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- Herausgeber: John Wiley & Sons
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- Sprache: Englisch
- Veröffentlichungsjahr: 2017
A fascinating analysis of the critical role commercial property investment played in the economic boom and bust during the global financial crisis The unprecedented financial boom stretching from the mid-1990s through 2008 ultimately led to the deepest recession in modern times and one of the slowest economic recoveries in history. It also resulted in the emergence of the draconian austerity policies that have swept across Europe in recent years. Property Boom and Banking Bust offers an expert insight into the complex property market dynamics that contributed to the Great Financial Crisis of 2008 and its devastating economic consequences. It is the first book to focus on a woefully underreported dimension of the crisis, namely, the significant role that lending on commercial property development played in the crisis. Among other key topics, the authors explore the philosophical and behavioral factors that propelled irresponsible bank lending and the property boom; how it led to the downfall of the banks; the impact of the credit crunch on the real estate industry generally in the wake of the financial crisis; the catastrophic effects the property bust had on property investors, both large and small; and how the financial institutions have sought to recover in the wake of the financial crisis. * Provides valuable insights into what happened in previous booms and busts, particularly in the 1970s and 1980s, and how they compare with the most recent one * Offers an expert assessment of the consequences of the global financial crisis for the banking system and the commercial property industry * Examines strategies banks have used to recover their positions and manage the overhang of indebtedness and bad property assets * Addresses strategies the real estate industry have used to recover from the collapse in property values Written in an accessible style, and featuring numerous insider case accounts from property bankers, Property Boom and Banking Bust disentangles the complex, tightly-woven factors that led to the Great Financial Crisis of 2008, while offering powerful lessons for property industry professionals on how to avoid having history repeat itself.
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Table of Contents
Cover
Title Page
List of Figures
Acknowledgements
Glossary
1 Introduction
Sub‐prime Lending Enters the Financial Vocabulary
The Global Extension
Commercial Property Market Context
Commercial Property’s Role in the Wider Economy
Property Investment and Short‐termism
Measuring Commercial Property Market Performance
Book Structure
2 Long‐term Changes to Property Finance and Investment
The Changing Role of the Banks in the United Kingdom
Property Development and Investment Finance
The Changing Investment Landscape of the Non‐banking Financial Institutions
The Other Main Players in Commercial Property
The Changing Face of Institutional Property Investment
Limited Partnerships
Jersey Rides to the Rescue
Unit Trusts and Indirect Investment
Conclusions
3 Economic Growth, Debt and Property Investment through the Boom
Global Economic Upturn and Debt Accumulation
The Property Boom and Escalating Debt
The Cost and Role of Debt
Development and its Finance in the Noughties Boom
The Weight of Money and Moving up the Risk Curve
Conclusions
4 The Anatomy of the Property Investment Boom
Commercial Property, the Macroeconomy and Globalization
Global Property Upswing
Market Trends in the Property Boom – Was Something Different this Time?
UK Investment Trends
Lending To Commercial Property in the United Kingdom
A Property Boom in an Irrational Market
Summary and Conclusions
5 The Global Financial Crisis and its Impact on Commercial Property
A Crisis Unfolds
The Impact on Global Property Markets
Capital and Rental Values in the United Kingdom Post 2007
But This Time the Bust Was Also Different
Investment Trends and Capital Value Falls
Changing View of Risk
Summary and Conclusions
6 Property Lending and the Collapse of Banks
The Crumbling of the UK Banking System
Royal Bank of Scotland
Halifax Bank of Scotland
Britannia Building Society and the Co‐operative Bank
Dunfermline Building Society
Irish Banking Collapse
US Experience
Discussion and Conclusions
7 Aftermath and Recovery
The Macroeconomic Context
Property Market Trends
Bad Bank Debts and Impairments: The Road to Redemption
The Response of Property Investors, Property Funds and Property Companies
Property Lending Post‐GFC
Implications for the Pricing of Commercial Property and Investment
Conclusions
8 Conclusions
Globalization
The Boom and Bust through the Prism of Valuations
Role of Banking
Irrational Exuberance
Could It Happen Again?
What Can Be Done?
Final Thoughts
References
Index
End User License Agreement
List of Tables
Chapter 02
Table 2.1 Average sectoral structure of institutional property investment funds in 1981 and 1995.
Table 2.2 Tax obligations by LPs for different levels of debt gearing before and after 2004 SDLT reform.
Chapter 03
Table 3.1 Household debt as a percentage of disposable income in selected OECD countries 1995, 2000 and 2009.
Table 3.2 Breakdown of outstanding property bank funding in the United Kingdom at the end of 2009 (£m).
Table 3.3 Indicative capital returns over the period 2004–2006 with different gearing ratios.
Table 3.4 Indicative capital losses over the period mid‐2007–mid‐2009 with different gearing ratios.
Table 3.5 Real value of private construction output by commercial property sector in Great Britain 1997–2015.
Table 3.6 Initial yield differentials of prime offices between UK provincial cities and the City of London 2001–2009.
Chapter 04
Table 4.1 Real house price growth in selected countries.
Table 4.2 Yield compression from the end of 2000 to end of 2007.
Table 4.3 Purchases by type of investor, 2002–2007 (£m).
Table 4.4 Net investment (£m) by investor type, 2002–2007.
