Brisbane and Perth due to an increase in supply (and weak demand).

Second, there is growing settlement risk from a potential oversupply of newly-built residential apartments in Sydney, Melbourne and Brisbane.

The second risk factor could negatively affect property development companies as well as the broader market, said Moody’s – “especially in the context of tighter lending restrictions imposed by the major banks recently”.

However, Australia’s major banks should be able to manage the risk because they have limited their exposure to the high-risk commercial property segments, said Moody’s.

The major banks’ commercial real estate loans as a percentage of total committed exposures is “moderate” at around 6-8 per cent, said Moody’s.

Australia’s big banks also tightened their lending criteria to the commercial real estate sector following material losses in the aftermath of the GFC, said the ratings house.

“As a result, we see foreign bank branches being more at risk of current headwinds in this segment, and expect the major banks’ CRE impairment levels to remain at moderate levels,” said Moody’s.

A stress test of the major banks’ commercial real estate exposures indicates only a “mild deterioration” in Common Equity Tier 1 ratios under a “severe stress” scenario, said Moody’s.

Property fears after Brexit vote are a sign of wider UK housing problems

From The Conversation.

Immediately after the UK voted to leave the European Union, a number of lead economic indicators went into reverse. Notable among them were housing, property and real estate shares that fell sharply both in the housebuilding sector and among banks with large property lending exposure. This was seen as a simple response to economic uncertainty; fears emerged of falling house prices and slowing activity in the property market.

This week the big story has been the weakening position of major real estate funds, primarily investing in commercial property – office buildings, shops, warehouses. The firms which manage the funds, Standard Life for example, are concerned that if investors rush to withdraw their money, there will be insufficient capital to repay them. At first, a number of funds reduced the amount that investors could get back. Now, at least six of them – including Standard Life, Aviva and M&G – have suspended trading altogether. This has not happened since the global financial crisis.

Commercial property is in the firing line. Hazel Nicholson/Flickr, CC BY

While it reflects the basic illiquidity of commercial property compared to the short-term needs of worried investors – it clearly speaks to a much more profound concern about the economy and the exposure to housing and property.

Most of us are not heavily exposed to property funds, but many of us are homeowners or hope to be. The risk of falling house prices in the post-referendum environment may threaten highly leveraged mortgages where home owners have taken on lots of debt. The most immediate risk is of “negative equity”, when the value of the house is lower than the loan amount outstanding.

Normally, such “underwater” loans prevent people moving home, but in the absence of repayment difficulties they are not an immediate problem. You just have to wait it out until prices turn. However, the current situation is complicated and potentially more worrying.

This is because of the government’s £31 billion commitment to various Help-to-Buy schemes, £12 billion of which in effect guarantees the exposed part of mortgage loans should prices fall. A sustained price fall which becomes associated with increased defaults on mortgages could mean the government has to make good those guarantees after repossessions on affected properties.

Taking a pounding

Falling house prices in the short run will also reduce existing owners’ capacity to support potential first time buyers: the bank of mum and dad (or granny and grandad) stepping in to help. This will further reduce access to home ownership because younger households increasingly face unaffordable deposit demands before they can get a mortgage. At the moment, access to the levels of cash needed often depends on rather arbitrary good fortune, timing and location. It often boils down to whether your family have the means to lend or give you what’s needed.

Much has been made of the high level of speculation and overseas investment in London’s vertiginous housing market. There were already signs that the market was weakening cyclically prior to the referendum. Subsequently, however, we saw last week that some foreign banks were refusing to lend to their nationals for property investment in the UK. The depreciation of sterling may be encouraging such purchasers into the market, but only if they can find the means to borrow.

In this way we see that a UK housing market dominated by an open, world city in London, does become linked to currency movements and international capital flows, despite the fundamentally local nature of housing and real estate.

