The Bank of England's warning about the risks that commercial property lending poses to UK financial stability was the latest in a series of negative statements about the sector by European central banks in recent weeks.
In its quarterly monetary policy overview published on March 27, the Bank of England warned of potential implications for the UK banking system as domestic, US and Chinese property borrowers are forced to refinance their debt at high costs. Commercial property prices, which have fallen sharply in many developed countries, “could fall further, resulting in significant losses for creditors,” it explained.
The warning follows a series of directives from the European Central Bank expressing similar concerns, the latest of which was issued on March 21. In its annual report on supervisory activity for 2023, the ECB wrote that commercial real estate is an “emerging risk” to financial stability.
Its concerns are manifold. The main one was about European banks' exposure to the sector through packaged or balloon loans after extensive on-site investigations. The report noted that these types of loan structures pose a higher refinancing risk as borrowers may need to refinance their loans at a much higher cost than initially expected.
Ultimately, the ECB is concerned that real estate failures pose systemic risk to the euro zone financial system. The concern stems in part from the European Systemic Risk Committee, the EU's macroprudential supervisor, saying in January 2023 that it was concerned about banks' exposure to the real estate sector. According to the committee, lending in some European markets was done with “high loan-to-value” ratios.
Real estate trade groups have expressed frustration, telling affiliate Real Estate Capital Europe they worry the ECB's commercial real estate risk assessment risks destabilizing an industry that has, at least internally, started to speak more positively about lending terms. The ECB declined to comment.
However, Peter Kosmetatos, CEO of property finance industry trade group CREFC Europe, distinguishes between the Bank of England and ECB announcements. He calls the Bank of England's comments that the UK commercial property sector continues to face downward pricing pressures and refinancing challenges “sober and reasonable,” pointing to the fact that property finance markets “indeed appear to be broadly healthier and more resilient in the UK than in mainland Europe.” Still, Kosmetatos criticized the ECB for failing to engage with the real estate industry's concerns.
“I am troubled by the continued European regulatory assault on real estate. If the ECB believes commercial real estate is dangerous, it should recognise the importance of understanding the industry holistically,” he said. “Instead, we see policymakers operating in effectively impregnable silos, taking inspiration from notions of the industry's downfall in the global financial crisis.”
He said the Bank of England has been more open to industry associations such as CREFC Europe, and that the Commercial Real Estate Forum, a cross-industry steering group that meets quarterly, helps the Bank of England gain insights from the industry. In contrast, he noted the ECB's “apparent lack of interest in such information channels” and its “poor understanding” of property company leverage levels.
The result, he says, is a lack of insight into how real estate finance works: “The way the ECB talks about the space suggests that there is a degree of confusion about different sources of capital and different routes to access real estate debt and equity risk.”
He added: “The rise of commercial real estate debt securitizations and increased regulation of commercial real estate lending by banks after the global financial crisis suggests that EU policymakers should be happy that some of the credit requirements of the commercial real estate market are being met by non-banks.”
Jeff Lapp, director of communications at INREV, a trade group for private real estate investors, believes the ECB's conclusion that real estate poses a risk to the financial system is “completely unfounded.” Mr. Lapp says data from INREV, which covers 80% of European private real estate investment vehicles, shows the real estate sector is not highly leveraged.
He explains: “While we understand that the ESRB based its conclusions about the industry on its study of the listed real estate sector, it is clear that the average leverage of unlisted vehicles, weighted by assets under management, was what the ESRB’s study uncovered. [at the fund and property level]is about 20 percent. If you know this information, [them] The real estate investment industry as a whole is much less leveraged than we thought.”
The ESRB did not get specific about its assessment of real estate lenders’ leverage levels, saying only that “available data” suggests bank lending is occurring at “high” LTVs in certain markets.Rapp added that if the ESRB had included an assessment of unlisted vehicles, which are much larger than the listed sector, in its January 2023 report, its calculation of average leverage for real estate funds “would have been significantly lower.”
NBFI Survey
After years of focusing on banks, regulators are now turning their attention to whether private markets need greater oversight, and there are efforts internationally to extend financial stability regulation to investment markets.
Central banks and financial regulators such as the UK's Financial Conduct Authority are separately examining risks to the financial system across the private lending market, known as “non-bank financial institutions.”
European Central Bank (ECB) Vice President Luis de Guindos addressed the role of commercial real estate in the non-bank financial institutions (NBFI) sector during a press conference following the central bank's latest interest rate announcement on March 7. He said the bank is monitoring non-banks with exposure to the sector “very closely” and that non-bank exposure to real estate is of more concern to him than bank exposure.
The NBFI sector is a broad term that covers the private market. In the real estate context, NBFIs include a variety of entities, such as real estate investment funds, insurance companies and pension funds, that invest directly in real estate or indirectly through real estate stocks and bonds. Central banks are concerned about the relationships between such entities and banks, for example the provision of loan-on-loan financing from investment banks to private real estate bond funds.
Lee Foulger, director of financial stability, strategy and risk at the Bank of England, hinted at the possibility of NFBI regulation in a speech on January 29, saying, “It will be important for all parts of the financial sector and the real economy to understand how the move to a higher interest rate environment will affect private credit markets, and in particular whether and how sector business model risks interact.” [with] “Macro Vulnerabilities”
As a result, both CREFC Europe and INREV argue that the ECB's public statements are based on limited and often historical knowledge about the industry, and they call on the ECB to open a dialogue with the industry.
Kosmetatos agrees that regulators should prioritize greater visibility when it comes to real estate finance, given that some lending activity has shifted to private markets. But he says, “The ECB needs better data and qualitative insights, including a more constructive dialogue with the industry. At this point, it's too early to conclude that the sector poses a risk to financial stability.”
Nicholas Smith, managing director of private credit at the Alternative Credit Council, a trade group that represents private credit managers, believes regulators are aware of their blind spots when it comes to the private market and are keen to correct them. But, he adds, “The challenge for the industry is that policymakers are lumping together a relatively disparate set of factors and concluding that 'something has to be done.'”
He explains: “The corporate lending market is very different to, say, asset-backed lending or lending to the real estate sector. To lump these markets together and argue that NBFIs should be the focus is not convincing. If you think there is a potential risk, get the data.”
Smith says ACC's own research on private market leverage, which includes data from real estate lenders, shows that leverage levels have broadly remained stable. “The data tracking this trend goes back nearly a decade, and the percentage of funds operating without leverage has broadly remained the same. Unleveraged funds and funds operating at low levels of leverage account for about 85% of the total. [European] market. This suggests that leverage has not increased significantly.”
There are signs that the ECB is committed to gathering more information: on 22 May, the European Commission launched a targeted consultation on the NFBI and will hold public workshops to gather information on credit institutions, their interactions with the banking sector, and how this is creating risk accumulation in the system.
“I sympathize with why they have to do this, and it's very sensible to assess the situation and try to see how it works. Evidence-based policymaking is important,” said Rupp, who will attend. But he added, “But in the face of that process, it's irresponsible for the ECB to continue making the kinds of statements it's making about real estate.”