Chapter 05
Table 5.1 A summary of the key events of the financial crisis in the United Kingdom and United States 2007–2010.
Table 5.2 National annual GDP growth in selected countries 2007–2009.
Table 5.3 Peak to trough changes in capital values in selected countries.
Table 5.4 Average falls in capital values by property sector, June 2007 to June 2009.
Table 5.5 Capital value falls November 1989 to May 1993.
Table 5.6 Percentage falls in capital value by region and property sector, June 2007–June 2009.
Table 5.7 Net investment (£m) by investor types, 2007–2015.
Table 5.8 Value of sales (£m) by type of investor, 2007–2015.
Chapter 06
Table 6.1 Annual impairment losses on loans and advances to customers at major UK banks, 2007–2013 (£m).
Table 6.2 Annual RBS impairment losses by lending category, 2008–2010 (£m).
Table 6.3 Annual growth of assets in selected divisions, 2004–2008 (£bn).
Table 6.4 Annual impairment growth 2008–2011 by asset type (£bn).
Table 6.5 Estimated long‐term value of underlying property in 2010 (€m).
Table 6.6 Commercial bank failures by year in the United States 1985–1993 and 2007–2015.
Table 6.7 Construction and land loan balances at year end in US commercial banks.
Chapter 07
Table 7.1 Change in real GDP per capita in selected countries 2008–2015.
Table 7.2 Most Recent Downturns in Real House Prices in Selected Countries.
Table 7.3 Change in real house prices in selected countries from 2007 to 2015.
Table 7.4 Trends in commercial property capital values for selected countries.
Table 7.5 Annual commercial property rental value percentage change in the United Kingdom 2007–2014 by sector.
Table 7.6 Annual commercial property capital value percentage change in the United Kingdom 2007–2014 by sector.
Table 7.7 Structure of Isobel joint venture sub‐performing loan fund.
Table 7.8 Number and value of European commercial property loan portfolio transactions in 2015.
List of Illustrations
Chapter 01
Figure 1.1 Nominal and real capital value growth 1971–1977.
Figure 1.2 Nominal and real capital value growth 1987–1997.
Figure 1.3 Real commercial property capital values 1981–2010 (1981 = 100). Figures deflated by the retail price index.
Chapter 02
Figure 2.1 Quarterly cash flow into specialist (retail) real estate funds, 2001–2007.
Chapter 03
Figure 3.1 Global debt outstanding in 2000 and 2007 broken down by sector.
Figure 3.2 Commercial property capital growth in selected countries.
Figure 3.3 Total property debt as a percentage of invested stock in different parts of the world 1998–2009.
Figure 3.4 Commercial real estate lending as a percentage of annual UK GDP 1970–2011.
Figure 3.5 Annual bank lending for property in the United Kingdom 2000–2010.
Figure 3.6 International sources of bank lending in the United Kingdom 2004–2010.
Figure 3.7 Bank base rates and 5‐year swap rates 2000–2010.
Figure 3.8 Average interest rate margins for bank lending to commercial property 2002–2011.
Figure 3.9 Average interest rate margins on prime and secondary retail properties 2002–2012.
Figure 3.10 Differences between initial yield and funding costs 2000–2010.
Figure 3.11 Average maximum loan to values on commercial property lending by banks 2002–2012.
Figure 3.12 Office development in London 1985–2011.
Figure 3.13 Annual retail warehouse space completed 1993–2014.
Figure 3.14 Annual completions of town centre and out‐of‐town shopping centres 1965–2014.
Chapter 04
Figure 4.1 Annual US economic growth and commercial property returns 1978–2014.
Figure 4.2 Annual UK economic growth and commercial property returns 1978–2014.
Figure 4.3 Commercial property capital growth in selected countries 2000–2009.
Figure 4.4 Long‐term capital and rental value growth patterns 1975–2015.
Figure 4.5 Annual contributions to capital growth 1981–2007.
Figure 4.6 Quarterly capital and rental value growth in the retail sector 2000–2009.
Figure 4.7 Quarterly capital and rental value growth in the office sector 2000–2009.
Figure 4.8 Quarterly capital and rental value growth in the industrial sector 2000–2009.
Figure 4.9 Net quarterly institutional investment into commercial property, 2001–2009.
Figure 4.10 Net quarterly institutional investment in the UK property sectors, 2001–2009.
Figure 4.11 Indices of the annual real value of institutional purchases by property sector 1981–2010.
Figure 4.12 Indices of the annual real value of institutional sales by property sector 1981–2010.
Figure 4.13 Value of commercial property transaction volumes, 2000–2009.
Figure 4.14 Weighted average yield of property purchased by investors compared to the market average in 2006.
Figure 4.15 Patterns in retail sales of property fund units to investors and commercial property values, 2000–2009.
Figure 4.16 Yield gap between yields on gilts and commercial property, 2001–2009.
Chapter 05
Figure 5.1 Office yields in the United Kingdom and Western Europe 2007–2015.
Figure 5.2 Office yields in EMEA countries and the Americas 2007–2015.
Figure 5.3 Yield trends in the Asia Pacific region 2007–2015.
Figure 5.4 Indexed capital value and rental value change in the UK property market 2000–2014.
Figure 5.5 Indexed capital value change by sector, 2000–2009.
