As we enter what may well be the late stages of the current economic cycle (with uncertainty exacerbated by looming trade wars and Brexit), we read with interest a recent report entitled somewhat provocatively “The CRE Lending Black Hole”, published by the UK’s Property Industry Alliance Debt Group.
The thesis of this document is that (in the context of the UK), if Commercial Real Estate (CRE) lenders (and investors for that matter) properly analyzed the complete “through the cycle” realised profitability of their CRE lending, they would begin to comprehend that, as the title suggests, it has recently been something of a “black hole”; because all the profits they believed they would make and had booked were negated (and more) by the losses from subsequent write-downs and write-offs. It is important to note that the particular period on which the report focused was 1992-2008; for which the authors calculated that write-offs (GBP 19.3BN) exceeded gross profits (GBP 7BN) by almost 200%- and this ignores losses from equity real estate investments.
We are sure that there will be those who quibble with the numbers and challenge the methodologies used (which are carefully explained). However, the difference between supposed profit and realized loss is simply too great to be dismissed. Furthermore, the authors argue that latent losses were potentially much greater at the bottom of the cycle, with lenders being “rescued” from even worse write-offs by being able to “hang on” and wait for values to recover as the economic recovery took hold. Nevertheless, it needs to be pointed out that the particular time period documented encompassed what was the worst downturn in several generations, and so was something of an “outlier”.
So, why did all this happen? What behaviours were major contributory factors? Could it happen again? Is this just a UK phenomenon?
To the first point, the report makes it clear that the 1992-2008 cycle was a more extreme version of previous ones; which, anecdotally, tend to result in a “crash” roughly mid-way through the second decade of expansion. While not participants, some of the Awbury Team have been around long enough to remember the crash of 1974- not as bad, but one that left scars and caused a secondary banking crisis. As in many other areas of the financial industry, it does seem that memories fade, and those still around, who do remember can seem like Cassandras, and too easily ignored.
In terms of behaviour, as the infamous Chuck Prince quote from 2007 makes clear, no-one likes to leave the party while everyone else is still dancing. Internal and external pressures from peers and competitors mean that one needs significant fortitude to decide that actually now would be a very good time to leave, just as it seems that everything is building to the peak. In fact, one should have left some time before. In addition, each sophisticated lending organization is convinced that its policies and procedures, coupled with the quality of its risk management and governance mean that it will be able to “get out” before it is too late. They are almost invariably wrong.
Since the Great Financial Crisis, the amount and quality of capital held by traditional CRE lenders has increased significantly, regulators are more vigilant, and such key metrics as Loan to Value Ratios (LTVs) more conservative. However, there are signs that valuations are stretched in a number of sectors, while the retrenchment of banks has led to much CRE lending now being undertaken by non-bank actors, which are less transparent to the markets. While many, if not most, are experienced and use much less overall leverage, nevertheless, the concern has to be that there are pockets of vulnerability that could trigger a down-cycle.
As the report makes clear, all its data are from the UK. However, one only has to look at experience in the US, Spain, Sweden, Japan- one could go on- to realize that the experience in the UK is hardly unique.
As students of financial history, the Awbury Team believes that a critical component of managing risk successfully is avoiding succumbing to “market groupthink”; being willing to take a contrarian view and, if necessary, walk away from transactions where, no matter how tempting the economics may be, the risk/reward ratio is skewed to the downside, with too many things having to go right. Avoidance of loss and ruin is essential.
Investors may not fully appreciate the losses that can offset profits in CRE; and outcomes measured depend upon the timeframes chosen. Trying to time a market is inherently dangerous (and not just in CRE!). Investors and lenders need to model for the fact that cycles turn; and that, to avoid being forced to liquidate in a hostile environment, one must maintain sufficient flexibility and robust liquidity until markets recover.
The report, while seeking to prove a point, does still provide a salutary example of why “this time round” it is rarely different; and that behaviours need to change if the inherent CRE “boom to bust” cycle is ever to be broken.
The Awbury Team