Banking, Lending and Real Estate

Claudio Scardovi, Alessia Bezzecchi

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781000022896
• Edition: 1
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

This book deals directly with the risk/return multiple trade-offs coming out of the closely intertwined relationship between banking and real estate. The authors explore how banks could embrace a more proactive approach to make the most of their, mostly 'long only', exposure to real estate, and create positive spillover effects on their real estate counterparts and the sector as a whole. It provides a "state of the art" representation and analysis of the strategies that best practices in banking are adopting to manage these issues and plan for a new set of interrelations, driving a "virtuous circle" as opposed to the current one.

Banking, Lending and Real Estate is built on the academic knowhow and professional expertise of the authors, who have been researching, writing and working on this joint topic for over a decade. With its pragmatic approach, it allows the reader to capture which leading hedge active and holistic approaches are available today and proven to treat, for example, the banks' overexposure to this asset class; to manage "unlikely to pay" and sub-performing positions; and to optimize the recovery value coming from the work out of real estate related NPL (and underlying assets). Case studies and relevant examples are provided, leveraging on the authors' experience in consulting projects in the EMEA region and from working with global, regional and domestic banks and the real estate players acting across its value chain.

This book will appeal to both academics and business practitioners within the banking, financial services and real estate sectors, as well as professionals from financial and strategic/industrial advisory working in those fields.

1 Banking and real estate

A difficult relationship

Claudio Scardovi and Alessia Bezzecchi

1.1 Intertwined destinies

Banking and real estate have always enjoyed a very close relation, apparently cosy but actually, most often, turning out to be built on shaky foundations (Scardovi and Bezzecchi 2014). Banks have developed their business model out of many intangible things. Intangible as, in fact, the money they manage as basis of their own commerce, as intangibles are the information advantages that have allowed to banks to profit from an easy intermediation game (“buy the money – sell the money – make a hefty spread”). And intangibility is the ultimate production factor of banking and of the financial services industry – i.e. risk, be it of a financial or non-financial nature (e.g. pure risks like morbidity or mortality).

Risk is the ultimate production factor as banks originate, structure, underwrite, hedge, intermediate, insure, syndicate and sell a lot of it and of many different natures, most of them interconnected. The bank’s intermediation game (the basic “buy the money – sell the money”) has developed also by stretching and leveraging risks. The bank has to manage the leverage inherently built into its “money multiplier” business model (on the back of 1 Euro of capital, it raises so many in liabilities that then it uses to extend loans to multiple counterparts), and it faces therefore a “liquidity risk” – should a sudden withdrawal of its funds happen. It also faces a credit or market risk, as it starts to employ those funds to derive some yield, either by extending loans or by trading on the financial markets.

Also, as typical average maturities of liabilities and assets differ (with the first one much shorter than the second), banks also must face this equity duration mismatch and bear reinvestment and refinancing risks. The further velocity created on the usage of the bank’s equity capital – obtained by securitising the assets in the banks’ portfolio and in their sale via secondary markets, in order to restart anew the lending cycle – is also adding further intangibility and instability to the banks’ business model – as almost anything that can wrong could potentially wipe out most of its capital.

Almost as an answer to face this “intangibility to the core,” banks have developed through time a very much close and intertwined relationship with the real estate sector – an almost incestuous one, as the interconnections have become so extreme – both in width and depth – so as to make banks the largest real estate players of all, at least in continental Europe, and ultimately dependent on the fortunes of this sector (as, of course, the real estate sector has, in turn, become ultimately driven by the fortunes of the lending business, if not – directly or indirectly – owned by the banks themselves).

It may look like an exaggeration in principle, but let’s just think of the balance sheet of a typical universal bank, in the continental European context, where banks’ lending still pretty much dominates the funding of small- and medium-sized enterprises (SMEs), small businesses and individuals and even more so in the real estate sector – as they finance real estate developers, new development projects and, of course, mortgages.

This typical universal bank will own real estate assets for its own use: “trophy” assets for its headquarters, owned less for their functionalities as for their ability to impress perspective clients and the collective imagination of societies, so as to convey the (usually unfounded) message relating how rich, safe, credible and hence stable the bank is; and other real estate assets used for their own branch network, becoming more irrelevant by the day as digital banking expands making the cost structure of traditional distribution channels more uneconomic and less useful by the day.

The idea of owning and not renting real estate assets has also been so engrained that banks have thought of “capitalising” their financial strength by buying instrumental real estate assets, on the assumption their volatility was much lower than other financial assets, or actually almost non-existent and with upward trends expected in the long-term – you would just need to wait long enough, to see their value double or triple in time and with no mark-to-market in the meantime.

