While regulators have moved to calm markets by providing liquidity facilities, guaranteeing deposits in collapsed US banks such as SVB and arranging the merger of Credit Suisse with UBS, uncertainty remains and banks are likely to be more cautious in protecting their liquidity positions. We do not believe the significant anxiety in financial markets will lead to a crisis equivalent to the GFC. However, the events over the last few weeks will have implications for the real estate market and real estate debt investment managers. That said, we don’t see a notable deviation from our perspective of the macro-economy presented in our House View (latest January 2023).
This short note lays out the events up to 24th March 2023 and potential impact on lending within real estate in the UK and Europe.
Recent Market Events:
In an attempt to calm markets, the Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and the US Treasury jointly announced the extraordinary measure that all deposits at SVB and Signature Bank would be refunded to depositors.
Whether steps taken by the Federal Reserve, US Treasury and FDIC to reassure markets have worked is yet to be seen and this is likely to weigh on future rate rises by the Fed.
The crisis has not spread to European markets. This is due to European banks holding less bonds relative to their US counterparts, and deposits being more stable in Europe (figure 1). In addition, debt securities, including government bonds, account for approximately 12% of continental European bank’s balance sheets, compared to 30% in US banks1.
Debt levels lower than pre-GFC in Europe
In Europe, the slow decline and subsequent merger of Credit Suisse also created uncertainty in the markets. However, the drivers of Credit Suisse’s collapse are mainly mismanagement and multiple expensive scandals over the last three years. While not highlighting system risks, uncertainties remain as market participants consider whether the turmoil in the banking sector is over, or if there will be a wider contagion.
There has been a significant change in investor sentiment globally. Equity markets have suffered, particularly in banking and finance. In the course of a week, US interest rate expectations have reversed, and bond yields have fallen as investors have switched from expecting higher peak rates, driven by strong employment, to an earlier Fed pivot as they weigh recession fears and become more risk averse. Listed REITs have been hit harder than wider stock indices, US mortgage REITs in particular, and there are rising concerns about the implications for credit availability.
Implications for Real Estate Debt
In the US, regional and specialist banks have become key players in real estate debt over the last 20 years. As of January 2023, small banks’ share of real estate debt market among all banks stood at 68%. Furthermore, against the backdrop of rapid interest rate increases from the Fed, small banks grew their real estate lending by nearly 20% over the last 12 months. This compares to 5% increased exposure by the large banks (figure 2). However, the recent bank uncertainty has resulted in a change in deposits flowing from small to big banks (figure 3). Given the increased pressures on small bank liquidity levels, they are likely to retreat from further new lending and refinance only the very best loans on their books. Large banks are also not immune and will want to protect their liquidity positions, resulting in reduced exposure to illiquid lending.
The same caution is likely to permeate across European banks as they also focus on raising their lending standards and protecting their liquidity levels. Therefore, financing conditions are likely to tighten further, creating a funding gap that alternative lenders can capture.
However, the retreat of banks from real estate lending is a double-edged sword for the market. On the one hand, the funding gap since the pandemic has grown and is circa £5-7bn per year in the UK and circa €51bn over the next 3 years across Europe , and will likely to continue to grow in the near term. Since the GFC, alternative lenders have increased their market share as banks, driven by regulation, have slowly reduced their exposure to certain real estate lending strategies. Therefore, the increased funding gap and reluctance from banks to fill the gap are likely to drive borrowers towards alternative lenders for their funding needs.
However, a healthy, functioning real estate market requires participation from variety of lenders including banks. If the banks retreat too much from this market, it is likely to reduce all activity and impact confidence in the asset class. The risks of this occurring in Europe are lower given the healthier liquidity positions of banks and the more likely scenario is that banks will focus more on their strongest borrowers and top assets. Banks are also more likely to act on loans approaching covenant breaches and force more refinancings in order to reduce the risk to their balance sheets of any potential defaults.
The banking crisis in the US has shaken markets globally. Whether regulators moving to reassure markets has worked is yet to be seen with large banks in the US receiving record deposits from those fearing more liquidity troubles for smaller banks. European banks fared better and the swift move by UK regulators to sell the UK entity of SVB to HSBC, and Swiss regulators to merge Credit Suisse into UBS, will have further reassured markets.
Banks will likely focus on protecting their liquidity positions and therefore become more risk averse to lending in the short term. This would cause constraints for borrowers looking to refinance their assets and that constraint would pose a significant challenge in some parts of the market. However, this scenario would provide opportunity for alternative lenders, with capital to deploy, to fill the gap left by banks.
Furthermore, our real estate equity colleagues flag considerable need for retrofit and asset enhancement, but with further constrained finance, and against high construction costs, this must result in polarization of the market, with the best assets having significantly better prospects of finance relative to the rest.
1 Moody’s: https://edition.cnn.com/2023/03/15/economy/european-bank-rules-svb/index.html
2 Bayes: The debt funding gap in the UK CRE sector, 2022
3 AEW: Debt Funding Gap Widens: https://www.aew.com/research/debt-funding-gap-widens-as-lower-collateral-values-icr-bite
Research Analyst, Debt
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