Bank of England warns on real estate defaults

British banks could lose up to $10.8 billion if the commercial real estate sector defaults on loans.

In its latest Financial Stability Report, the Bank of England notes UK commercial real estate prices have fallen 16 per cent since their peak in June last year.

“Derivatives contracts suggest prices are expected to keep falling for the next couple of years,” the report said.

“Taken at face value, these contracts imply a peak to trough fall of about 20 to 25 per cent, although, as with the US ABX index, illiquidity in the market and hedging may cause derivatives indices to overstate potential price falls.”

Property Investment Research director Mark Wist said the report confirms the fall in real estate prices and that it could make things tough for Australian property managers operating in Europe.

“If there was an Australian manager trying to re-finance or making acquisitions, they would find it hard with banks tightening lending,” he said.

“I suspect it will affect any manager looking to enter the European market and will make them think again.”

The bank also notes there have been large withdrawals from UK real estate investment funds, which have caused some to freeze redemptions.

Outflows from UK real estate funds in December almost hit $1.2 billion, but this has slowed in the first quarter of this year to $212 million in February.

“Commercial property companies’ default rates have remained low because, although falls in collateral values and tighter credit conditions have reduced their ability to borrow, rental income has continued to grow,” the report said.

“But according to the Investment Property Forum, rental income growth is expected to slow in 2008 and 2009.”

Wist said there is a danger that falling property values can start the descent into a crash.

“The property cycle has been waiting for a catalyst to fall and it looks like it has been found,” he said.

“It is far too early to say if the market has bottomed yet.”

In a traditional property cycle, the fall in prices force investors to sell due to pressure from bankers and values continue to fall until the market decides there are buying opportunities. The cycle then starts its upward trend, usually after a number of players have become causalities.

The tightening of lending to the UK commercial real estate sector is illustrated by banks lending only $2.1 billion of commercial real estate mortgages in the last quarter of 2007 compared to $18 billion in the last quarter of 2006.

However, according to the bank’s report, UK banks are holding $34 billion of highly rated commercial backed mortgage securities that could reduce default losses down to $3.4 billion.

“Declining commercial property values may increase the riskiness of loans held on (banks’) balance sheets,” the report said.

“Falls in property values erode the equity buffer with which borrowers can withstand financial shocks, implying higher losses on commercial property loans in the event of default.

“At the same time, lower collateral values could result in commercial property companies finding it increasingly difficult to refinance existing loans, which may increase the probability of default.”

This latest concern about Britain’s banking sector comes after the Royal Bank of Scotland announced plans to sell $25.4 billion in stock to bolster its capital earlier this week.