1.2 A “low, upward volatility” fallacy

Of course, the real estate volatility has indeed been pretty low, until measured properly or at all. And the prevailing, almost universal, accounting treatment of instrumental real estate (at historical costs, with revaluations so rare to almost ensure that they were all upward-looking – you just wait enough, and the inflation will do the rest) has certainly favoured this “low, upward volatility” paradigm. On this basis, banks have become even more eager to be long on real estate assets and on its cycle – almost a one-way bet on the value of bricks, no matter what the cash flow is.

They are the owner (albeit not end users) of the real estate assets they finance with their leasing portfolio, and as such, they bear all the operational risks associated with them as well. And they are almost co-owners of the real estate assets that are part of the reserves their insurance business has to put aside, to cover future claims of policyholders, be them of a life or P&C (property and casualty) nature. Banks are also the owner of real estate assets that are entering their books as component of principal trading or investment strategies, or as they come from the exchange of sub-performing debt into equity, or from the repossession of real estate assets that were put as collateral to loans that, as they have become non-performing, have left these properties as the only chance to recover.

The long position of banks on real estate assets does not, however, stop here as another, even greater and more influential exposure typically comes from performing loans and other sub- and non-performing ones (and including the so-called “grey area”) where the real estate assets are representing the “lion share” of the collateral in use, driving in a significant way its “probability of default” (PD) and partially related “exposure at default” (EAD) and “loss given default” (LGD). The case is obvious for retail mortgages and for loans to SME backed by real estate assets, and it’s even more direct and plain for the loans extended to real estate developers and usually tied to a special purpose vehicle (SPV) that is the owner of the building being developed (sometimes just a portion of land, or a half developed urbanisation plan), with no recourse allowed on the real estate company itself.

Ultimately, not many assets from the bank’s balance sheet are left that could be deemed as neither directly nor indirectly related to the real estate sector. It is also true that the massive backlog of non-performing exposures/non-performing loans (NPE/NPL) left after the global financial crisis has left banks with a larger share of repossessed real estate assets, most of them with limited liquidity and dubious quality, vis-à-vis the initial appraisal that was confirming their contribution to the “loan-to-value” at the origination and inception of the loan.

Indeed, the perfect storm of the global financial crisis was mostly driven by the prick of the bubble in the real estate sector, initially in the USA and then elsewhere. Following this, banks found out that, indeed, not all is good in real estate, as the sector is not always going up and even when it does so, over very long-time horizons, it can barely match the loss in purchasing power determined by the inflation registered over the same period. Banks also found out that real estate assets are surely unmovable, but their prices are moving a lot – hence, they have a very high volatility – if you just can find a way to measure their mark-to-market on a more objective and frequent basis.

Real estate is also very “cyclical,” as it is driven by the cycles of saving and investment of the people and companies in an economy, not to mention fiscal policies (on one side, housing is a sensitive topic, so a number of expansionary fiscal policies are often used to manage the election and political cycle; on the other side, houses are easy to tax and it’s very difficult to avoid taxation when a tax hike needs to be performed in extremis). All in all, it is not unreasonable to state that real estate is then contributing very little to the diversification of the risks underwritten by banks in their lending portfolio – hitting harder when things are bad and capital cushions are thin.

It then looks like that this “designed to be virtuous” relationship has been turning “vicious,” with the materiality of real estate contributing other headaches to banking and vice versa. This close and intertwined relationship is then turning out to be built on shaky foundations – and this is more relevant for our discussions on credit workout, and for the recovery attainable from the active management of the NPE/NPL real estate collaterals. Not to mention the future credit underwriting and the active and holistic management of the overall exposure of banks to the real estate sector.

1.3 Bricks after the storm

What else could go wrong for the “bricks after the (first) storm” of the global financial crisis that started in 2008 with the default of Lehman Brothers (also largely due to its real estate undertakings and fatal bets)? And what could go wrong for the banks that have been unwillingly turned – “obtorto collo” – into real estate owners and property developers-in-chief? Digital transformation and the so-called “Fourth Industrial Revolution” brought about by new technologies could not certainly impact such a “high-touch, unmovable and concrete” component of the global economy. Or, are these also going to change its dynamics in the absolute and relative performance of its valuations?

For example, with the diffusion of the “shared economy” (where everybody rents something, on the spot, so there is no more need to buy and hold a real estate asset… or where hotels and hospitality are just crowded out by extended value proposition of the likes of AirBnB)? And with the continuously changing scale and scope and value dynamics of large and small cities, urban areas and of the countryside (with the gentrification trend driving the polarisation between high and low end on one side, and augmented reality, super digital connectivity, faster and faster travelling and commuting changing the way we work – more and more from home – and live our mobility)?