No more happy hunting ground? Davide D’Amico/Flickr, CC BY-SA

Home to roost

Falls in share prices, the forced intervention in real estate funds and worries about lending and government exposure to the downside of help-to-buy guarantees explain why the Bank of England says that the Brexit risks are crystalising and is moving to do something about it. However, it is hard not to draw the conclusion that the red flags going up across the housing and banking sectors reflect the underlying or chronic problems we know beset the housing market in Britain:

• Market imperfections in the form of the long term inability to build in sufficient numbers to address growing housing demand.

• Dwindling public investment in social and affordable housing in a period of high and rising housing need.

• Tax raids on the private rental market by targeting buy-to-let investors just when they are playing a critical role by filling the gap between the market and the non-market sectors.

• Tighter mortgage lending in the wake of the mortgage review that sought to reduce future lending risks after the global financial crisis.

• Privileged tax advantages to home owners which lock them in and create a society of insiders and outsiders. This worsens intergenerational inequalities and crowds out other forms of more productive business investment

Broken system. Ben Salter/Flickr, CC BY

Combining these points helps explain the underlying volatility in the housing market. It allows prices and market volumes to fluctuate more than the economy as a whole, while long-term real house price inflation encourages speculation in property assets and serves to frustrate people’s housing and labour mobility choices.

Governments and opposition parties must take concerted long-term action to normalise housing as an asset and a commodity. The policy world must recognise the need to approach housing more constructively, treating it as an entire system win which housing consumption rather than tenure matters most.

Frankly, we must seek to bring an end to a culture where politics is premised on defending existing asset owners’ housing capital rather than providing sufficient housing in the right places at prices and rents ordinary people can manage at different life-cycle stages. If not, we will be condemned to repeat these crises periodically, alongside slowly worsening chronic problems of exclusion, non-affordability and poisonous widening inequality.

Author: Kenneth Gibb, Professor of Housing Economics, University of Glasgow

Foreign Commercial Property Investment Significant – RBA

In the RBA Bulletin there is an interesting analysis of foreign property investors in the commercial sector. The FIRB publish data on approvals for proposed foreign investment on an annual basis. The value of these approvals has increased substantially in recent years, from $11 billion in 2009/10 to nearly $35 billion in 2012/13

RBACommercialProperty0Foreigners have accounted for around one-quarter of the value of commercial property purchases in Australia since 2008, up from one-tenth in the previous 15 years. In the first half of 2014, they purchased nearly $5 billion worth of commercial property, about 40 per cent of the value of properties that were sold. Net purchases (which also account for sales) by foreigners amounted to $4 billion in the first half of 2014, close to its level for all of 2013.

RBACommercialProperty1The recent increase in foreign investment has been most pronounced in the market for office property. Foreigners’ purchases have accounted for around one-third of the value of turnover of office buildings since 2008, with purchases consistently exceeding the value of foreign sales.

RBACommercialProperty2Since 2008, foreign buyers have accounted for 40 per cent of the value of purchases in New South Wales, compared with 20 per cent of turnover in Victoria, Queensland and Western Australia. Foreigners’ preference for New South Wales reflects their strong appetite for office buildings in the Sydney CBD, which industry participants attribute to the greater liquidity of the market and the large amount of prime-grade office space.

RBACommercialProperty3Foreigners from many parts of the world have become more active in Australian commercial property markets, although much of the rise in net investment in the past few years reflects an increase in purchases by investors based in Asia and North America. Net investment from Europe has also increased, albeit by much less.

They conclude that the available data indicates that foreign investment in commercial property has increased in recent years, with foreigners having accounted for around one-quarter of the value of commercial property purchases in Australia since 2008. The higher demand for Australian buildings has been broad based across a range of institutions from Asia and North America, although sovereign wealth funds and pension funds have accounted for a greater share of foreign investment more recently. Foreign buyers have typically purchased existing buildings, enabling domestic firms to sell assets for higher prices, supporting their financial position and freeing up capital to be used on new developments. To date, foreigners have shown a preference for purchasing office buildings in New South Wales, but analysts expect foreigners to spread into other markets as they become more familiar with Australia. In any case, foreigners’ acquisitions have benefited developers operating in several states and sectors, and so the indirect effects on construction activity have not been constrained to the New South Wales office market.