Funding issues for banks will not derail a recovery in property lending

If you are reading this - congratulations! You and your bank have survived the most tumultuous decade for global banks since the 1930s.

The ‘noughties’ will be remembered for year after remarkable year: first, a run of record profits, followed by earnings collapses and government assistance. 2009 had a stomach-churning start in which European bank shares halved - and then went on to treble in value.

The decade ended in December 2009 with announcements of potential big changes to the ways banks will be funded and regulated in future - if you want to know more, they are clearly set out in a suite of six linked reports from the new banking research team at Barclays Bank*.

Some of what came out in December, in the Basel II proposed amendments, and the Central Bank announcements about withdrawing long-term funding support, sound scary. The Basel Committee on Banking Supervision’s proposed revisions to the Capital Requirement Directive aim to ensure banks hold more capital and more liquid funds. This could see some banks having to shrink, or at the least, not grow, unless they can raise very substantial new equity. Some of those, including the Irish banks and RBS, were once the largest lenders to the UK and Irish property markets.

Banks that want to increase lending may also have to increase deposits, either to meet tougher loan-to-deposit ratios and Basel’s Net Stable Funding Ratios, or because their other funding options in the capital markets are reduced.

On refinancing, Barclays estimates that the amount of new funding from other sources that European banks will need as a consequence of being weaned off the ECB emergency funding is €875bn. This is on top of impending bond refinancing needs of €850bn. Regulatory requirements will mean that banks that relied on shorter-term bond funding will have to refinance at longer maturities.

Needless to say, this will all cost a bit more, and will cost some (weaker) banks more than others, unlike the days of plentiful cheap funding for all. And all this when banks’ funding options are reduced: Pfandbrief and other covered bond markets are recovering but there is still no securitisation market.

And yet no one is panicking about European banks’ abilities to fund themselves. At Fitch Ratings’ 2010 Outlook for Credit Markets this month, speakers were sanguine about the refinancing task and its consequences. The conclusion of the Barclays’ analysts is that some banks will manage to increase lending while others will have to shrink, and this is another step along the road towards more differentiation between banks and their strategies and growth.

For the time being there would appear to be nothing in this macro picture that is more important for active UK property lenders than the state of the underlying property market and levels of transactional activity.

Who the borrowers are and what they want will be far more crucial drivers of property lending this year and next.

One thing borrowers don’t want at any price is securitisation back- not yet anyway. Issuers might want it - it makes sense to try to re-open another funding option - and asset-backed securities investors might want it. But some borrowers are still in a mess with securitised loans even now values have turned. There were fund managers tied up in knots because they couldn’t sell properties backing securitised loans to reduce debt and now there are others just as frustrated because they can’t free assets to sell into the rising market.

As telling is the handful of very strong sponsors - Value Retail, Liberty International - who have chosen to pre-pay CMBS and refinance by taking out straightforward investment loans instead. Value Retail’s Scott Malkin says he doesn’t want securitisation because it is too inflexible, and the group is part-way through a switch over of the company’s European portfolio. Refinancing strong sponsors will continue to be a key source of deals for banks with the appetite to lend.

Now that the UK market has turned and investors are piling back into property, transactional turnover as well as pricing, is rising in response. But not all the buyers want debt. The institutions are leading the current charge: Aberdeen Property Investors was just the latest when it announced this month that it has £500m of segregated client money it wants to spend on UK property as soon as possible, on top of £250m it placed in Q4 09. Since pension fund clients often don’t want geared investments it doesn’t necessarily follow that lending volumes will be hugely up this year on the £20bn-£25bn low of last year.

That said, lending will increase. Property companies are also looking to expand or restructure their portfolios and London-based private equity funds that have survived in good shape, like MGPA, AREA Property Partners, Europa and Orion have started to close more UK and European deals. Some of the 80 or so UK funds in the pipeline will raise capital and start buying this year.

Finally, one of the most powerful changes in lenders’ favour is that debt is accretive again and more borrowers will want some. The quarterly performance data for UK funds released last Friday (22 January) by IPD showed funds swinging from three years of negative returns to a record quarterly positive return of 10.4%, amplified by gearing.

Compared with six months ago, active banks will be spending a bit less time wondering where the next deal will come from, and more on working out whether potential opportunities are the right ones to lend on at all.