Tony Edgley at Jones Lang LaSalle discusses the increasing relevance of real estate debt market transparency
The Transparency of Commercial Real Estate Debt Markets
Rankings:
- Australia, Ireland and Canada have the most consistent and thorough CRE debt regulations
- MENA scored lowest on data availability
- Europe has the highest score for both lending regulations and data availability
- Latin America performs the worst on lending regulations
- Asia earns higher transparency scores than Latin America or MENA but lower than Europe or North America
The massive financial crisis that hit the global economy in 2008 profoundly affected the real estate debt markets. Commercial real estate (CRE) debt was both a contributing factor and a target of the crisis. For example, the collapse of Lehman Brothers was, in part, due to its sizeable and highly-leveraged CRE debt portfolio. These holdings lost significant value causing Lehman’s counterparties to question the investment bank’s solvency—ultimately leading to its demise. More recently, The Bank of Spain has announced that it will have to use nearly €100 billion to inject capital into and restructure the 45 Cajas, a banking sector that heavily financed both residential and commercial property during the credit bubble. Like many other announcements about troubled property loans over the last two years, this news has caused shock waves that have reverberated around the world’s financial markets.
In an effort to understand how two of the core themes of transparency—information flows and consistent regulatory oversight—apply to CRE debt markets, Jones Lang LaSalle has added two debt-related scores to the 2010 Index. One question evaluates the breadth and depth of data available on CRE debt, including: amount and type of loans made each year, debt maturities, legacy loan profiles, delinquency and default rates, and types of collateral. The other examines how well CRE lending risks are monitored by regulators of financial institutions, including banks and life insurance companies. It should be noted that these new questions do not directly address the transparency of the broader debt securitisation process, which was almost entirely shut down in many countries for nearly two years. Nor do they address the regulation and transparency of proprietary trading at financial institutions (such as Lehman) and hedge funds, which hold highly-structured CRE debt instruments, like mezzanine loans or subordinate tranches of CMBS, for investment purposes. Without doubt these forces were at play during the financial crisis. Nevertheless, these new scores do address basic aspects of real estate debt transparency, which presumably would be useful to both investment firms and regulators. The scoring of the debt-related questions reveals these broad trends:
- The average transparency score for the role of real estate lending regulators is higher than the average score for the availability of CRE debt data. In other words, regulators in many countries are/were doing a reasonably good job monitoring collateral values and changes in cashflow relating to CRE loan quality. In retrospect, a large part of the CRE credit crisis appears to be linked to the fact that regulators in many countries did not have supervisory authority for loans that were securitised. Moreover, information on CRE debt is not generally available to the broader marketplace in many countries.
- In a parallel trend to the overall transparency scores, levels of debt transparency vary greatly between regions as well as between developed and developing countries. In many developed countries, the regulatory oversight process achieves reasonably high scores. But, the scores on the availability of information on CRE debt markets do not. In less developed countries, scores on both attributes are in the Semi-Transparent range, or lower.
Data Availability for CRE Debt Markets
Scores for real estate lending regulations are generally higher than scores for data availability on real estate debt markets because data collection has been slower to develop than financial regulation. Basel II was implemented in 1989 and although it did not mandate regulations among banks in the world, it did provide bank regulators with a framework that could be implemented if the country regulators so desired. In contrast, data collection and dissemination for real estate debt has been slow to develop. Many of the countries that do not have real estate debt time-series data are also without time-series data on real estate market fundamentals or performance benchmarks. In many developing economies, data collection is a lower priority relative to more basic transparency issues, such as establishing property rights and enforcing contracts. Furthermore, in the absence of well-developed secondary markets, many countries have no reason to collect and publish data on CRE debt as loans are not traded, and are usually held to maturity. In other markets, like many in Latin America, debt is not widely available for financing commercial properties so, of course, very little information exists on the sector.
Although extensive real estate debt market data exists in the United States, Canada, and Ireland (all scoring a ‘1’), this is not true in many other Highly Transparent countries. Just over 89% of countries received a score of Semi-Transparent or below on this question. Even top-ranked, Highly Transparent countries such as France, New Zealand, and Germany struggle to provide market participants with a data time-series on real estate debt outstanding, maturities and originations. Perhaps this lack of data in some of the world’s most highly transparent countries has contributed to a lack of understanding on the real estate debt market. Simply put, it is hard for market participants to factor information they do not have into prices.
Despite having plentiful information on its CRE debt market, the United States and the United Kingdom were both at the centre of the financial crisis. This raises questions about the link between real estate debt transparency and the availability of data on real estate debt markets. Real estate debt data informs market participants of capital flows (originations, outstanding, maturities) and of credit characteristics (debt coverage, loan-to-value, delinquency and default rates). While much of it was used to understand correlations and default probabilities when structuring commercial mortgage-backed securities (CMBS), it was not used to prevent lax underwriting or correctly adjust for periods of severe economic downturns when asset returns move closely together causing correlations to rise. Plentiful data does not eliminate risk. The Anglo-American experience shows that in the world of debt, plentiful data may have encouraged financial engineering, like debt securitisation, which actually raised volatility in real estate markets. The self-regulating nature of fully-disclosed debt data broke down when highly complex structures masked the characteristics of the underlying loans.