Figure 5.6 Contributions to capital growth, 2000–2009.
Figure 5.7 Peak to trough change in capital values by length of unexpired lease.
Figure 5.8 Peak to trough changes in capital values by asset quality defined by value.
Figure 5.9 Net investment by financial institutions by property sector, 2006–2014.
Figure 5.10 Transaction volumes in the commercial property market 2000–2015.
Figure 5.11 Market and valuation yields, 2007–2010.
Figure 5.12 Yield Spreads of Sales by Investor Types, 2007–2009.
Figure 5.13 Quarterly cash flow into specialist (retail) real estate funds 2000–2015.
Figure 5.14 Yield gap between gilts and commercial property, 2001–2009.
Chapter 06
Figure 6.1 Major UK banks’ customer funding gap, 2000–2008.
Figure 6.2 HBOS property and property related exposures, drawn balances at November 2008.
Figure 6.3 HBOS impaired loans as a percentage of year‐end loans and advances, 2000–2009.
Figure 6.4 HBOS monthly impairment losses charged to the income statement in 2008.
Chapter 07
Figure 7.1 Actual and forecast 10‐year gilt yield gaps, 1987–2013.
Figure 7.2 Actual and forecast index‐linked gilt yield gaps, 1987–2013.
Guide
Cover
Table of Contents
Begin Reading
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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
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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–dc23LC record available at https://lccn.loc.gov/2017031759
Cover Image: © MarianVejcik/GettyimagesCover Design: Wiley
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.
List of Figures
1.1
Nominal and real capital value growth 1971–1977
1.2
Nominal and real capital value growth 1987–1997
1.3
Real commercial property capital values 1981–2010 (1981 = 100)
2.1
Quarterly cash flow into specialist (retail) real estate funds, 2001–2007
3.1
Global debt outstanding in 2000 and 2007 broken down by sector
3.2
Commercial property capital growth in selected countries
3.3
Total property debt as a percentage of invested stock in different parts of the world 1998–2009
3.4
Commercial real estate lending as a percentage of annual UK GDP 1970–2011
3.5
Annual bank lending for property in the United Kingdom 2000–2010
3.6
International sources of bank lending in the United Kingdom 2004–2010
3.7
Bank base rates and 5‐year swap rates 2000–2010
3.8
Average interest rate margins for bank lending to commercial property 2002–2011
3.9
Average interest rate margins on prime and secondary retail properties 2002–2012
3.10
Differences between initial yield and funding costs 2000–2010
3.11
Average maximum loan to values on commercial property lending by banks 2002–2012
3.12
Office development in London 1985–2011
3.13
Annual retail warehouse space completed 1993–2014
3.14
Annual completions of town centre and out‐of‐town shopping centres 1965–2014
4.1
Annual US economic growth and commercial property returns 1978–2014
4.2
Annual UK economic growth and commercial property returns 1978–2014
4.3
Commercial property capital growth in selected countries 2000–2009
4.4
Long‐term capital and rental value growth patterns 1975–2015
4.5
Annual contributions to capital growth 1981–2007
4.6
Quarterly capital and rental value growth in the retail sector 2000–2009
4.7
Quarterly capital and rental value growth in the office sector 2000–2009
4.8
Quarterly capital and rental value growth in the industrial sector 2000–2009
4.9
Net quarterly institutional investment into commercial property, 2001–2009
4.10
Net quarterly institutional investment in the UK property sectors, 2001–2009
4.11
Indices of the annual real value of institutional purchases by property sector 1981–2010
4.12
Indices of the annual real value of institutional sales by property sector 1981–2010
4.13
Value of commercial property transaction volumes, 2000–2009
4.14
Weighted average yield of property purchased by investors compared to the market average in 2006
4.15
Patterns in retail sales of property fund units to investors and commercial property values, 2000–2009
4.16
Yield gap between yields on gilts and commercial property, 2001–2009
5.1
Office yields in the United Kingdom and Western Europe 2007–2015
5.2
Office yields in EMEA countries and the Americas 2007–2015
5.3
Yield trends in the Asia Pacific region 2007–2015
5.4
Indexed capital value and rental value change in the UK property market 2000–2014
5.5
Indexed capital value change by sector, 2000–2009
5.6
Contributions to capital growth, 2000–2009
5.7
Peak to trough change in capital values by length of unexpired lease
5.8
Peak to trough changes in capital values by asset quality defined by value
5.9
Net investment by financial institutions by property sector, 2006–2014
5.10
Transaction volumes in the commercial property market 2000–2015
5.11
Market and valuation yields, 2007–2010
5.12
Yield Spreads of Sales by Investor Types, 2007–2009
5.13
Quarterly cash flow into specialist (retail) real estate funds 2000–2015
5.14
Yield gap between gilts and commercial property, 2001–2009
6.1
Major UK banks’ customer funding gap, 2000–2008
6.2
HBOS property and property related exposures, drawn balances at November 2008
6.3
HBOS impaired loans as a percentage of year‐end loans and advances, 2000–2009
6.4
HBOS monthly impairment losses charged to the income statement in 2008
7.1
Actual and forecast 10‐year gilt yield gaps, 1987–2013
7.2
Actual and forecast index‐linked gilt yield gaps, 1987–2013
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.
