Occasional Paper-commercial Real Estate

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UTI BANKRisk Department

Central Office

SVP( Risk ) :

VP( Risk ) :

OCCASSIONAL PAPER : 29th November 2006

Understanding the dynamics of commercial real estate marketsEmpirical findings

Abstract :

In this paper, we attempt to review relevant research literature on real estatemarkets in particular commercial real estate to understand stylized facts oncommercial real estate assets, their pricing, demand supply dynamics, their financingand risk issues to lenders. This study is motivated by the growing importance ofcommercial real estate segment in India both to investors and banking industry interms of their increased exposures.

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Background

Real estate investments have emerged as a specific asset class on account ofgrowing urbanization and housing demand across the globe. Changing geographies,economic growth and townships have contributed to a an asset class such as realestate.

Global markets for Real Estate differ in terms of their structural features,performance and risk dimensions across countries. Market reports as of FY2006report the size and maturity of major markets as below :-

Real Estate markets Journal of Real Estate Research

Region Market Size % of marketmaturitylevels.

Americas USD 4 trillion 91%

Europe USD 2.4 Trillion 51%Asia Pacific USD 1.4Trillion 72%

Maturity indicates that the availability of market information, marketliquidity, political stability , financial market institutions , legalframework and transparency.Overall annual returns in direct real estate segment ranged between 8.8% to 12.9%across Europe and US.

Current trends in real estate across the above markets can be briefly traced asunder:-

Europe: Europe accounts for 37% of the global real estate market, 20% of the listedreal estate market and only 15% of the global REIT markets. Although Germany is thelargest European real estate market aggregating to USD 911 billion investible stock,it has one of the smallest listed real estate markets. However, as per change inlegislation across Europe, property companies are being compulsorily made toconvert themselves into REITs. Such structural changes are expected to increase thelisted real estate portfolio as a percentage of the total portfolio. Although overalleconomic growth in Europe appears weak, the retail market continues to performwell thereby impacting rents on a positive side. Western European countries expectrentals to recover and be on the rise given that the increase in occupancy rates. Alsowith the current spread between capitalization rates and cost of financing real estatevery narrow, it appears that rentals will recover during the current fiscal.

Asia Pacific: With growing exports, investment and domestic demand, rising wagesand increased retail spending, economic growth in Asia Pacific is reported to continueto be strong for the coming years. The Asian real estate markets such as Singapore,Hong Kong and Japan have grown by 8,10 and 5 times respectively over last threeyears. Much of this growth can be attributed to relaxation in FDI in this segment,establishment of REITs and increased liquidity and transparency. Economic growthlies at the heart of many real estate opportunities across the Asian region.

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In case of India, with domestic investment and consumer spending growing withoverall economic growth, the demand for quality real estate most particularly inresidential, retail space and other commercial segments is high, whereas the supplyof such quality stock is lagging behind. This demand supply imbalance is creatingsignificant opportunities in this region with prices of commercial real estateincreasing.

According to RREEF (Real Estate Research division of Deutsche Bank A.G.) as againstthe global backdrop, the level of activity in Indian real estate markets has over thelast three years shown an exponential growth. Total stock of commercial real estateworth in India is estimated at USD 300 billion of which USD 83 billion is suitable forinvestment products. However, market sources peg investment so far at USD 4billion. Also it is reported that the current growth rate in real estate investment is at30% per annum which is very high. In terms pattern of financing, around 61% of theproperty being financed is through debt while the rest 30% is by way of equity. Debtfinancing is predominantly through bank loans and this component has grown thefastest. Recent Deutsche bank research expects strong growth potential in all realestate segments with commercial real estate portfolio to grow by USD 66 billion andbe worth USD 366 billion by 2010.

For Indian cities demand is likely to continue to remain strong for good quality officespace. Given the shortage of good quality office space, given the quality of goodquality supply, positive rental growth is expected to continue over the forecastperiod, albeit at more moderate levels than seen in the last few years. Strongerrental growth is expected in the range of second tier cities that are experiencinglower levels of new supply than tier-one cities such as Mumbai.

