Property Boom and Banking Bust Property Boom and Banking Bust The Role of Commercial Lending in the Bankruptcy of Banks Colin Jones Professor of Estate Management The Urban Institute Heriot‐Watt University Stewart Cowe Formerly Investment Director Real Estate Research and Strategy Scottish Widows Investment Partnership Edward Trevillion Honorary Professor The Urban Institute Heriot‐Watt University This edition first published 2018 © 2018 John Wiley & Sons Ltd All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by law. Advice on how to obtain permission to reuse material from this title is available at http://www.wiley.com/go/permissions. The right of Colin Jones, Stewart Cowe, and Edward Trevillion to be identified as the authors of this work has been asserted in accordance with law. 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Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. Library of Congress Cataloging‐in‐Publication Data Names: Jones, Colin, 1949 January 13– author. | Cowe, Stewart, author. | Trevillion, Edward. Title: Property boom and banking bust : the role of commercial lending in the bankruptcy of banks / Colin Jones, Stewart Cowe, Edward Trevillion. Description: Hoboken : Wiley-Blackwell, 2017. | Includes bibliographical references and index. | Identifiers: LCCN 2017031759 (print) | LCCN 2017043453 (ebook) | ISBN 9781119219200 (pdf) | ISBN 9781119219217 (epub) | ISBN 9781119219255 (paperback) Subjects: LCSH: Real estate investment. | Commercial real estate. | Mortgage loans. | Financial institutions–Real estate investments. | Banks and banking. | Global Financial Crisis, 2008–2009. | BISAC: BUSINESS & ECONOMICS / Real Estate. Classification: LCC HD1382.5 (ebook) | LCC HD1382.5 .J666 2017 (print) | DDC 332.109/0511–dc23 LC record available at https://lccn.loc.gov/2017031759 Cover Image: © MarianVejcik/Gettyimages Cover Design: Wiley Set in 10/12pt Warnock by SPi Global, Pondicherry, India 10 9 8 7 6 5 4 3 2 1 To Fiona and Louyse for their patience and understanding during the preparation of this manuscript. For Margot for her constant support over many years and to Adriana who encouraged me to put pen to paper. vii Contents List of Figures ix Acknowledgements xi Glossary xiii 1 Introduction 1 Sub‐prime Lending Enters the Financial Vocabulary 2 The Global Extension 5 Commercial Property Market Context 6 Commercial Property’s Role in the Wider Economy 13 Property Investment and Short‐termism 14 Measuring Commercial Property Market Performance 14 Book Structure 16 2 Long‐term Changes to Property Finance and Investment 21 The Changing Role of the Banks in the United Kingdom 21 Property Development and Investment Finance 25 The Changing Investment Landscape of the Non‐banking Financial Institutions 29 The Other Main Players in Commercial Property 30 The Changing Face of Institutional Property Investment 31 Limited Partnerships 34 Jersey Rides to the Rescue 37 Unit Trusts and Indirect Investment 39 Conclusions 41 3 Economic Growth, Debt and Property Investment through the Boom 43 Global Economic Upturn and Debt Accumulation 43 The Property Boom and Escalating Debt 46 The Cost and Role of Debt 52 Development and its Finance in the Noughties Boom 57 The Weight of Money and Moving up the Risk Curve 61 Conclusions 63 4 The Anatomy of the Property Investment Boom 65 Commercial Property, the Macroeconomy and Globalization 66 Global Property Upswing 68 Market Trends in the Property Boom – Was Something Different this Time? 71 viii Contents UK Investment Trends 76 Lending To Commercial Property in the United Kingdom 82 A Property Boom in an Irrational Market 83 Summary and Conclusions 88 5 The Global Financial Crisis and its Impact on Commercial Property 91 A Crisis Unfolds 92 The Impact on Global Property Markets 95 Capital and Rental Values in the United Kingdom Post 2007 98 But This Time the Bust Was Also Different 100 Investment Trends and Capital Value Falls 106 Changing View of Risk 112 Summary and Conclusions 114 6 Property Lending and the Collapse of Banks 117 The Crumbling of the UK Banking System 118 Royal Bank of Scotland 121 Halifax Bank of Scotland 122 Britannia Building Society and the Co‐operative Bank 130 Dunfermline Building Society 131 Irish Banking Collapse 132 US Experience 136 Discussion and Conclusions 139 7 Aftermath and Recovery 143 The Macroeconomic Context 144 Property Market Trends 147 Bad Bank Debts and Impairments: The Road to Redemption 151 The Response of Property Investors, Property Funds and Property Companies 158 Property Lending Post‐GFC 161 Implications for the Pricing of Commercial Property and Investment 162 Conclusions 166 8 Conclusions 169 Globalization 171 The Boom and Bust through the Prism of Valuations 173 Role of Banking 173 Irrational Exuberance 174 Could It Happen Again? 176 What Can Be Done? 177 Final Thoughts 179 References 181 Index 191 ix List of Figures 1.1 Nominal and real capital value growth 1971–1977 9 1.2 Nominal and real capital value growth 1987–1997 11 1.3 Real commercial property capital values 1981–2010 (1981 = 100) 16 2.1 Quarterly cash flow into specialist (retail) real estate funds, 2001–2007 39 3.1 Global debt outstanding in 2000 and 2007 broken down by sector 46 3.2 Commercial property capital growth in selected countries 47 3.3 Total property debt as a percentage of invested stock in different parts of the world 1998–2009 47 3.4 Commercial real estate lending as a percentage of annual UK GDP 1970–2011 48 3.5 Annual bank lending for property in the United Kingdom 2000–2010 48 3.6 International sources of bank lending in the United Kingdom 2004–2010 49 3.7 Bank base rates and 5‐year swap rates 2000–2010 52 3.8 Average interest rate margins for bank lending to commercial property 2002–2011 53 3.9 Average interest rate margins on prime and secondary retail