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.
off balance sheet
It refers to the ability to place assets and liabilities off a company’s balance sheet.
open ended funds
A collective investment vehicle where the number of shares or units can be increased or decreased according to cash flow into and out of the fund.
pre‐let
A pre‐let is a legally enforceable agreement for a letting to take place at a future date, often upon completion of a development.
REIT
A Real Estate Investment Trust is a listed company which owns and manages (generally) income producing real estate and which is granted special tax measures (i.e. income and capital are paid gross of tax with any tax being paid according to the shareholder’s tax position).
retail fund
An open‐ended fund that invests funds which are derived from selling units primarily to individual investors.
rights issue
A rights issue occurs when a company issues more shares and its existing shareholders have the initial right to purchase them.
securitization
This is the practice of pooling assets (often commercial/residential mortgages) and selling, usually bonds, with interest payments to third party investors. The interest payments on these securities are backed by the income from the mortgages.
sovereign debt crisis
The failure or refusal of a country’s government to repay its debt (interest payments or capital) in full is a sovereign debt crisis.
upward only rent review
A typical lease may have points in time in the future when the rent is due for review. An upward only rent review is the term used to describe a situation in which the rent payable following a review date cannot be reduced (even if market rents have generally fallen since the last review).
1Introduction
Two shots from Gavrilo Princip’s semi‐automatic pistol at Sarajevo set in train a complex chain of events that lead to the First World War (Taylor, 1963). Commentators writing on the assassination of Archduke Franz Ferdinand of Austria‐Hungary and his wife Sophie on the 28 June 1914 could not have imagined that this ‘local difficulty’ would rapidly escalate, develop into the world’s first global conflict and cost the lives of an estimated 17 million combatants and civilians. It would also sweep away the remnants of three empires, bring about the decline of monarchies, instigate the rise of republicanism, nationalism and communism across large swathes of Europe and change the social fabric forever (Strachan, 2001; Taylor, 1963).
Almost a century later, financial commentators reviewing the failure of New Century Financial, one of the largest sub‐prime lenders in the United States, which filed for Chapter 11 bankruptcy protection on the 2 April 2007, could not foresee that that this local problem would escalate and develop into the world’s first truly global financial crash and almost see the ending of the capitalist system as we know it. It was to cost unprecedented billions of pounds, euros, dollars and just about every other major currency in attempts to address the issue.
The Great War had a defined start and conclusion. It formally began with the Austro‐Hungarian declaration of war on Serbia on 28 July 1914, which then drew in other countries owing to a series of alliances between them. Hostilities formally ceased on Armistice Day on 11 November 1918. But despite that cessation of hostilities, not all the contentious issues were addressed at the ensuing Versailles peace conference. Many consider the outbreak of the Second World War two decades later to be a direct consequence of the flawed decisions made at Versailles (Strachan, 2001; Taylor, 1963).
Fast forward a century and the timing of the global financial crisis (GFC) cannot be quite so precisely stated. There was no single action or event that one can say triggered the crash, nor has there been a point in time – so far – when we can say that the crash is now finally behind us. We can certainly agree that not all financial hostilities have ceased, even a decade on, and we still remain years away from a complete return to normality. Austerity still lingers on for millions, and many governments are still printing money in an attempt to kick‐start growth while the living standards for those in the worst affected countries remain at depressed levels. And in a striking comparison with the Great War, one wonders whether decisions made in the heat of the financial battle will not create a lasting peace but merely represent unfinished business prior to another major financial crisis erupting.
The banks were at the forefront of criticism over the scale of the crisis – and justifiably so – with their lax underwriting standards and their ineffective weak response to the crisis. But at the heart of the problem was the banks’ interaction with commercial and residential property, their questionable lending practices, their almost casual disregard for risk and their creation of complex and barely understood financial products which pushed the risk out into an unsuspecting world.
This book seeks to lay bare the role of property – primarily commercial – in what became known as the global financial crash, explaining the rationale behind the banks’ lending decisions and highlighting the changing emphasis on property on the part of both investors and lenders. While many excellent books have been written extolling the faults of the banking system and exposing the gung‐ho policies of the bankers, fewer have looked at the specific role real estate played in the crash. This book addresses that omission.
This chapter begins by looking at how sub‐prime lending evolved and not only led to the demise of the lenders of this product in the United States but also brought the international banking system to its knees in the GFC. It then explains the historical commercial property market context to the banking collapse and in particular the dynamics and role of property cycles. The next section discusses the role of commercial property in the macroeconomy, highlighting the interaction between the two. In the following section, the emergence of investment short‐termism is considered with its potential consequences. The penultimate section explains some prerequisites for the analysis of property market trends presented in subsequent chapters. Finally, the book structure is explained in detail.
Sub‐prime Lending Enters the Financial Vocabulary
While the housing market downturn in the United States was the critical event which ultimately lead to the onset of the global financial crash, the residential property markets played a less significant role in the rest of the world. As we will read in later chapters, it was exposure to the commercial property markets and an over‐reliance on ‘wholesale’ funding via global capital markets that precipitated the crisis in the United Kingdom and other Western economies. However, to set the scene on the contributing factors to the global crash, it is important to explain why sub‐prime lending was such an issue and how problems in that market spilled over to the derivative markets and thence to the wider world.