Financial Regulation of Lending
The countries with the highest scores for consistent and thorough CRE debt regulation are Australia, Ireland and Canada. This question followed a more normal distribution than the data availability question—57% of countries scored either a ‘2’ or a ‘3’. However, with only four countries scoring a ‘1’, it is clear that many well-developed countries struggle to achieve highly transparent real estate lending regulations. The United States and the United Kingdom did not score a ‘1’ on the lending regulations question. By contrast, countries that remained relatively unscathed from the crisis such as Australia and Canada scored very well. However, the monitoring of whole loan lending practices is not the only important aspect of a country’s CRE debt transparency. Securitised debt raises new disclosure and regulatory challenges. If the Securities and Exchange Commission (SEC) had been monitoring Lehman Brothers sizeable concentration of mezzanine loans and B-notes (subordinate tranches of securitised debt) properly, perhaps it would have flagged Lehman’s problems before the bank reached crisis mode.
Banking Crises and Financial Regulation Transparency
During the 2005-2007 credit bubble, new sources of real estate debt were made available across a wide variety of lending institutions—banks, life insurance companies, credit unions, and other non-bank financiers. However, extensive academic work has been undertaken on banking crises and there is a strong relationship between banking crises and the quality of lending regulations in a country. Sometimes this relationship appears counterintuitive with countries that have recently experienced a banking crisis having, on average, more lending regulations than those that have not. Banking crises occur in both developing and developed countries but a disproportionate number of banking crises occur in developing countries.1 Real estate debt analysts will need to watch how Basel III unfolds in helping to regulate CRE lending across the world. The latest proposals from the Basel Committee (known as Basel III) will require banks to maintain a core capital ratio of 6%, to become strict on their definition of ‘Tier 1’ capital, to meet liquidity coverage ratios, and to reduce the counterparty risk associated with derivatives and repurchase agreements. If any of these proposals are implemented across the world’s lending institutions over the coming years, then the transparency surrounding CRE banking regulations will certainly change.
Developed vs. Developing Countries
Developed countries score better on the lending regulations and data availability question than their developing country counterparts. However this finding is not particularly insightful alone. The largest disparity between developed and developing countries is on the lending regulations question. As Carmen Reinhart and Kenneth Rogoff note in their book This Time is Different: Eight Centuries of Financial Folly, developed countries faced banking challenges many centuries ago during their economic developmental stage. After centuries of learning, developed countries have implemented tougher banking regulations.2 On the data availability question, many developed countries have no single organisation responsible for gathering time-series data on mortgages outstanding, originations, and maturities.
Regional Findings
There are also regional differences in regards to the transparency of debt markets. MENA has the lowest average score on data availability. In Dubai, the Nakheel Group failed to make its debt service payments on Dubai World in 2009, and ever since, the region has been rethinking how real estate properties should be financed. A debt restructuring proposal for Dubai World has been released which addresses how the government will deal with the excessive debt as well as the oversupply of property resulting from the severe overbuilding of the past eight years. Although this proposal represents progress, most real estate debt in the region has been downgraded, especially in Dubai.
Europe has the highest average score for both lending regulations and data availability. The developed countries in Europe have had centuries of practice in refining lending regulations. Within the European Union, Ireland has been a leader in addressing its real estate debt problems, principally through the government-created National Asset Management Agency (NAMA). This workout vehicle has been designed to acquire good and bad loans from participating institutions, and with its implementation, there is now full disclosure of property level loans and regular reports on the performance of these loans. Also scoring well on debt transparency is Sweden where, following the crisis of its banking system in the 1990s, controls on lending have been tightened and the government systematically tracks lending to property.
Latin America performs the worst on the lending regulations question as most countries do not have a competitive debt market for financing commercial real estate properties. Debt in Latin America is often onerously expensive or non-recourse debt does not exist. For example, in Brazil, banks rarely make non-recourse loans to real estate. In Mexico, commercial banks have just started to finance commercial real estate properties; historically, much of the financing has come from major non-bank financiers like GE Capital. In Argentina, debt is almost non-existent for real estate properties. In Reinhart and Rogoff’s book, it is interesting to note that Latin American countries have spent a large amount of time in sovereign debt default since independence. Although not pointedly conclusive, this fact does help shed some light on why Latin America does not have the most sophisticated, functioning debt market. Perhaps investors find lending money in the region too risky given the history of default.
CRE debt in Asia earns higher transparency scores than Latin America or MENA, but lower than Europe or North America. The People’s Bank of China has announced several different rounds of new regulations regarding CRE and residential debt in the last several months. These new regulations are examples of the important role that the government plays in monitoring debt flows to real estate across Asia. Japan, South Korea and many other Asian countries have also tightened regulations on CRE lending, a result of past crises set off by lax commercial and residential real estate lending practices.
Debt Transparency is a Complex Issue
As we discovered when we set out to add debt transparency to the 2010 GRETI, there are many different ways to evaluate real estate debt transparency. The new country scores address some of the most basic aspects of whole loan transparency in a complex market that now includes securitised and highly structured debt. In the aftermath of the financial crisis, the importance of understanding CRE debt markets and how they are regulated became clear. The GRETI 2010 finds that the amount of data available on real estate debt markets is limited in nearly all countries, but has still been used by rating agencies and investment banks to structure CMBS and to evaluate loan quality. This may explain why so many real estate loans ran into trouble. By contrast, many developed countries have scored reasonably well in terms of lending regulations, even though there has been little regulation of the securitisation process and little holistic risk management of the financial system.