A regulatory push for banks to set aside more capital against their trading books has led to the banks pulling back from funding commercial property, leaving room for other players to fill the vacuum.

But at the Investment Magazine Infrastructure & Real Estate Conference, delegates heard private debt funding could bring a plethora of new risks to non-bank lenders such as superannuation funds and fund managers.

Intermediate Capital Group co-head of UK real estate, Kevin Cooper, told delegates the danger was that banks had historically performed poorly when lending to this sector. This raised the question of how superannuation funds would fare – especially as they lack expertise in credit analysis.

Cooper cited research showing that, over the long term, banks lost money on commercial real estate (CRE) even before they had to absorb the impact of tough regulatory capital demands.

The CRE Lending Black Hole: Steady gains followed by extreme pains, which Property Industry Alliance debt group chair Rupert J. Clarke wrote late last year, concluded that banks that lent money at the end of a major cycle incurred catastrophic losses that swamped all the lending profits generated during the rest of that cycle.

Clarke concluded that not only did the banks lose money in the last major cycle, but also in the previous two UK property cycles, implying that, in aggregate, the industry has been loss-making for more than 50 years.

Cooper pointed out to delegates that McKinsey & Co. and Bank of England supported the finding that CRE lending was unprofitable. They also concluded that through the cycle losses would probably be widespread and not just a result of the behaviour of a limited number of “irrationally exuberant banks”.

Cooper and Clarke were joined for the discussion by Principal Global Investors head of global research Indraneel Karlekar. All three panelists warned it was very likely that many other CRE lending markets internationally had experienced similar through-the-cycle profitability obstacles, given the similarities between the UK CRE lending market and other CRE lending markets.

Notwithstanding this, CRE lending stakeholders seem unaware of the historic through-the-cycle “profitability black hole” dynamics of the market they operate in, and do not appear to have clear strategies to address end-of-cycle risks.

The fear is history will repeat.

Cooper said: “Our firm conviction is that when people promulgate on getting back into the real-estate sector, the first thing to ask is how the banks have done.”

The discussion then switched to looking at which risk/reward characteristics stack up at this stage of the investment cycle.

When questioned about an appropriate late-cycle strategy, Principal Global Investors head of global research Indraneel Karlekar suggested a ‘barbell’ approach. This means making half the portfolio long-term bonds and the other half very short-term bonds.

Karlekar said investors should put the lion’s share of the money into low-risk core property with a small amount in an opportunistic bucket – using either debt or equity.

Elizabeth Fry has been a financial journalist for more than 25 years and has written for a number of publications, including CFO, The Financial Times and The Australian Financial Review.
Leave a comment