Prior to 2007, few commentators beyond the United States had heard of the term ‘sub‐prime’. Events would soon propel the term into the forefront of common usage, but in a less than flattering way. Sub‐prime lending, at the outset, was the consequence of a genuine attempt to broaden the scope of mortgage provision in the United States and promote equal housing opportunities for all. Unfortunately in their quest to engage the wider population, lenders targeted more and more inappropriate customers: those with a poor credit history, those with job insecurity or even those without a job. Not for nothing were these loans called NINJA loans (no income nor job nor assets). It is useful to look at the US experience in some detail.
These sub‐prime mortgage loans generally took the form of a ‘2–28’ adjustable rate mortgage involving an initial ‘teaser’ mortgage rate for two years followed by a upward resetting of the mortgage rate for the remaining 28 years. The mortgages were sold on the premise of rising house prices and customers were offered the prospect of refinancing the mortgage (possibly with a mainstream lender) at the end of the initial two‐year period if they could demonstrate an improvement in their financial position and credit rating. Regular repayment would support the household to rebuild its credit rating. Not all could, of course, and borrowers in that category would remain on a sub‐prime mortgage but at considerably higher mortgage rates.
It was the sheer scale of the sub‐prime market that propelled the crisis into one of major proportions. Sub‐prime mortgages were relatively rare before the mid‐1990s but their use increased dramatically in the subsequent decade, accounting for almost 20% of the mortgage market over the period 2004–2006, and that percentage was considerably higher in some parts of the United States (Harvard University, 2008). But it was not just the volume of sub‐prime mortgages in force that was the problem: it was the number of mortgages which were due to have reset rates in 2007 and 2008. Not only would these mortgagees face higher rates from the reset but general interest rates were rising, compounding the problem.
Even before the full impact of the housing market downturn became evident, defaults on the sub‐prime loans were rising. By the end of 2006, there were 7.2 million families tied into a sub‐prime mortgage, and of them, one‐seventh were in default (Penman Brown, 2009). In the third quarter of 2007, sub‐prime mortgages accounted for only 6.9% of all mortgages in issue yet were responsible for 43% of all foreclosure filings which began in that quarter (Armstrong, 2007).
The effect on the US housing market was profound. Saddled with a rising number of mortgage defaults and consequential foreclosures by the lenders, house prices collapsed. Once these house price falls had become entrenched in the market, further defaults and foreclosures occurred in recently originated sub‐prime mortgages where the borrowers had assumed that perpetual house price increases would allow them to refinance their way out of the onerous loan terms. A growing number of borrowers who had taken out sub‐prime mortgages and/or second mortgages at the peak of the market with 100% mortgages found themselves carrying debt loads exceeding the values of their homes. In other words they had negative equity in their homes, meaning their homes were worth less than their mortgages, rendering refinancing impossible. It also made selling the homes difficult because the proceeds would fall short of outstanding debt, forcing the sellers to cover the shortfall out of other financial resources, which many did not have. If they tried to sell and were unable to make good the deficit, the loan was foreclosed and the house sold. Sub‐prime default rates had increased to 13% by the end of 2006 and to more than 17% by the end of 2007. Over the same period, sub‐prime loans in foreclosure also soared, almost tripling from a low of 3.3% in mid‐2005 to nearly 9% by the end of 2007 (Harvard University, 2010).
By September 2008, average US housing prices had declined by over 20% from their mid‐2006 peak. At the trough of the market in May 2009, that fall had increased to over 30% (Jones and Richardson, 2014). This major and unexpected decline resulted in many borrowers facing negative equity. Even by March 2008, an estimated 8.8 million borrowers – almost 11% of all homeowners – were in that category, a number that had increased to 12 million by the end of the year. By September 2010, 23% of all US homes were worth less than the mortgage loan (Wells Fargo, 2010). As the housing and mortgage markets began to unravel, questions were being asked about whether the damage would be confined to the housing market or whether it would spill over into the rest of the economy. No one knew at that stage just how the rest of the economy would suffer.
There was not long to wait for the answers to these questions. The reduction in house prices, bad as it was, had a consequential hit on the financial system through its impact on a process known as securitization that expanded significantly in the decade leading up to the GFC. Securitization involves the parceling together of many mortgages to underwrite the issue/sale of bonds to investors whose interest would be paid from the mortgage repayments. Securitization has three benefits for an issuing bank: it generates fee income by selling the resultant bonds to other institutions; it creates a secondary market out of what were illiquid mortgage assets; and, just as importantly, it moves these mortgages ‘off balance sheet’, which lowers the banks’ capital requirements. This in turn allows the income generated from the sale of the bonds to expand a bank’s lending.
Mortgage lending banks and companies sold bond packages of mortgages, known as residential mortgage‐backed securities (RMBSs), to whichever institution its marketing team could attract as a way of raising funds on the wholesale market. These purchasing institutions were not just US domestic institutions, they were global, and so the seeds of the global financial crash were sown. These securitized bonds were structured so that the default risks attaching to the underlying mortgage loan and the originating lender were transferred to the bond holder. To make them therefore more marketable bond issuers usually arranged further add‐ons in order to reduce the risk to the purchaser by improving the credit standing of the bond. These extras were default insurance providing credit enhancement. Incorporating these into the bond allows them to be granted a positive credit rating by specialist ratings agencies. This in turn allows companies to issue the bonds at lower interest rates, that is, at higher prices.
