Pricing of risk and the cost of money: how banks are pricing property funding

Pricing of risk and the cost ofmoney: How banks are pricingproperty fundingAllan GriffithsReceived: 21st February, 2001

AbstractWhen the author was first asked to write for the Journal, the workingtitle was ‘Creative property lending and how to maximise gearing’. Asa member of the Association of Property Bankers, and having thehonour of being a past president of that organisation, the author wasnot at all sure that he should accept the engagement! However,encouraged by the chance to get a point of view across — ie thatsound property lending does not necessarily depend on low loan-to-value ratios (and the promise of payment in liquid measure), theauthor gave in. In this paper, he wants to look at techniques forunderstanding risk, avoiding unnecessary risk, and establishing‘correct’ pricing for the risks which cannot be avoided. Of course,there is no such thing as ‘correct’ pricing, but in this context, theauthor means pricing at a level which, over the long term and afterallowing for the occasional loss, still shows a profitable outcome. Itwas often said after the 1990 crash (mainly by insolvencypractitioners), that for many property lending banks, it would havebeen cheaper to pay for their entire property lending teams to playgolf for the previous ten years! At the risk of soundingcondescending, this paper will start with something obvious butwhich nevertheless is fundamental.

THE DIFFERENCE BETWEEN DEBT AND EQUITYDebt has a repayment date. Therefore, when making a loan, if thelender can not see how they will be repaid without relying uponfavourable market conditions at the time of repayment, that is notdebt: it is equity. Now that is all right if it is priced as such and theremuneration arrangements give an upside reward, but not if theonly return is a front-end fee and a margin.So, when structuring a loan, it is vitally important, at least in the

first instance, to calculate how much debt can be supported by thecontractual income which the security will generate and whichamortises down to nothing, or at worst a modest residual position.At DZ, irrespective of the loan term required by the client, a

model is always constructed over the entire period of the remainingincome stream. This is because, what is more important than theinitial loan, is how much the debt can be allowed to be outstandingat the time when the client wants to repay.

Allan Griffiths

has been head of property

lending at DZ BANK London

Branch (formerly DG BANK)

since August 1997 having

joined to set up the Property

Lending Department. He has

specialised in property finance

since 1984 and has worked

extensively with Japanese and

German banks. Allan is a

maths and physics graduate of

the Open University but

prefers the property industry

to more cerebral pursuits. He

has been a member of the

APB since 1994, a Standing

Committee member since 1995

and president from October

1998 to 1999. He remains

intrigued as to why many

property bankers still think

that a loan-to-value covenant

has any validity as a risk

management tool.

Keywords:residual risk, residual debt, exityield, fixed rates, yield curve

Allan GriffithsHead of Property Lending,DZ Bank10 Aldersgate StreetLondon, EC1A 4XX, UKTel: +44 (0)20 7776 6172Fax: +44 (0)20 7776 6162E-mail: [email protected]

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Clearly, this approach often requires the lender to take a long-term risk on tenant covenants. Therefore one needs to be eithervery choosy about tenant quality and/or construct a cash-flowmodel around the assumption that some of the rent will not bepaid.Most of DZ’s lending falls into this category and, for what it is

worth, margins generally vary between 90 b.p. and 150 b.p. overthe cost of an amortising interest swap to create a fixed rate overthe whole loan term. As most readers will probably know, lendingwhich is 100 per cent risk weighted implies a notional use of capitalof 8 per cent of the loan amount. Thus an average margin of 1 percent generates a notional return on capital of 12.5 per cent. Thesedays, many banks consider this level of return to be unacceptablylow — hence their great interest in securitisation and fee-generatingactivities.

RESIDUAL RISKThe author previously mentioned residual debt positions. This is asubject that causes a lot of angst among property lenders. How canone reliably estimate the value of a building in the far future? Nowis a time of rapid change in many walks of life, not least in theproperty industry. In the last decade, many new innovations havebeen witnessed that are now commonplace, such as regionalshopping centres — readers may remember when the Metro Centre,Gateshead was first planned? Everybody thought John Hall wasmad — until M&S came along with a pre-let: Canary Wharf. Thisfailed twice, yet is now a roaring success, setting rental levels notfar short of City levels, and which provided the opportunity for thelargest ever securitisation in the UK.What about new challenges such as the onset of hot desking and

home working, or the impact of e-commerce on retail demand?Clearly, all these issues can have a major impact upon futuredemand for space, and upon people’s concepts of location,specification and build quality.How then does one decide upon an acceptable residual position?

The author is pleased to say that he considers fears about residualpositions to be much more imagined than real. Consider thefollowing:

. At DZ, the average contractual length of the loan portfolio isalmost 11 years, yet in the last year, over 10 per cent of the bookhas been prepaid, and DG has only been in this market for threeyears or so.

. A high profile German mortgage banker recently confided that,whereas their loans typically were for 10 or 15 years, the actualaverage life of his book over a ten-year period was less than threeyears! Very few of his loans went to final maturity. Notsurprisingly, he is much more concerned about replacing assetsthan he is about residual debt!

What price?

Occupier trends

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Pricing of risk and the cost of money: How banks are pricing property funding

. Even if, despite the statistical improbability, a loan does go tofull term, potential problems can be seen looming from a longway ahead. Therefore, the usual protective covenants one wouldexpect to find in commercial loan documentation should give thelender adequate remedies to avoid disaster.

With these thoughts in mind, at DZ, when considering goodlocations, it usually feels comfortable with a residual debt that is nomore than 50 per cent of residual value. However, in somecircumstances, eg government-let property located in poor areassuch as, say, suburban Liverpool, which were built with jobcreation in mind, rather than investment value, DG would not takeany residual position at all, regardless of covenant strength.Residual value can mean either vacant possession value or site

value, whichever the external valuer deems most appropriate, basedupon his view of the location, age and quality of the building. DZdoes not ask him to project future value — his crystal ball is nobetter than the bank’s! Rather, the concern is with current valueswhich, even in these times of low inflation, should at least bemaintained over the long run.