A snap shot of the Asian Real Estate Markets vs other Mature markets is presentedbelow:

Country Total Real EstateInvestment USD

Billion

% of Investments throughlisted property REIT type

structuresJapan 900 13%

Hongkong 180 39%

Australia 144 58%S Korea 77 1%

Singapore 36 61%India 25 Less than 1%

Taiwan 16 21%Malaysia 11 65%

Germany 605 1%UK 662 10%

USA 3500 More than 80%

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Bank lending and real estate exposure

Real Estate Exposure of Banks as a percentage of total credit has increased steeplyfrom 0.40% of the credit book to 1.80% of the total credit book as on FY 2006. It isimportant to note that as compared to levels of Banking system exposure to RealEstate during the Asian Crisis which was around 40 to 56% of the total creditdeployment, the proportion of exposure of Indian Banks to this segment is very less.

The major drivers to real estate activity has been, growing industrial requirements forcommercial space, increased demand for commercial space for Retail shoppingformats due to rise in retail spending including dwelling and investment demand forhousing from the salaried class. However, the concerns surrounding real estate

activity is on the steep rise in prices of commercial and residential real estate. As themacro and regional economic growth has been on the rise over past three years,structural changes such as increased consumer spending in life style, retailpurchases and also search for quality residential requirements, townships, etc. haspushed up the demand for real estate. Although demand has increased during theshort run, supply of quality residential and commercial real estate lags far behindresulting in the steep rise in prices.

Special aspects of commercial real estate market:

Although overall real estate exposure of the Indian Banking system is on the rise,expectations of a price bubble and heated economic activity in the commercial

segment is of critical concern. Therefore a review of stylized facts pertaining togeneric risks associated commercial property segment will be of interest prior toraising concerns about the real estate lending by Banks in the Indian context.

Commercial property market has a number of distinctive features relative to otherasset markets. These include heterogeneous supply, the absence of central tradingmarket, infrequent trades, high transaction costs, lack of price transparency owing tothe role of bilateral negotiations, rigid constrained supply and the use of real estateas collateral for lending. Contracts underlying commercial property are generally oflong term in nature and have a two fold reliance on external finance : short termfinance to cover the construction phase and long term finance to fund the operationsduring the occupancy period. Although equity financing is feasible, generally thecommercial real estate properties are debt financed.

Based upon applied research findings in the real estate segment, a detaileddiscussion of specific aspects of commercial real estate markets is presented below.

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Economic aspects of commercial real estate

Demand Supply dynamics :- The market demand function for commercial real

estate depends upon a) the number of optimistic buyers b) the reservation priceperceived by the investors/purchasers c) borrowing capacity of these buyers d) thelending attitude of Banks and financial institutions.

Supply side :- On the supply side of commercial real estate, the major influencingfactors empirically observed are a) the stock of near to or completed newconstruction(which would have commenced in an earlier period),the depreciation rate. The supplyside dynamics is viewed to be more of an adjustment function and is usually laggedas compared to the demand growth. The new investment component is in turn afunction of bank lending for new construction projects which is influenced by theborrowers endowment, interest rate, current prices of property and the lendingattitude of banks.

Bank lending channel Linkage with commercial real estate

Bank lending channel is a major influencing factor of demand and supply forces forcommercial real estate. Therefore bank lending to commercial real estate segmenthas implications for property prices and also for the cyclicality of real estate Weexplore some specific aspects of these linkages in this section.

Bank Lending : At first property prices affect the volume of bank credit for variousreasons. From the borrowers point of view, changes in property prices are expectedto have an impact on their wealth and their borrowing capacity inducing them tochange their borrowing plans. This pushes the credit demand by borrowers during

rising property prices.

Banks are involved not only in direct lending in real estate but also providing loansagainst collaterals involving property. Lending to property companies alone isinfluenced by this collateralization apart from the cash flow argument. Many acorporate with adequate reserve assets as property reduce the cost of externalfinancing by leveraging on commercial real estate assets during times of increasingproperty prices. It is generally observed that Banks are willing to provide moreproperty related loans at cheaper terms when property prices are higher, therebygenerating a propagating mechanism through which property and credit cycles arestrongly linked with each other.

Changes in credit availability and lending attitudes have a sizeable impact on thedemand for real estate and investment decisions on new construction, which willultimately lead to changes in property prices. It has been widely documented byvarious researchers that capital seeking investment opportunities and thecompetition among financial institutions after financial deregulation helped tostimulate the building frenzy phenomenon in a number of countries in the 1980s to1990s.

Due to lack of time series data available in commercial real estate segment, most ofthe empirical work on bank lending and its impact on property prices have beenbased upon housing price data. Country specific research reveal strong evidence of

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dynamic interaction between house prices and bank lending in Hong Kong, theNetherlands and United States . It is observed that in the short run, there issignificant two way interaction between house prices and bank lending where as inthe long run, the causality is from house prices to bank lending.

