LONDON — Fitch Ratings has found a way for banks to safeguard themselves from heavy losses should the commercial property market crash.
Naturally, the greater percentage a bank lends towards a property, the greater risk the bank takes on. When it comes to commercial property — anything from offices to shops — in a major market downturn, it can be doubly risky because commercial real estate (CRE) owners can run up millions upon millions in debt, and if a business goes bust, it will not be able to pay its bills.
This is what happened during the credit crisis of 2007/2008.
In a report sent to Business Insider, credit ratings agency Fitch argues that by looking at CRE loans during the two years leading up to the credit crisis (2005-2007), it found a new key way in which banks can safeguard against heavy losses should a seismic market crash happen again.
The report titled “UK CRE: Countercyclical Lending Boosts Loan Returns,” argues that first of all, the usual way for firms to lend money against property is via the loan-to-value (LTV) mechanism — the ratio of a loan to the value of an asset purchased. The higher the percentage, the higher the risk is for the lender.
Fitch says by calculating the LTV cyclically-corrected value (CCV) of a commercial property and only lending a certain percentage against that, this would help banks bear losses or even breakeven, in the event of a market crash.
CCV is determined by Fitch as a reduction of a property’s open market value by any overvaluation by the current market — which is made up of prime rents and yields with their long-term trends and averages. In other words, a property may be worth £1 million right now but after reducing this by how inflated its price is by looking at overvaluation calculations, you will come up with a CCV number.
For example, based on Fitch’s calculations, a “65% LTV loan made on a Birmingham industrial property would currently result in an 84.5% LTCCV (the methodology reports 130% overvaluation in this market segment).”
Fitch found that during 2005-2007 banks that lent to a 75% LTVCCV had “broken even” even though there was a market crash. Those which lent up to 70% of the LTVCCV protected banks from half of portfolio losses.
“We believe a long-term cyclically-corrected measure of market value provides UK CRE lending businesses with a useful risk management tool,” said Euan Gatfield, Fitch’s head of EMEA Commercial mortgage-backed securities.
“Our analysis of pre-crisis loans indicates that interest coverage ratios and loan-to-value metrics kicked in too late in the property cycle, whereas a cyclically-corrected measure would have offered forward-looking protection.”
And banks may need to make sure where they stand in light of the state of Britain’s property market right now. Morgan Stanley recently said three separate indices that measure major movements in UK house prices are heading to zero or going negative.
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