1. The CRE Lending Black Hole
Rupert Clarke
Chairman PIA Long-term Value Group
Managing Partner, Lipton Rogers Developments
February 2019

2. The Property Market is Cyclical

3. CRE Index Capital Value Trend line – Inflation Adjusted (Source Radley Associates)

4. The Cyclical Rise and Fall of CRE (Source Radley Associates)

5. CRE Lending Rises Rapidly through the Cycle

6. Rapid expansion of New CRE Loans through the Cycle (Source Bank of England, de Montfort survey)

7. Loans Outstanding rose from £31bn - £255bn (1992-2008)

8. Calculating Cumulative CRE Lending Profits Compared to End of Cycle Losses

9. CRE Industry Profitability Calculation Components
Gross Revenue
Ave. Margins: % - 1.1%
Ave. Arrangement Fee: % - 0.5%
Ave. Redemption Fee: % - 0.1%
Ave. Non Utilisation Fee: % of Ave. Margin
Overhead Assumptions: % Cost/Income Ratio
Reg. Cap. Assumptions: %
Sources: de Monfort Survey, Lending Organisation Executives

10. 2008- 2018 CUM. W/Offs = £19.3bn (Source Bank of England)

11. The 1992-2008 Cycle CRE Lending Black Hole
Gross Revenue from Margin and Fees: £28.0 bn
Less Business Operating Costs: £ 8.4 bn
Less Regulatory Capital Costs: £12.5 bn
Gross Profit through the Cycle: £ 7.1 bn
Gross profit as a % of Peak O/S %
Reported end of cycle Write Offs: £19.3 bn
Write Offs as a % of Peak O/S %
Overall Cycle CRE Lending Loss: £12.2 bn

12. But reported Write Offs do not reveal the full picture

13. Latent losses at market value low point substantially exceeded reported write offs
Timing of write offs and Market Recovery
£19.3bn of write offs occurred after market values had recovered
Bottom of the cycle latent write offs: c.£30bn+
Holding on until things get better not an option for all
The impact of Mark to Market
The market value of distressed loans < face value
High LTVs + low margins = significant discounts
Mark to market impairment = an additional c.£30bn
Latent write downs of loan assets could have been as high as £60bn

14. What other research has looked at CRE lending profitability and what has it found?

15. Other CRE Lending Profitability Research
Mckinsey (Nov 2009)
Data from major European CRE Lenders (40% of market),
“the industry is not covering its cost of capital”
“Conservative organisations pulled back in early 2007…..”
CBRE (Q2 2015)
“CRE Lending Industry performance negative ”
Fitch (April 2017) and BAML (February 2018)
“All Loan losses from loans made ”

16. Why do End of Cycle CRE Lending Losses Exceed Cumulative Profits
Why do End of Cycle CRE Lending Losses Exceed Cumulative Profits? Mathematical Factors and Behavioural Factors

17. CRE Lending Cycle Losses - Mathematical Factors
Lending book expansion through the cycle
£31bn to £255bn in 14 years
The larger the growth the greater the probability of losses

18. Cum. Profit/O/S vs Annual Loan Growth (simulation)

19. Last Cycle Cumulative Profitability Vs Loans O/S

20. CRE Lending Cycle Losses - Mathematical Factors
Lending book expansion through the cycle
£31bn to £255bn in 14 years
The larger the growth the greater the probability of overall loss
End of Cycle Profit Margins too low

21. Profit margins evaporated in second half of the cycle

22. CRE Lending Cycle Losses - Mathematical Factors
Lending book expansion through the cycle
£31bn to £255bn in 14 years
The larger the growth the greater the probability of losses
End of Cycle Profit Margins too low
Volumes of End of Cycle new lending too high
£164bn of new loans in 2006 – 2007: 65% of the 2008 £255bn peak
c.75% LTV’s followed by a 42% average fall in values

23. CRE Lending Cycle Losses - Mathematical Factors
Lending book expansion through the cycle
£31bn to £255bn in 14 years
The larger the growth the greater the probability of losses
End of Cycle Profit Margins too low
Volumes of End of Cycle new lending too high
£164bn of new loans in 2006 – 2007: 65% of the 2008 £255bn peak
c.75% LTV’s followed by a 42% average fall in values
LTV’s need to be proactively managed
Lenders need “End of Cycle Strategies” to reduce LTV’s …....or
LTV’s need to be lower throughout the cycle