It is clear from the above that property prices and credit growth are interlinked

strongly.

Real estate Cycles : Commercial real estate cycles and credit cycles are driven bythe same economic factors. On the one hand credit cycle behaviour is largelydetermined by economic conditions and prospects ( GDP and interest rateexpectations). In the short run, the supply of commercial property is fixed and in thelong run, the supply adjusts gradually because of lags in the delivery of newconstruction and also obtaining licenses for development of land for additional supplyof commercial space.

Due to the supply lag and also because commercial real estate asset ispredominantly financed by banks, commercial property prices are linked to futureexpectations of returns. Further commercial property prices adjust quickly to anychanges in return expectations. As return expectations are dependent upon commoneconomic factors such as GDP growth, interest rates, vacancy rates etc, commercialproperty prices are also subject to the vicissitudes of business cycles.

The anatomy of a real estate cycle generally exhibits the following pattern:-

Supply of commercial property is fixed in the short run. Therefore wheneconomic growth and utility demand for commercial real estate increase suchthat reservation price ( the perceived price for utility of the property) is morethan the current price of real estate, builders tend to initiate newdevelopment/construction by availing bank borrowings.

While demand keeps increasing, the supply curve adjusts with a lag due totime taken to obtain approvals and deliver the new property. The pressure onprice therefore is high.

Research findings indicate that investment decisions show a high degree ofdependence on current prices rather than future property prices.

At first adaptive expectations induce bankers and investors to extrapolate thecurrent property price assuming that past growth rates to be maintained inthe future. Therefore there is tendency to determine future property pricesbased on current prices.

During a buoyant period, higher property prices as mentioned earlier causesincreased bank lending due to comfort of collateral value. Although it is

difficult to segregate the bank lending to purchase of property and that fordevelopment of the same and their lagged impacts on price of property, it isgenerally believed that increased bank lending for purchase of propertypushes demand and thereby prices as supply although equally financed bybanks adjusts only after a lag. Therefore bank lending on the supply sideresults is delivery only in medium to long run thereby depressing prices atthat time. The difficulty for lending institutions to adjust their lending forpurchase of property in accordance with actual percentage of completion ofreal estate projects and the resulting short term supply, there is a scope forcyclical fluctuations.

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Other explanation to volatile property prices/asset bubbles is in the context offinancial liberalization. In many cases financial liberalization causes increasedcompetition among lenders which in also increases the quantum of creditavailable to investors and therefore price climb. The boom period could lastlonger if increase in property prices encourage inflows of foreign capital.

However when the impact of building frenzy starts kicking in and the supplyof new construction cannot be absorbed, property price start falling. Giventhat bank credit is sensitive to property price movements, subsequentrationing cause the contraction of the cycle.

Empirical studies establish strong links of credit to commercial propertyacross countries that experienced crises linked to property losses. Throughthe period 1985 to 1995

Conceptual model of real estate dynamics

Conceptual model of real estate dynamics can be summarized by a generic structuralequation model as below

Dt = N[1-f(PT)]. L[Yt,i t,Pt,Wt] where Ly>0, Li0

Pt

Kt=(1-)Kt-1+It-1It-1=. t-1(Yt-1,i t-1,Pt-1,Wt-1)y>0,I0

Dt=Kt

D- Demandfor commercial realestateN= No of borrowersP= property priceF(P)= cumulative distribution function of reservation prices.L= borrowing capacity of investors

Y= income proxied by real GDP.i= Interest rateW= lending attitudeK=adjustment function of the stock of market supply of buildings.

= depreciation rateI= completed new construction.

=new construction financing by banks.

The capacity to borrow ( of investors ) is an increasing function of real income, andproperty prices but an decreasing function of interest rates. The financing of newconstruction by lenders is an increasing function of real GDP growth and propertyprices by a decreasing function of interest rates.

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Risk issues in Analyzing Real Estate A Lenders perspective

In addition to the above generic economic aspects of commercial real estatesegment, lenders concern surround the effect of financial accelerator on asset prices.