It would be dangerously naïve to assume that the “second” storm of the digital and technological transformation (and of the many “social” and “behavioural” changes driven by this) is going to have limited impacts on the real estate sector and on the banks’ exposure on this. It could (and should) certainly – and this is a safe bet – change the way banks approach, the way they value and monitor, repossess and manage real estate assets, using data and machine learning/artificial intelligence (ML/AI) applications as a force for good and as an opportunity to rethink their governance, organisation, management, risk underwriting and commercial strategies as well. The reference to the alternative asset management professional industry comes again as handy.

Banks are, de facto, for all the above-mentioned reasons, almost like hedge funds, with a long position on the real estate sector and cycle. It may appear (or they may hope) that they have bought a call on the real estate underlying to their loans. In fact, and most likely, they usually end up selling a put to the borrowers, potentially getting hold of the worst kind of repossessed assets at the worst possible moment and with limited opportunities to even touch the precious, valuable ones (that the debtor will retain, will long judicial processes require to reposes them). As real estate long-only hedge fund, the volatility driven by their large exposure (either direct or indirect) on real properties drives a lot their regulatory, economic and market value of equity (whether properly measured and monitored by regulators and investors alike, it is another matter) and their future success or failure.

Given this critical relationship and oversized exposure, it is striking to observe how banks still tend to measure, control and manage their exposure on real estate assets in a very traditional and unsophisticated way – they may have very complex modelling and databases and software for managing the few exotic derivatives they may have been left with, but then they end up relying on valuations on real estate assets that are driven by appraisals done by third parties that still use such rough proxies like “price per square meter” or “price per bedroom” etc.

These “independent” third parties, whatever the sophistication they may develop in the future in their valuation approaches, also run the “client’s capture” risk, ending up ratifying whatever value is expected and hoped for by the banker that is hiring them in the first instance. The overall set of valuation methodologies, active management initiatives and, finally, organisational and governance approaches are, therefore, worth a full revisit – as the day of reckoning of this dangerous relationship is approaching and is already manifested in the banks’ challenge to recover value from NPE/NPL.

1.4 Fifty shades of grey

For a start, a real estate asset valuation should be addressed with a clear understanding of the value derived by its final, best owner. Basically, the analysis should start with the question regarding “which kind of value are we trying to measure and for what stakeholder?” The answer will be different if we want to place a flat to a family that is going to use it as first or second house, or to a long-only, long-term investor trying to rent it as part of a strategy to build some decent, predictable yield over a very long-timed horizon. Or to a real estate developer that wants to buy many of them to change their end use and refurbish the entire building. Or to an asset manager trying to aggregate assets for a Real Estate Investment Trust (REIT) to be then IPO-ed and listed in the stock market.

Figure 1.1 shows how a correct approach to valuation should address both the “who is the potential best and available buyer?” and the “what is the final end use foreseen for the asset?” questions. Based on the answer to the first question, we could likely segment the potential bidders into retail or institutional, and into end users or investors, driven then by different holding periods and trading strategies – and related risk/return profiles.

End uses could then be multiple and include the individuals/ families’ own use – to be addressed by market comparable and Discounted Cash Flow (DCF) analysis or the investors’ asset sale – to be analysed with a DCF that takes into account the sale costs, the income perceived in between and the discount on full price to be considered, given the market liquidity and the deepness and abundance of potential bidders. Vice versa, an asset held by investors as income producing should be addressed as the net present value (NPV) of future income net of operating costs, with specific hypothesis on occupancy rates and idle times between different contractual renting agreements, etc.

Figure 1.1 Valuation approach is driven by the potential buyer counterpart and final use of the asset.

Whilst confirming the superior approach derived from the use of DCF valuation models, the main point we want to raise here is that value is not, as many other things in life, absolute and fully objective, as it needs to consider the overall market conditions, the investors’ behaviour and expectations and any other kind of social development that could change – even in a significant way – the subjective perception of a real estate “fashionableness” (see Figure 1.1).

Their substitution value (or cost of construction, net of amortisation) is usually uncorrelated to this subjective value, and to the market one, that is emerging as a result of the interplay of the many subjective considerations played by the market participants. Hence, the approach to segment and determine which potential end users are the best owners and likely available buyers, and which end uses they could consider for the asset, is a critical component of the approach – determining what is “trophy” and what is “worthless.”

It’s then not usually a question of black or white, as man...

Table of contents

• Cover
• Half Title
• Series Page
• Title Page
• Copyright Page
• Table of Contents
• List of figures
• List of tables
• 1 Banking and real estate: a difficult relationship
• 2 Real estate strategy for banks: not an oxymoron
• 3 Credit workout and real estate management – in the digital age
• 4 Data management: NPL assessment in a digital world
• 5 Optimal value management: strategy, governance and organisation
• 6 Case study in credit workout: Urbi et Orbi Bank
• 7 Real estate: market analysis, international evidence and strategic planning
• 8 Real estate appraisal: fundamentals, appraisal process and valuation
• 9 Stress testing a real estate portfolio through value at risk
• Index