Impact of Changes in Lending Conditions on Real Estate Borrowing Costs

Executive Summary

This report provides an insight into changes in lending conditions that have effected or impacted real estate borrowing costs. The report contains analysis of the banks role in financing real estate, how the Basel committee act and their actions having a direct influence on borrowing costs and the political sphere of the financial market. After investigating these various entities and what their core functions, goals and aims are it becomes abundantly clear how changes in lending condition can effect borrowing costs. By the use of market reports, academic journals, government reports and national statistics I was able to develop an understanding of changes in lending conditions and identify the extent to which various organisations including the bank of England operate in effecting borrowing costs. Since the financial crash in 2008 credit was not as easily accessible as it was prior to this business, investments which include real estate faced a harsh and challenging environment to obtain means of funding, rejection rates for business, loans and investments were at an all time high and companies did not follow the Bank of England base rate all this changed in the most recent decade but the aftermath can still be felt to date.

The Banks are the main source of capital for lending money to the real estate sector. They are further regulated by several government based organisations these organisations are responsible for conditions on which the capital is lent. They include but are not limited to, the Financial Conduct Authority (FCA), The Prudential Regulation Authority (PRA), The Financial Policy Committee (FPC) and the Bank of England. Access to capital in the real estate sector is key to the countries recovery and long term growth of the economy without money flowing through the market it would mean that the economy would take a large hit. In the last decade many businesses small and medium sized have struggled to gain credit from banks to try and grow, they have generally been seen as risky investments by the banks this is because they have less assets that lenders can use as security. This has had a direct effect on the real estate market as borrowing costs have increased for business who fall within this bracket as the banks would try to secure the capital against any and all assets of the business[1].

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Banks are at the forefront for lending they are the ones who have the capital to give funding to the real estate sector. The banks are not necessarily the ones who make the changes to lending regulations but they enforce changes to lending conditions which in turn impact real estate borrowing costs. Banks do have a responsibility to lend money to numerous different investments one of them being real estate, with investments there is always a risk that the borrower may default a large onus is placed on risk in investments. To ensure risks in borrowing costs were minimal in 1974 the formation of the Basel Committee was started. The committee comprises delegates from banking authorities across the world who meet at the Bank of International Settlements in Basel. The main role of this committee is to set a global standard of regulations that all member countries must follow, they cooperate together to ensure that all banking supervisory matters are in line with the global agenda. The committee releases papers with the new regulations that have been set by the members every few years they are called the Basel reports and give strict regulations banks must follow and the implications of these regulatory rules.

The Basel committee are directly responsible for changes we see in lending conditions they are in control by setting standards, requirements and reviews which are reviewed periodically and have a direct impact on lending conditions. The main focus is market integrity and supervision of risk management. By reviewing the processes under which capital is lent through capital requirements, buffers and liquidity standards the committee is able to effect the conditions under which money is borrowed from local and national banks[2]. The changes that the Basel framework has incorporated into out lending system with the New Capital and Liquidity standards has meant that risk on investments is considered to be at a higher coloration than it had been, it has also meant there is more transparency which has meant banks must consolidate their liabilities accordingly.

Politics in the last five years has paid a crucial part in the financial market more so than economics, the Brexit referendum and elections across Europe have meant that there was much uncertainty in the economics of the U.K. the Macro-economics of a country can and have proved to play a large part in the overall economic stability. Since 2016 there had been increases in lending margins, interest rates and equity requirements in the financing of real estate. When we look at the figures for the debt to equity ratio it is clear that the increase in interest in the last two years has not affected the market significantly as official figures show there was a slight dip in investments in 2016.

The graph shows the split on equity and debt in the real estate sector, the trends at the end of 2016 showed that investment transactions are stable and are likely to raise for 2017 even with the increase in interest rates. The rise in interest rates for real estate are likely to fuel economic growth and lead to more competition in the sector. As the real estate market is a considerable size there are many conditions that may affect larger more commercial based properties than smaller deals in the market. Mid-sized equity firms were able to participate and compete against the large central banks and fund investments, this was one of the main objectives of Basel iii[3] which helped promote market integrity by means of healthy competition[4].

One of the main causes of changes in lending conditions is when businesses and individuals default on loans this causes major volatility in the market and can mean that future investors and the economy suffers in upcoming years. The Basel reports and other regulations created by prudential and the Financial Policy Committee have in the recent years placed a large emphasis on risk in the industry this is due to previous investments being defaulted on and causing banks to ‘write off’ loans which result in large deficits.

Source: Bank of England

The data sourced from the Bank of England gives a clear and incontestable image of the write offs that have been implemented by banks although in the more recent years the numbers have fallen the raise in 2014 is one of the main reasons that in the later years the figures dropped as banks would have been more wary as to the purpose of the money being lent and the exposure to risk as a result less money was lent to the commercial real estate market.