EXIT YIELDSSome lenders adopt a different technique. Rather than model cashflow through to expiry of contractual income, they simply requirethat (1) the property would have a remaining life after the loanmaturity — usually a minimum of ten years; and (2) that the rentalincome passing at maturity looks comfortable compared with theirview of value at that time. This is the so-called exit yield. Generally,for properties with initial yields of 8 per cent or less, acceptable exityields would be in the region of 14–15 per cent.While this method avoids potentially tricky discussions about

residual risk, it does not avoid risk. Also, what might seem like anacceptable exit yield today will not help very much if one is tryingto dispose of the property in a collapsed market and there are nobuyers around at any price (it has happened before)!

FIXED RATE LENDINGIt was mentioned earlier that at DZ most of the loans are funded on afixed rate basis which can be achieved by the use of amortising interestrate swaps. This is another innovation which one takes for grantedtoday but which did not exist ten years ago. When one thinks about it,they can only exist because of computer technology. Withoutcomputers, the calculations just could not be done fast enough. Someof the industry’s more senior practitioners may remember a time whenthe only way of lending fixed rate was to grant a bullet loan withrental surpluses accruing to a collateral deposit account. This wasvery cumbersome and never popular with borrowers because theywere paying LIBOR (or base) plus on the whole loan for the wholetime and only getting LIBID minus on the collateral.

Location, location,location!

Derivatives canmitigate risk


Griffiths

In the context of this paper, the main benefit of fixed rateamortising loans is that both borrower and lender avoid exposureto adverse market changes during the life of the loan. If the fundingis fixed for the whole period of the remaining income stream, thisrisk is largely eliminated.

REVERSE YIELD CURVEAnother benefit of fixing the interest rate for as long a term aspossible is that a reverse yield curve is currently enjoyed in the UK.While historically this is a rare phenomenon, it has existed for all ofthe four years in which the author been at DZ. Currently, it is notas steep as it has been but, nevertheless, the cost of 25-year moneyis approximately 20 b.p. less than 10-year money.

CASH-FLOW MODELLING TECHNIQUESSo far in this paper, it has been tacitly assumed that lenders alwayslend on singly let property, which quite obviously is not the case. Inmost property lending situations, such as multi-let offices, shoppingcentres or industrial estates, income is derived from numeroustenants of variable quality and with lease breaks or expiries atdifferent times. In such cases reliance only upon contractual incomewill not help very much as the level of debt which such anapproach would generate would not be considered very competitive.Instead, assumptions have to be made about re-letting potential:how long will voids take to fill? What level of rent could be reliablyobtained on re-letting? What lengths of lease are achievable?All of these issues require professional local knowledge to

answer, which is why the selection of an appropriate valuer isvitally important. DZ places far more emphasis on conservativecash-flow assumptions than upon open market value. DZ wouldmuch rather use a smaller firm which has appropriate localknowledge than a large firm that does not have much to offerexcept a reputation and lots of professional indemnity insurancecover!

OLD VERSUS NEW LEASESWhen the new legislation was introduced in 1996 to abolish theDoctrine of Privity in property leases, there was considerabledebate about how this would affect rental levels and propertyyields, and might lead to a two-tier market.Probably everyone now accepts that this did not happen.

However, prudent lenders do sometimes need to make a distinctionbetween old and new leases. In the case of multi-let buildings, asmentioned earlier, cash-flow assumptions have more to do with re-letting potential rather than the financial strength of particulartenants. Therefore the lack of privity usually would not be amaterial issue. However, in situations where the lender is relyingupon income from one or only a few tenants, it is important tocheck whether or not privity applies. If it does not, what measures

Achievable rents, voidperiods

Privity of contract

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Pricing of risk and the cost of money: How banks are pricing property funding

are in place to protect the landlord from deterioration in covenantstrength should the tenant wish to assign the lease? Usually, alender faced with a new lease will look for restrictive financialcovenants binding upon the assignee and/or an AuthorisedGuarantee Agreement which requires the assignor to guarantee thenew tenant.

SHORTENING LEASE LENGTHSEver since the 1980s boom and subsequent bust, there has been amajor change in lease terms and particularly in the incidence oftenant break options and overall lease lengths. While, recently, thebalance of power has shifted back towards landlords to someextent, the days of 25-year full repairing and insuring leases with nobreak options appear to have gone forever. At present, thegovernment is putting a lot of pressure upon the industry to abolishupward only reviews and has threatened legislation if this is notachieved.Clearly, the trend for shorter leases has a significant impact on

lenders. Quite obviously, the shorter an income stream becomes, theless its net present value. This will lead to different marketconditions: on the one hand, cash flow lenders will want to lendlower initial amounts, while, on the other, borrowers will encouragelenders to take higher residual positions.

CAN ONE GET COMFORTABLE WITH THIS HIGHER RISKPROFILE?Comfort can be taken from other property markets where leases areusually shorter than here. Take Germany, for example, where leasesare generally for terms of less than ten years, so German mortgageproviders routinely have to take a view on residual values and re-letting prospects to a much greater extent than in the UK.Nevertheless, their market works well and has done so for manyyears.The message is that lenders will have to get more comfortable

with residual risk than they are now. This necessarily means thatthey will have to be even more thorough in considering theproperty characteristics and make sure that they have access toappropriate professional advice.

Shorter leases causelower loan to valueratios?

Residual risk is hereto stay


Griffiths

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Pricing of risk and the cost of money: how banks are pricing property funding