The purchasers of the bonds were provided with reassurance that the borrower would honour the obligation through additional collateral, a third‐party guarantee or, in this case, insurance. In the United States this was undertaken by guarantees from insurance companies known as ‘monoline insurers’ (the United States only permits insurers to insure one line of business, hence the term). Because of their specialism these companies were typically given the highest credit rating, AAA, defined as an exceptional degree of creditworthiness. These monoline companies provided guarantees to issuers. This credit enhancement resulted in the RMBS rating being raised to AAA because at that time the monoline insurers themselves were rated AAA. Any RMBS these insurers guaranteed inherited that same high rating, irrespective of the underlying composition of the security.
These practices were considered sufficient to ensure that default risks were fully covered, and during the boom years leading up to 2007 few investors paid much regard to the risks, anyway. By the end of 2006, these mortgage securitization practices were beginning to unravel. It was finally dawning on investors that their portfolios of sub‐prime mortgages and the derivatives created from them were not as ‘safe as houses’ and that they could well be sitting on significant financial losses. The truth was that sub‐prime lending was not adequately monitored in spite of many senior people at the Federal Reserve and the Treasury having commented that this was a disaster waiting to happen (Penman Brown, 2009). Indeed, consumer protection organizations and university sponsored studies had repeatedly produced critical surveys of the practice from as far back as 1995 (Penman Brown, 2009).
The security provided by default insurance also proved to be illusory. The size of this insurance market was huge and the insurers were undercapitalized. At the end of 2006, Fitch (one of the credit ratings agencies) estimated that the largest 10 monoline insurers had over $2.5 trillion of guarantee insurance on their books, compared with cumulative shareholder funds of less than $30 billion (Fitch Ratings, 2007). These figures included all insurance business and not just mortgage bond insurance, although the latter would have accounted for a sizeable proportion of the total. The reserves of the insurers were grossly inadequate to cope with the volume of claims that emerged from 2007. The result was that the confidence in many of these financial products that had been created was decimated and valuations collapsed. The resale market of these bonds became moribund and new sales impossible.
It had become apparent just how damaging the downturn in the US housing market had come to be, not just in terms of the human misery and hard cash of the American households affected but also for the banks. And it was not just the US financial institutions which were affected; the process of selling on these securitized bonds to any interested buyer had ensured that the risk was pushed out to the wider world. The RMBS structure resulted in a transfer of the credit risk from the originating lender to the end investor – a critical factor in the credit crunch that was to ensue. That transfer of risk would not have been quite so problematical were these end investors actually able to identify, assess and then quantify the risks. But such were the complexities of these securities that it was almost impossible for anyone to do so, and no one could differentiate between the ‘good’ and ‘bad’, so all were tainted.
We know now the recklessness of some of these securitization practices. In monetary terms, they proved to be far more serious and far‐reaching than the recession that could have resulted from merely a housing crisis. Not only did they magnify the extent of the problem but they moved the financial consequences away from the original players, turning the local US sub‐prime problem into one of global proportions. And the biggest concern of all was that the securitization processes embroiled hundreds of financial institutions, none of which actually knew what their exposures (or potential losses) were.
The Global Extension
When evidence of the financial crisis first emerged in the summer of 2007, followed by the collapse of the Northern Rock bank in the United Kingdom in the September of that year, many (in particular, Continental European commentators) believed that the crisis created in the United States was a problem that would be confined only to the United States and to the United Kingdom. For a while, European institutions and regulators denied the existence of any problems in their markets. But as evidence grew of the increasing nature of the troubles, particularly through widespread participation in the securitization markets, it became clear that few countries across the world would be unscathed from the financial fallout. In fact most European countries were affected as the GFC took hold.
In quick succession, the European Central Bank (ECB) was forced into injecting almost €100 billion into the markets to improve liquidity, a Saxony based bank was taken over and the Swiss bank UBS announced a $3.4 billion loss from sub‐prime related investments. The news from the United States was equally grim. Citigroup and Merrill Lynch both disclosed huge losses, forcing their chief executives to resign, while in a truly depressing end to 2007, Standard and Poors downgraded its investment rating of several monoline insurers, raising concerns that the insurers would not be able to settle claims. If anyone had any doubts as to the severity of the crisis, the events in the closing months of 2007 surely laid them bare. The banking authorities responded by taking synchronized action. The US Federal Reserve, the ECB and the central banks of the United Kingdom, Canada and Switzerland announced that they would provide loans to lower interest rates and ease the availability of credit (see Chapter 3 for how the story subsequently unfolded).
The later, but connected, sovereign debt problems encountered, initially and most severely, by Greece, but also by Portugal, Italy, Ireland and Spain, were a direct consequence of the crash. At the time of writing, the Greek debt crisis remains unresolved despite the harsh austerity demanded by the ‘troika’ (the European Commission, the IMF and the ECB) in exchange for the release of ‘bailout’ funds. The Greek economy in 2016 had shrunk by quarter from its pre‐GFC level and unemployment was 24% after three funding bailouts. At the same time the nation’s debt continues to grow (Elliot, 2016).