In 2012 the Financial Services Act[5] was introduced by means of statutory law this act changed the way many financial services work by imposing a strict supervision and management framework upon high street lenders, national and local banks and finance firms across the U.K. The act in essence gave the Bank of England macro-prudential responsibility over financial services firms who had a large proportion of the market and also risk that is attached to this proportion. One major change that the act bought was the way in which the money that is obtained by means of fines and penalties is used, prior to the act the money was paid to the financial institution that imposed the fine but now this money is given directly to the exchequer[6] this change in legislation could mean that the regulatory body who imposes the fines on business who do not follow the relevant framework have less of interest in ensuring fines are upheld and also paid as it is not given directly too them but as the money will be going to the treasury the general public would see some improvement in their lives as any money paid to the Bank of England would help the economy by means of offsetting deficits, tax and or interest cuts. After the changes were implemented by s.109 the value of fines did increase but in the most recent years we have seen a large decrease.

Source: Financial Conduct Authority[7]

Source: Financial Conduct Authority[8]

Lending conditions on Loan to Value (LTV) have changed considerable over the years with banks and financial institutions concerned more so with risk and profitability it has meant that consumers and commercial business who wish to take out mortgages for real estate have had to put a larger deposit down which have been increasing year on year. The interest rates on large percentage of LTV was higher than that of a lower percentage of capital this meant that consumers and commercial business were more inclined to have a larger down payment to avoid paying more in interest over the length of the loan/mortgage[9].

The Bank of England can again effect lending conditions which ultimately impact real estate costs. This is because they are the sole organisation that regulate inflation, interest and tax for the entire country. When interest and inflation is raised annually as it has been in the most recent decade[10] it has caused the financial sectors to rise prices in order to maintain a steady profit, this can however drive people into the market as it can be a clear indicator of economic growth but with many of these commercial banks and lenders using their own interest rates using as oppose to the base rate from the bank of England it has meant that interest rates on loans and LTVs have increased significantly.

Source: Bank of England

Bibliography

• Department for Business, Innovation and Skills – Evaluating Changes in Bank Lending Angus Armstrong April 2013 https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/193945/bis-13-857-evaluating-changes-in-bank-lending-to-uk-smes-2001-12.pdf
• Basel Committee on Banking Supervision – The Market Risk Framework https://www.bis.org/bcbs/publ/d457_inbrief.pdf
• Basel Committee on Banking Supervision – The Market Risk Framework https://www.bis.org/bcbs/publ/d457_inbrief.pdf
• CRBE Capital Advisors Analysis of Trends in Europe’s Debt Market – European Commercial Real Estate Finance Update 2017 – Paul Lewis, Isra Erpaiboon, Raphael Rietema
• Financial Services Act 2012 http://www.legislation.gov.uk/ukpga/2012/21/contents/enacted
• Financial Services Act 2012 Section 109

• Financial Conduct Authority – Enforcement Annual Performance Report 2017/18 https://www.fca.org.uk/publication/corporate/annual-report-2017-18-enforcement-performance.pdf
• Financial Conduct Authority – Enforcement Annual Performance Report 2017/18
• ABC Finance – Commercial Mortgage Rates and Fees (Online Resource) https://abcfinance.co.uk/commercial-mortgages/calculator/rates-and-fees/
• BBC Business News – UK Inflation Hits Six Month High September 2018 (Online Article) https://www.bbc.co.uk/news/business-45572856

[1] Department for Business, Innovation and Skills – Evaluating Changes in Bank Lending Angus Armstrong April 2013 https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/193945/bis-13-857-evaluating-changes-in-bank-lending-to-uk-smes-2001-12.pdf

[2] Basel Committee on Banking Supervision – The Market Risk Framework https://www.bis.org/bcbs/publ/d457_inbrief.pdf

[3] Basel Committee on Banking Supervision – The Market Risk Framework https://www.bis.org/bcbs/publ/d457_inbrief.pdf

[4] CRBE Capital Advisors Analysis of Trends in Europe’s Debt Market – European Commercial Real Estate Finance Update 2017 – Paul Lewis, Isra Erpaiboon, Raphael Rietema

[5] Financial Services Act 2012 http://www.legislation.gov.uk/ukpga/2012/21/contents/enacted

[6] Financial Services Act 2012 Section 109

[7] Financial Conduct Authority – Enforcement Annual Performance Report 2017/18 https://www.fca.org.uk/publication/corporate/annual-report-2017-18-enforcement-performance.pdf

[8] Financial Conduct Authority – Enforcement Annual Performance Report 2017/18

[9] ABC Finance – Commercial Mortgage Rates and Fees (Online Resource) https://abcfinance.co.uk/commercial-mortgages/calculator/rates-and-fees/

[10] BBC Business News – UK Inflation Hits Six Month High September 2018 (Online Article) https://www.bbc.co.uk/news/business-45572856