properties 2002–2012 54 3.10 Differences between initial yield and funding costs 2000–2010 55 3.11 Average maximum loan to values on commercial property lending by banks 2002–2012 56 3.12 Office development in London 1985–2011 59 3.13 Annual retail warehouse space completed 1993–2014 60 3.14 Annual completions of town centre and out‐of‐town shopping centres 1965–2014 60 4.1 Annual US economic growth and commercial property returns 1978–2014 66 4.2 Annual UK economic growth and commercial property returns 1978–2014 67 4.3 Commercial property capital growth in selected countries 2000–2009 70 4.4 Long‐term capital and rental value growth patterns 1975–2015 72 4.5 Annual contributions to capital growth 1981–2007 73 4.6 Quarterly capital and rental value growth in the retail sector 2000–2009 74 4.7 Quarterly capital and rental value growth in the office sector 2000–2009 75 4.8 Quarterly capital and rental value growth in the industrial sector 2000–2009 75 4.9 Net quarterly institutional investment into commercial property, 2001–2009 76 4.10 Net quarterly institutional investment in the UK property sectors, 2001–2009 77 x List of Figures 4.11 Indices of the annual real value of institutional purchases by property sector 1981–2010 78 4.12 Indices of the annual real value of institutional sales by property sector 1981–2010 78 4.13 Value of commercial property transaction volumes, 2000–2009 79 4.14 Weighted average yield of property purchased by investors compared to the market average in 2006 81 4.15 Patterns in retail sales of property fund units to investors and commercial property values, 2000–2009 82 4.16 Yield gap between yields on gilts and commercial property, 2001–2009 86 5.1 Office yields in the United Kingdom and Western Europe 2007–2015 96 5.2 Office yields in EMEA countries and the Americas 2007–2015 96 5.3 Yield trends in the Asia Pacific region 2007–2015 97 5.4 Indexed capital value and rental value change in the UK property market 2000–2014 99 5.5 Indexed capital value change by sector, 2000–2009 101 5.6 Contributions to capital growth, 2000–2009 103 5.7 Peak to trough change in capital values by length of unexpired lease 105 5.8 Peak to trough changes in capital values by asset quality defined by value 105 5.9 Net investment by financial institutions by property sector, 2006–2014 106 5.10 Transaction volumes in the commercial property market 2000–2015 108 5.11 Market and valuation yields, 2007–2010 110 5.12 Yield Spreads of Sales by Investor Types, 2007–2009 111 5.13 Quarterly cash flow into specialist (retail) real estate funds 2000–2015 112 5.14 Yield gap between gilts and commercial property, 2001–2009 113 6.1 Major UK banks’ customer funding gap, 2000–2008 119 6.2 HBOS property and property related exposures, drawn balances at November 2008 125 6.3 HBOS impaired loans as a percentage of year‐end loans and advances, 2000–2009 127 6.4 HBOS monthly impairment losses charged to the income statement in 2008 127 7.1 Actual and forecast 10‐year gilt yield gaps, 1987–2013 165 7.2 Actual and forecast index‐linked gilt yield gaps, 1987–2013 166 xi Acknowledgements We thank MSCI for permission to use its data on worldwide property trends. We also thank Property Data for permission to use their UK transactions data. Both of these data sources represent the essential empirical base for the book. We also acknowledge the support of CBRE, the De Montfort UK Commercial Property Lending Survey, the Investment Property Forum and Real Capital Analytics in giving permission to reproduce figures from their reports. xiii Glossary APUT Authorised property unit trust – a means by which personal investors can access and invest in the property market. BASEL III The Basel international agreements relate to common global standards of capital adequacy and liquidity rules for banks. These were first introduced in 1988. Since 2013, the amount of equity capital that banks are required to have has been significantly increased by BASEL III. Fannie Mae Fannie Mae is a US government sponsored enterprise originally set up in 1938. It operates in the ‘secondary mortgage market’ to increase the funds available for mortgage lenders to issue loans to home buyers. It buys up and pools mortgages that are insured by the Federal Housing Administration (see below). It finances this by issuing mortgage‐backed debt securities in the domestic and international capital markets. Federal Housing Administration The Federal Housing Administration is a US government agency created in 1934. It insures loans made by banks and other private lenders for home building and home buying. Freddie Mac Freddie Mac is a US government sponsored enterprise established in 1970 to provide competition to Fannie Mae and operates in the same way. lending margins The difference between the rates banks charge to borrowers and that paid (usually) on the wholesale markets or to savers. limited partnership A partner in a limited partnership has limited liability but normally has a passive role in management. There is also a manager who decides the investment policy of the partnership. liquidity Liquidity is the ability to transact quickly without causing a significant change in the asset’s price. Property tends to be considered illiquid, not least because of the time taken for a transaction. NAMA The National Asset Management Agency was established in 2009 by the Irish government as one of the initiatives taken to address the crisis in Irish banking. It took over the bad property loans from the Irish banks in an attempt to improve the management of credit in the economy. OECD The Organisation for Economic Co‐operation and Development (OECD) comprises a group of 34 countries that includes all Western countries. It was set up in 1961 to promote policies that improve economic and social well‐being in the world.