Financial accelerator mechanism-Implication for asset price :-

The financial accelerator mechanism essentially is the linkage between bank creditand asset pricing. During a growth phase, increased credit towards purchase ofproperty and development, pushes property prices up. As mentioned earlier, banksare willing to provide more property related loans at relatively relaxed terms andconditions by basing their decisions on higher values of collateral. This implies thatbanks become less concerned about adverse selection and moral hazard problemsduring the upswing. This myopic lending approach although applies to all types oflending is more pronounced in case of real estate due to the influence of collateralvalues. The financial accelerator channel becomes more amplified and can drive theasset price bubble if banks tend to underestimate the default risk of property relatedloans while borrowers subject themselves to a moral hazard by trying to leverage

their property values ( by offering them as collateral) to reduce the cost of externalfinance. Empirical research studies report that countries where borrowing constraintsare higher, the impact of financial accelerator mechanism on real estate asset pricesis also high. This why it is reported that firms facing higher borrowing constraintsgenerally show higher sensitivity to changes in net worth ( due to higher prices ofreal estate ) resulting in investment spending based upon real estate collateral.

Opaqueness of supply side situation :

Lenders often are left with paucity of data in respect of actual proportion ofcompletion of commercial real estate space irrespective of the segment of interest.Unlike manufacturing industry where some level of macro metrics are available oninstalled capacity, operating rates and the current stocking levels, real estate being

regional and local in its dynamics despite common economic factors that drive itsoverall growth does not enable collection of this data. In emerging markets thisopaqueness is even more severe leading to errors in expectations of demand, rentalsand supply side adjustments.

Therefore banks base their lending decisions on current price levels andextrapolation there of which may not be sensitized to possible supply demandadjustments in the currency of the exposure. Therefore future projections about realestate trends have a great deal of uncertainty.

Underwriting Standards :

Differentiation factors as between banks and financial institutions that survived thereal estate cycles in the US and other parts of developed markets were a)conservative underwriting standards and b) the ability to retain those standards oflending despite stiff competition in credit markets in the property segment. Webriefly discuss some of the critical credit risk metrics used to set underwritingstandards by different banks internationally.

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The basic purpose of setting underwriting standards is to assess the probability ofdefault and correspondingly enable pricing the risk.

Conceptually the Default Risk can be defined as a function of the following

),,,( NOIDSCRLTVfPD=

PD- default probability is a function of LTV-loan to Value ratio.DSCR-Debt service coverage ratioNOI- Net Operating Income.

-Set of other variables that contribute to default risk.

Loan to Value Ratio ( LTV) :

The LTV ratio measures the equity participation required of borrowers in projects. LTVis endogenous to the loan underwriting process and lenders usually adjust the LTV bycutting the exposure depending upon the severity of other risk dimensions. Of

particular importance to lenders will be to observe the time varying LTV along thecurrency of the exposure. LTV also reflects upon the risk appetite of the lender.However research studies show lack of strong association between LTV and creditrisk spreads contrary to expectation. It is important to note that a lower LTVnecessarily does not signal a safe loan as the lender has required the borrower toenhance his equity component given the level of risk reflected by other factors.Although in theory we expect that mortgages with higher LTV should ideally havehigher credit risk spreads, statistical studies on various commercial mortgageportfolios in mature markets indicate that this relationship is not robust. Certainregression type studies done to test whether the relationship between LTV and creditspread is monotonic indicate that spreads increase with LTV ratios for LTV ratios upto 70% while they decrease with LTV ratios for LTV ratios beyond 70%. Themortgages with highest LTV ratios of 90% were found to have lower spreads. These

results indicated that the relationship between LTV ratios and mortgage spread iscomplicated as lenders choose a lower LTV ratio in case risky borrowers rather thanhave higher spreads as it would only aggravate the default risk due to lower DSCR.

Debt Service Coverage Ratio( DSCR) :Adjustments to LTV given the Net Operating Income results in higher DSCR.Internationally lending banks focus on LTV and DSCR as they are considered to bethe key proxies for risk. Uni variate studies of DSCR on commercial mortgageportfolios indicate that although the signs of the co efficient of DSCR is negativeindicating an inverse relationship between the default risk and DSCR thresholds, theco- efficient are not statistically significant from zero.

One alternative to improvise over the effectiveness of the above two measures is to

observe the Time-Varying LTV and the Time-Varying DSCR thresholds. In maturemarkets, lending institutions develop a property index based upon prevailing rentalmovements or use updates in property values or Net Operating Income in order torecomputed the change in the LTV and resulting DSCR.