Commercial Property Market Context
The GFC is at the core of the book, with a focus on the associated commercial property boom in the lead up to the crisis and the subsequent bust, including the role of the banks and its consequences. The book takes an international perspective but draws heavily on the UK experience. This section sets the scene by considering the historical commercial property market context, including property’s role as an investment and the significance and dynamics of cycles.
Traditionally, commercial property was regarded as primarily a place to conduct business. It was only in the 1950s that commercial property became a key investment medium (Scott, 1996; Jones, 2018). By the early 1970s, the commercial property investment sector consisted of not much more than city centre shops and offices, town shopping centres and industrial units which accommodated the many manufacturing operations around the country. These segments reflected the localities and premises of conducting business at that time. But the nature of cities was about to see a dramatic upheaval.
The period from the mid‐1970s onwards witnessed major economic changes in the United Kingdom, seen in the decline of manufacturing and the growth of services and a major urban development cycle stimulated by the growth of car usage and new information communication technologies (ICTs). This led to the rise of alternative out‐of‐town retailing locations and formats such as retail warehouses along with the advent of retail distribution hubs and leisure outlets (Jones, 2009). Developments in ICT in particular have resulted in the obsolescence of older offices, replacement demand and provided greater locational flexibility (Jones, 2013). These changes brought property investors new classifications of property, such as retail warehouses and retail parks, out‐of‐town shopping centres, distribution warehouses and out‐of‐town office parks. Many firms, both large and small, also elected to invest cash flow into their business activities rather than in the bricks and mortar supporting them by effecting sale and leaseback deals or even full sale of their premises, thereby providing further opportunities for outside investment in property assets.
Property as an investment class differs from the mainstream classes of equities and bonds on several counts, one of which is its liquidity, or more precisely, its lack of liquidity. Unlike its equity and bond cousins, transactions in which can be completed at times almost instantly, buying and selling property (both residential and commercial) can take an age. Equally, it is not easy to switch off the development pipeline when conditions deteriorate. At times these two attributes do not lie easily with investors, and they often give rise to extremely volatile investment performance and cycles. This volatility was never more evident than during the run up to the global financial crash and during the subsequent bust. But that commercial property boom and bust period was not the first in recent memory, nor will it be the last!
Commercial property has a long history of cycles. Much of property’s volatility is down to variations of supply and demand during an economic cycle. In times of economic growth and when confidence is high, occupational demand for new space rises, which in turn pushes up rents because of lack of suitable supply. This in turn attracts investors and stimulates new development, but because of development time lags continuing shortages see further rises in rents and capital values. However, as has been the way over much of the past, if too much new development (particularly of a speculative nature) coincides with an economic slowdown or a recession, these new buildings fail to find tenants and so the next property downturn begins (Barras, 1994; Jones, 2013).
Investment activity and the variability in the accessibility of finance is a critical element in this classic model of a property cycle. The ready availability of borrowing and equity capital amplifies the upturn supported by relaxed lending criteria that enables investors by being highly geared to make large profits. The availability of credit also contributes to stimulating speculative bubble effects that inflate capital values and transaction activity. Liquidity in the property market increases during this period with rising values and positive investment sentiment, so that selling will be relatively easier, encouraging profit taking (Collett, Lizieri and Ward, 2003; Jones, Livingstone and Dunse, 2016). Some, at least, of the initial unwilling sellers will be assuaged by the rising values. The downturn is similarly exaggerated as banks become more risk averse as properties they have funded in the boom lie empty and hence property developers default on their loans. The consequence is that there is a famine of credit for a number of years following the downturn (Jones, 2013, 2018).
An important dimension of investment is the relationship between gearing, risk and return. The concept of gearing, called leverage in the United States, is basically using other people’s money to invest and make a profit, or to be more precise, borrowing other people’s money to invest. This is a key concept in explaining the dynamics of a commercial property cycle.
Two types of gearing can be distinguished – income and capital. Income gearing relates to the proportion of trading profit accounted for by interest on loans. Capital gearing measures the proportion of total capital employed that is debt capital. The two are clearly related as higher capital gearing means greater interest payments. Essentially, if an investor is highly geared, when the economy/property market is growing and interest rates are relatively low, the returns will be high. However, the investor’s position changes dramatically when the economy/market turns down as the gearing effect is magnified in the reverse direction, and profits are often turned into losses. The chapter now reviews property cycles in practice, beginning with a detailed examination of the United Kingdom, where they are well documented, before then considering the wider global context.
Past UK Experience
In the United Kingdom there have been a number of boom and busts since the Second World War. A significant property boom occurred in the 1950s with Britain in critical need of new commercial premises following the devastation of the war. With the physical rebuilding of the country, the United Kingdom was also moving away from an economy rooted in heavy engineering to one more linked to the service sector. New office space was urgently needed, especially in London, and to a lesser extent modern retail space was also in short supply. In the initial years of this boom there was little development risk as bomb sites were plentiful, contracts were invariably tendered on a fixed price basis and both interest rates and inflation were low, while on completion there was a high demand for office and retail space.
Developers typically obtained short‐term finance for the site purchase and for the cost of construction from the major banks (who equally regarded this form of lending as virtually risk free). Once the property was completed and let, the developers generally replaced the short‐term finance with longer term fixed‐rate finance from the insurance companies. As explained in Chapter 3, the banking model at that time focused on the provision of short‐term finance only, hence the requirement to look elsewhere for this longer term finance. At that time, the rental income of completed properties was typically above the cost of borrowing, so these projects were mainly self‐financing. In the early years, development profits were generally high as development gains were free from tax (Fraser, 1993; Jones, 2018).