24. CRE Lending Cycle Losses – Behavioural Factors
Peer Pressures
Fear of moderating lending “too early” and losing out
Organisational inertia
Collective complacency, kicking the can down the road
Short term horizons
Business plans and profitability targets are short term
Organisations do not look at the whole cycle profitability
Lack of clear end of cycle CRE lending strategies
The need for an unambiguous “End of Cycle Strategy” is not recognised

25. Relevant Last Cycle Statistics
Lenders consistently fail to recognise end of cycle risks: After making a record breaking £82bn of new loans in 2006, 89% of CRE lenders planned to increase their new lending activity in 2007 (de Montfort)
Lending activity usually rapidly increases as values increase and the end of the cycle nears:
New CRE loans : £22bn.
New CRE loans : £234bn (de Montfort/Bank of England)
The majority of losses are linked to end of cycle loans: All last cycle CMBS write offs related to issues (Fitch)
End of cycle CRE lending losses swamp all of the lending cycle profits…

26. The 1992-2008 Cycle CRE Lending Black Hole
Gross Revenue from Margin and Fees: £28.0 bn
Less Business Operating Costs: £ 8.4 bn
Less Regulatory Capital Costs: £12.5 bn
Gross Profit through the Cycle: £ 7.1 bn
Gross profit as a % of Peak O/S %
Reported end of cycle Write Offs: £19.3 bn
Write Offs as a % of Peak O/S %
Overall Cycle CRE Lending Loss: £12.2 bn

27. Some other obvious questions
Why has the Regulator not acted in the past? Wasn’t it just the Scottish, Irish and Icelandic banks? Was a repeat of previous cycles? Can’t you predict a potential crash? Will it be different this time/next time?

28. Why has the Regulator not acted in the past?
A lack of clear guidelines/no CRE specialists
How can the regulator possibly decide when to act?
A micro approach to macro problems
Market failures are macro. The regulator preoccupation with micro is a misleading distraction
Regulators should not worry about taking action too early
Better for everyone too early than far too late
Clear roles and responsibilities
Treasury, Bank of England, FSA – who was in charge?

29. Wasn’t it just the Scottish, Irish and Icelandic banks?
Scottish, Irish and Icelandic banks: loss ratios of up to 20% compared to the industry average of 7.6%
“Median banks” experienced a 3.5% loss ratio (B of E data) – profit levels were still insufficient to cover their losses
89% of banks wanted to increase CRE lending in 2007 after a record year in 2006, the worst possible time to be lending.
New lending in 2007 increased £84bn (another record year) with 62% increasing their new lending volumes
The obvious conclusion is that the vast majority of CRE lenders suffered through the cycle losses

30. Was 1992-2008 a repeat of previous cycles?
Rapid lending growth = Major CRE Write Offs and through the Cycle losses

31. Cum. Profit/O/S vs Annual Loan Growth

32. Was 1992-2008 a repeat of previous cycles?
Rapid lending growth = Major CRE Write Offs and through the Cycle losses
Growth in CRE lending cycles
21% pa in the 8 years up to 2008
28% pa in the 8 years up to 1990
92% pa in the 3 years up to 1974
Not explained by growth in market values over the same period
4.5% pa in the 8 years up to 2008
6.9% pa in the 8 years up to 1990
19% pa in the 3 years up to 1974
Conclusion: The UK CRE Lending Industry has been loss making for over 50 years
(a pattern that is likely to have been repeated in other developed CRE Lending markets)

33. Can’t you predict a potential crash?
1934
1970
1988
2004

34. Will it be different this time/next time?
The Good News
Currently average LTV’s are 60% or less and have come down
Loans O/S are c.35% lower than 2008 O/S (vs , 200%+ O/S increase)
New “slotting” approach to Reg. Cap. is holding lenders back
Lending organisations are also generally being more cautious
The Bad News
Market values (ex retail) are substantially above long term trend
Unregulated lenders and other below the radar lending is increasing
Lending organisations still do not have explicit end of cycle strategies

35. The 1992-2008 Cycle CRE Lending Black Hole
Gross Revenue from Margin and Fees: £28.0 bn
Less Business Operating Costs: £ 8.4 bn
Less Regulatory Capital Costs: £12.5 bn
Gross Profit through the Cycle: £ 7.1 bn
Gross profit as a % of Peak O/S %
Reported end of cycle Write Offs: £19.3 bn
Write Offs as a % of Peak O/S %
Overall Cycle CRE Lending Loss: £12.2 bn

36. The CRE Lending Black Hole
Rupert Clarke
Chairman, PIA Long-term Value Group
Managing Partner, Lipton Rogers Developments
February 2019