The lure of high returns

The sight of collapsing property markets in south-east Asia is likely to prompt collective sighs of relief from bankers in the US and the UK, who learnt only too well the dangers of overlending to the sector not so many years ago. Never again, bankers vowed, would they indulge in the rash lending practices which caused the property markets on both sides of the Atlantic to boom and bust so explosively.

Indeed, for the first half of the decade, lending to property projects has been subdued, with almost no money available for speculative development. Yet, new data suggests that however painful the lessons of the last recession have been, rising property values and surplus cash on bank balance sheets are tempting money back into property.

Significantly, a portion of new money is coming from new types of lenders, such as building societies and institutional investors who are buying property-backed securities.

DTZ Debentham Thorpe, the international property consultancy, concludes in its 1997 Money into Property Survey that traditional bank lending to property is still falling. Data from the Bank of England shows outstanding debt to property companies fell to just over £30 billion sterling, down from just over £40 billion five years ago. Although the decline has been steady, it was not as precipitous in the past two years as it had been for the previous three.

However, DTZ notes the Bank data is only a part of the picture. When all the sources of debt finance are added together, the total is nearly 50 per cent higher than the Bank data shows, at about £43 billion, says DTZ. The Bank only tracks the loans of the licensed deposit-takers, a measure that omits the German mortgage banks and state-owned Landesbanks, which are among the most vigorous lenders to the sector. DTZ estimates this category now accounts for a further £3.5 billion in outstanding property loans.

Salmaan Hasan, head of property finance in the London office of BHF Bank, a German wholesale bank, says the willingness of institutions such as his to lend is partly a function of historical good fortune.

"The German banks weren't in this market in the 1980s," he says. "But they followed the German investors in the 1990s who saw the very attractive yields being offered in the UK market."

German open-ended funds, flush with cash, needed new markets for investment. The UK, in the aftermath of the property crash, has proved attractive and there is no sign German lenders intend to scale back their activities.

The ability of these German lenders to provide finance is partly due to their ability to issue pfandbrief - notes which are secured by 60 per cent of the property against which the loan is drawn. They are able to sell these at relatively low interest rates in the wholesale markets, allowing the banks to compete aggressively for business.

Meanwhile, the DTZ report notes, there is a small, but noticeable, increase in the off-balance sheet debt finance for property. A number of financial institutions have begun to issue asset-backed securities, repackaging their loans as debt securities for sale to other investors.

Admittedly, securitisation is a tiny part of the UK market. However, data from the US shows it becoming an increasingly critical source of commercial real estate debt finance. Net losers, according to data from the Federal Reserve Bank of New York, are insurance companies and thrifts (building societies). Between the end of 1993 and the first quarter of 1997, lending to non-farm, non-residential property by so-called private mortgage conduits - securitised vehicles - nearly trebled to $67.1 billion (£42.2 billion) from $25.5 billion. Lending to that category of property by banks during that period rose by just under $50 billion, to $371.4 billion, a smaller proportionate rise.

In the UK, the newly deregulated building societies are laying claim to the role of newest, serious entrant to property finance. Current outstandings are £3.7 billion, up from £2.9 billion at the end of 1995.

DTZ surveyed lenders on that most critical measure of confidence in the property sector - the willingness to provide debt finance for speculative development. It found that 60 per cent of those surveyed were willing to lend speculatively, up from 45 per cent in 1995, albeit, they say, with a large dose of caution.

Another indication of the growing availability of debt finance is the narrowing margins on property-related loans. Corporate loans are now available at 30 basis points over London Interbank Offered Rates (Libor), while non-recourse loans to limited partnerships with high-quality properties are at 75 basis points over Libor. Speculative loans, however, continue to carry big risk premiums, the DTZ survey concludes, suggesting that lenders may act as a brake on the oversupply which characterised the 1980s.

When DTZ surveyed lenders on their required loan-to-value ratios, it found a loosening of requirements. Nearly three-quarters of those surveyed said they would offer a 75 per cent LTV on an investment loan and a 70 per cent LTV on a non-speculative development loan.

Overall, says Peter Evans, head of research at DTZ and author of the report, the data shows lenders are willing to extend increasing amounts to property, but not with the abandon of the 1980s boom.

A note of caution is necessary, he says. Lenders have tended to assume that the strong rental growth in prime properties will necessarily spill over into secondary product. "The relatively optimistic picture we see for prime space does not ripple through the rest of the market the way it has in previous cycles," he says.

Lenders that are unable to make the distinction will be quick to learn the same painful lessons as their counterparts in south-east Asia.