The construction boom lasted for almost a decade, but this highly profitable period for the developers came to a natural conclusion at the beginning of the 1960s. The low barriers to entry attracted a raft of new players, increasing competition for the dwindling stock of available sites, which increased acquisition costs and lowered profits. The changing balance between supply and demand also brought an end to the excessive profits. A recession in 1962 further cut demand, and the office development boom in London was brought to an end two years later when Harold Wilson’s new Labour government banned any further development in the Greater London area (Marriott, 1967). The advent of higher inflation also bid up construction costs and ultimately changed the dynamics of investing in commercial property during the 1960s.
As inflation became entrenched, lease lengths and more importantly rent review periods were reduced, in stages, to five years, which became the norm in the United Kingdom for decades to come. So inflation brought the prospect of future increases in rental income from an investment in commercial property at periodic rent reviews. It altered the nature of commercial property from a fixed‐income to an equity‐type investment (Fraser, 1993). This changed the attitude of the life assurers. They had been merely passively involved in providing long‐term finance, but now they wanted a stake in the upside; that is to say, they started to take an equity stake in the entire development project. From that position, it was but a small step to undertaking the entire development project alone and even to broadening their exposure by directly investing in any form of commercial property. It was the beginning of life assurance funds acting as both financiers to and direct investors into commercial property (Fraser, 1993).
In the early 1970s the liberalization of the financial markets (which are referred to in depth in Chapter 2), rapid economic growth and the expectation of membership of the European Economic Community (now the European Union) in 1973 brought about significant increased demand for office space, and not just in London. Obtaining accurate commercial property data for that period is not easy, but average commercial property values are reported to have increased by over 23% in both 1972 and 1973, with office properties delivering by far the greatest growth (MSCI/IPD, 2014a). Fraser (1993) notes that the increases in values during this period far exceeded those of any year within living memory. That may well be so, and certainly, no nominal capital value rise in any calendar year since has ever exceeded those witnessed over 40 years ago. Even stripping out inflation reveals that the real rates of capital growth were pretty exceptional too. Real capital growth, as shown in Figure 1.1, in 1972 and 1973 was 14.8% and 11.4% respectively (MSCI/IPD, 2014a). The 1972 real capital growth figure has since been exceeded just the once at the peak of another boom in 1988.
Figure 1.1 Nominal and real capital value growth 1971–1977.
Source: MSCI/IPD (2014a). Reproduced with permission.
With economic fundamentals positive during these boom years there was rising tenant demand justifying the invigorated investor interest in the asset class. However, the boom was the first one in the United Kingdom to have been markedly affected by the use of debt to support investment (a topic that is further explored in Chapter 3). From 1967, the flow of funds into property increased substantially until 1973 (which also was the peak year of growth in property capital values and in the country’s GDP) but then reversed quickly as a recession impacted. It is intriguing to note that although property companies were net disinvestors from 1974, financial institutions such as life assurance companies were actually still investing (Fraser, 1993). That dichotomy is not as strange as one may initially think. The life assurance funds and pension funds were in the midst of strong fund inflows at the time, so strong in fact that even cutting the overall allocations to the commercial property asset still resulted in funds being invested in property. Equally, these institutional funds, which used less debt (if any) to assist purchasing, were also not under the same selling pressure as the property companies were when the property market turned. We look into the position of the life assurers in more detail in Chapters 2 and 3.
The property bust came as UK inflation reached 20%, the balance of payments continued to deteriorate and there was a series of sterling crises. A new Labour government was forced to obtain a loan from the IMF and hike interest rates. Coupled with a tight fiscal policy, there were sharp falls in the stock market and in commercial and residential property values. Banks’ balance sheets were weakened, particularly those whose assets were secured on property. And in a striking resemblance to events more than 30 years later, bank deposits began to be withdrawn in what became known as the ‘secondary banking crisis’, which is considered in more detail in Chapter 2 (Fraser, 1993).
Property companies were faced with rising debt interest payments as interest rates rose coupled with at best static income as the overheating economy contracted by a cumulative 4% over the two years from 1973. Many highly indebted property companies were forced to sell to address their debts. Much of these companies’ debt had been borrowed from what was known as the secondary banking sector, whose future was by then looking precarious. Not only were these property companies unable to obtain new loans, they were faced with the difficult task of either having to refinance maturing loans or having to sell property in order to remain solvent. As more and more property was placed on the market, buoyant 1973 gave way to an altogether different couple of years. A hard landing was the inevitable consequence (Fraser, 1993).
In nominal terms, the fall in commercial property values was recorded only over one calendar year (1974, when average values fell by 18%). But in inflation‐adjusted terms, the downturn was much more acute, covering three years (1974–1976) and cutting values by an inflation‐adjusted 49% (see Figure 1.1). In all likelihood, the actual duration of the fall would have been longer and its magnitude would certainly have been even more acute had more frequent valuation data been available then, rather than only the annual figures. Nevertheless, the above 49% fall in real capital value was just as severe as seen in the commercial property crash of 2007–2009 (MSCI /IPD, 2014a).
