The Bank of England’s Financial Policy Committee recently stated that commercial real estate (CRE) lending underwriting standards have, of late, loosened, and that if this trend continues banks could quickly become less resilient to stress in this market. This statement reminds us of the wider economic implications of irresponsible CRE lending and therefore the importance of fully understanding CRE lending risks during boom periods so as to mitigate the consequences of the next crash.
Loan-to-value (LTV) ratios have long been used by CRE lenders as a tool for assessing the risk on CRE loans. This ratio compares the loan amount to the market value of the property at the time the loan is made. A higher LTV indicates a higher level of risk of loss on the loan.
Whilst delightfully simple, the LTV ratio only takes into account the current market value of an asset, a value which changes in tandem with the property cycle. As a result, the use of this ratio can be misleading to lenders by understating the level of risk on their CRE loans during property booms.
To demonstrate this, let’s consider two scenarios for a real estate asset the value of which changes considerably through the boom and bust periods of the property cycle.
In the middle of our property cycle, Lender A advances a loan with an LTV of 50% on an asset that has a market value of £100m: Lender A advances £50m. At the peak of the cycle, Lender B advances a loan on an identical asset with a similar LTV ratio of 50%, but the asset now has a market value of £150m: Lender B advances £75m.
Now let’s consider when the property bubble bursts, the market crashes and the assets’ value drops to just £50m. How do our two lenders fare? Lender A will be nervous but won’t actually lose anything on their loan of £50m. Lender B, however, will potentially be nursing a loss of £25m on its £75m loan – a 33% write-down.
Although the outcome of these two scenarios are dramatically different, they were both advanced with the same LTV ratio of 50% - the same ‘perceived’ level of risk. This therefore demonstrates how LTV is a very ineffective means of assessing the risk to lenders on their CRE loans consistently through the cycle.
Taking the long-term view
What is needed, therefore, is a LTV ratio which uses a form of ‘value’ which reflects the specific property against which the loan is made, but which is also insensitive to the highs and lows of the property cycle. For want of a better name, we call this ‘long-term value’. Loan to long-term value (LTLTV) would be a metric which could be applied as a measure of CRE lending risk, and which could produce a consistent indication of risk regardless of the position in the property cycle. The concept would support CRE lending when it is most needed, following a bust, and would constrain excessive lending during the boom period, thereby protecting financial stability. Back-testing through the last cycle suggests that such a concept would be significantly better than using market value-based LTVs.
The implementation of LTLTV
The LTLTV concept is still in its early days and more work is needed to establish exactly how it could be put into practice. One method for calculating this value could be the use of a cash flow projection with a fixed capitalisation rate. Another could be the use of a market value that is then adjusted by reference to a property index to factor in the position in the property cycle.
Of course, LTLTV is not a perfect predictor in all cases, but it is – and only needs to be - a reasonably good measure of the total risk arising from the CRE loan book of an individual bank. Combined with adequate levels of capital requirements, this measure should help to reduce inappropriate lending.
The use of LTLTV as a risk metric is one of the recommendations made in “A Vision for Real Estate Finance in the UK”. The concept is one which is gaining wider appreciation in the industry, with the Bank of England’s Financial Policy Committee recently highlighting the pro-cyclicality of the regulatory capital regime as a potential source of structural vulnerability. In relation to commercial real estate, this is precisely what LTLTV seeks to address. As an industry we should help ourselves and our regulators avoid the mistakes of the past by finding an easy to use and effective measure of risk on CRE lending.