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This enables tracking of time varying measures of LTV and DSCR. In some default riskmodels, the change in LTV including the original LTV at the time of taking theexposure is imputed to effectively capture the impact of change in LTV on account ofchange in NOI or property value etc on default risk of commercial mortgages. Sincethere is a correlation between LTV and the DSCR at the origination of the loan, by

including the changes in LTV over time in the default risk model, such multicorrelations are also taken care off.

Other measures are based upon the general characteristics of the mortgage such asmentioned below

Net Operating Income :

The level of Net Operating Income generated from the commercial mortgage as apercentage to the appraised value of the mortgage after having adjusted foroperating expenses and depreciation rate is a good indicator of performance.

However if this ratio is computed asVALUE

NOI

it will help track cyclical effects and

its impact on property prices.

Occupancy Rate :

For most of the commercial property mortgages other than owner occupied, thevacancy rates or occupancy rates are of critical concern. However the availability ofdata on average level of occupancy across regions and segments of commercialmortgages is difficult to obtain. Average occupancy rates serve to be of criticalimportance when applying the relative valuation approach to properties. Other riskmeasures include the average age of the property, location, maintenance costs ,cross correlation of income/rentals with other commercial real estate segments etc.

Risk Measures -Portfolio Level

Understanding the portfolio composition , along with the banks credit culture, riskappetite, historical performance in this sector is crucial to the risk assessmentprocess of real estate portfolio.

Portfolio analysis of real estate exposures require assessment of risk across thefollowing dimensions :-

Composition by asset class :

Of primary concern is to compare the individual lending institutions composition of

commercial real estate exposure as between Retail, Office , Hotels and Industrialspace with the overall banking systems lending pattern to commercial real estatesegment or at least set against the peer group banks and financial institutions. Thekey risk to identify will be whether there exists sub-segments within the commercialproperty segment as mentioned above that behave differently such that prices ofthese properties among asset classes would not tend to fall simultaneously. Acorrelation analysis of rentals, occupancy rates and property values over time acrossthese segments will help enhance information on the above. Also apart from mere co

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movements, correlation among volatilities in real estate value, rentals etc will be ofprimary concern.

Geographic diversification :Location of commercial real estate assets help to determine the extent ofvulnerability of to regional economic downturns. Just as diversification among asset

classes is of critical importance to mitigate risk, diversification in commercial realestate portfolio across geographies is equally risk mitigating.

Correlations across business cycles :

Although there may be a high degree of correlation as between asset class orgeographies at a given point in time in the commercial real estate portfolio, theconcern remains that for those geographies and asset classes where magnitude andsignificance of correlation among rentals, property value are currently low may tendto be high during economic downturns. Therefore it is important that correlationmeasures are tracked across business cycles. An Irish study of commercial bank realestate portfolio over period 1970 to 2005 indicated that magnitude of correlation asbetween retail, industrial and office space is higher during economic downturns thanduring a economic growth phase. These type of findings will be useful in taking riskbased lending decisions.

Maximum loan size exposures, loan size limits to a developer/investorrelationship/project and commercial real estate in aggregate and other constraintsare important to assess the loss severity and the risk attitude of lending institutions.

Loss Characteristics :

Moodys analysis of commercial bank real estate portfolios pegs loss rates acrossasset classes as under.

Loans financing existing structures is assumed at 50%.

Single family construction loans 20%

Other development and construction loans 60%.

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Conclusions :

The challenge for banks and regulators is to understand the dynamics of commercialreal estate at a macro level and to detect deviations from fundamentals. Banks needto appropriately price and ration credit such that the bank is able absorb the cyclicalvolatility in property prices which may be persistent over time and market across

cross country correlations. An interesting finding is that use of real estate ascollateral provides a channel through which property prices are influenced and thismechanism stimulates itself during an economic growth phase. While the financialaccelerator mechanism presents the underlying currents that spiral an asset pricebubble, it is important to note that in countries such as Hongkong, although assetprices dipped sharply by 70% from the peak levels, the banking system wasremained resilient. Stringent LTV norms imposed by regulators and strong capitalbase attribute to the strength of the banking system.

Banks must take into account time varying value perspective in respect of LTV, DSCRand NOI apart from other risk factors and thereby adopt a long term approach toproject evaluation. Of special interest would be to research the impact of commercialproperty cycles on the profitability of the banks.

Submitted for discussion

Krishnan ChariAsst Vice President( Risk)

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REE-TOTAL CREDIT

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

1.80%

2.00%

2001 2002 2003 2004 2005 2006

REE-TOTAL CREDIT

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Occasional Paper-commercial Real Estate