What risk does property in London and the South East pose to UK financial services businesses?
Laura Miller asks what risk is posed to financial services businesses from risks associated with the London and South-East property market.
London dominates the commercial property market, holding around 40% of its total value, according to investment research firm Edison Group.
For London residential it’s around 20%. After the capital, the rest of the South East is the biggest market. UK financial institutions, variously invested with generally large exposures, are susceptible to changes in the value of southern property.
For banks the impact depends on how much their loans are backed by lower risk residential or more risky commercial property. For insurers and asset managers exposure is typically through equity and direct property funds.
Insurers generally shoulder more risk than asset managers, with investments backed by shareholder capital.
Asset managers, alternatively, invest for third parties, though their direct property open-ended funds have struggled in the past, where declining values triggered withdrawal requests which could not be met due to property’s illiquidity, and access to investor cash refused until conditions improved.
As the UK economy has faltered and unemployment increased, these exposures presented a problem.
At the end of 2020 Halifax expected house prices to fall 2% to 5% this year. The Office for Budget Responsibility predicted an 8% fall. Retail property values were forecast to decline up to 40% by Duff & Phelps in October, and consultancy Carter Jonas in September predicted office rents could dip by more than 10% in many parts of London.
Yet financial institutions’ balance sheets are not overly worried; banks’ provisioning in Q4 2020 was better than expected, as government programmes removed their need to build reserves aggressively.
“Banks have generally beaten earnings expectations and there are few signs of stress,” said Rob Murphy, managing director of Edison Group. The Spring Budget has provided significant further succour for institutional investors; an extension of the stamp duty holiday; a new government-backed mortgage guarantee scheme; and tax breaks for businesses with physical premises in the most distressed sectors.
To take the residential measures first.
The stamp duty holiday on the first £500,000 of a purchase has been extended for a further three months until June 30. Then the nil rate band will be set at £250,000 - double its standard level - until September ends. Homebuyers can save thousands, especially in the expensive South, spurring them to buy properties now rather than wait, injecting cash into the value chain of conveyancers, brokers, estate agents, and mortgage lenders and investors in residential property.
Last year home prices rose 7%, a six-year high, largely driven by the first stamp duty holiday. Matthew Tooth, chief commercial officer at LendInvest, said: “The extension, combined with the highly successful vaccination drive in the UK, means we can expect higher growth over the next quarter.”
House prices had already risen steadily for a decade, particularly in London and the South East, to the benefit of financial institutions.
Mortgage access - residential
To keep them rising while increasing access, the Budget also contained a 95% mortgage guarantee scheme for homebuyers with 5% deposits on properties worth up to £600,000, until the end of 2022. Lloyds, NatWest, Santander, Barclays and HSBC and Virgin Money have committed to offer them. The scheme is broad; open to everyone, not just first time buyers, and older housing stock not just new builds.
London in particular will be supported. Estate agent comparison site GetAgent.co.uk found buyers in the capital save most, and Haringey, north London enjoys the nation’s biggest saving; with average prices at £568,561, the scheme reduces the required deposit by £56,856.
Guy Harrington, CEO of lender Glenhawk, said for first time buyers this is “a game changer”, and as “the roots of the market, nurturing them will benefit the rest of the housing tree”. Some have expressed caution.
Islay Robinson, CEO of high-net-worth mortgage broker Enness Global, warned 95% mortgages “take the market into overheated, dangerous territory”. He said: “We’ve previously seen the results of this kind of precarious lending to those who aren’t in the financial position to commit to it”. But he added many lenders are already protecting themselves, by removing high loan to value mortgages.
Following the announcements, the OBR revised its 2021 house price forecast up by 9 percentage points, now expecting a rise of 5%.
High-end homes in prime outer London had already risen for the seventh consecutive month in February, according to Knight Frank, a real estate consultancy, including Belsize Park, Dulwich and Wimbledon, where prices are up 4% since last April.
In prime central London transactions in the year to February 2021 were 20% down, with annual prices down 4.4% and flat since the market reopened last May. But Tom Bill, head of UK residential research at Knight Frank, said the central London property market has been disproportionately hit by an 80% drop in passenger numbers through Heathrow and “that gap will close as international buyers can get back on aeroplanes”.
Government scaffolding of residential property prices is good news for insurers, which are increasingly invested in equity release mortgages (ERMs) to back their annuity portfolios; as Deloittes pointed out in its report, ‘Market implications of COVID-19 for UK life insurers’, any volatility in residential property prices could increase no negative equity guarantee risk for insurers holding ERMs.
Banks benefit strongly too, as the main mortgage lenders, though even if a price fall were to occur, Bank of England stress tests and generally much lower loan to value mortgages mean they are well insulated. “Changes in regulations post the global financial crisis have taken a lot of risk out of the sector,” said Darius McDermott, managing director of investment firm Chelsea Financial Services.
Most banks have high core Tier 1 equity ratios, and now heavily issue contingent convertible debt which, if things get bad, turns into equity, providing banks even more safety. “Consequently we have generally preferred investing in bank debt to equity in recent years,” he added.
After years of rapidly rising home prices, and relatively high deposits on new debt, systemic problems would require steep price falls and wide scale defaults. “I just don’t see it,” said Laith Khalaf, analyst at AJ Bell, “yes unemployment is rising, but 60% of those who have lost their jobs are under 25, and can only dream of buying a four bedroom pad in Surrey”.
Turning to commercial property. Negative effects of forced closures and mandated changes to working from home due to the pandemic have been acute in some sectors.
In central London “retail and leisure have suffered the most damage, with closures meaning businesses have had to defer rent or been unable to pay rent entirely,” said Murphy of Edison Group. Offices, he said, have held up better, “only partially full but tending to still be collecting rent” .
Yields have risen on retail and leisure properties – so correspondingly values have fallen. Insurers have become more invested in Commercial Real Estate Loans (CRELs) to back their annuity portfolios, alongside banks. However falling values isn’t too much of a problem where properties are security for loans. “It will become a problem if corporates and individuals are unable to service their loans once government programmes cease, as the collateral value backing the loans will have fallen,” said Murphy.
Provisions for bad loans are made by calculating loss in the event of default. Inevitably, loss will be higher if values fall. “The real issue is whether there are defaults on the loans, for example with SMEs where business is part of collateral,” Murphy added.
However the Budget also had measures specifically to ease pressure on these sectors, and stave off defaults. Relief on business rates, paid only by businesses with physical property, has been extended for retail, leisure and hospitality until July 2021, and these sectors will continue to enjoy up to two thirds off business rates until March 2022.
The relief is capped at £2m, primarily targeting smaller and medium sized companies, which look most vulnerable. Lisa Hooker, consumer markets leader at PwC, said for many retail and hospitality businesses the extension “is a lifeline”, albeit there was no indication of an extension to the eviction moratorium which has been a “critical measure to help the survival of the high street”.
Phil Vernon, head of business rates at PwC, said restarting rates charges while these companies were still unable to trade “would have been the final straw for many”, now averted.
Asset managers’ property funds mainly invest in commercial property. Due to lockdown and valuers not being able to value them, most were suspended last March, but are now open or about to reopen.
A regulatory review hangs over them; due to property’s illiquid nature daily dealing can be a problem so may change to six monthly. “But investors that wanted out will mainly be out by now, I don't see another huge outflow unless the UK economic recovery hits a stumbling block,” said McDermott of Chelsea Financial Services. Commercial property, he added, still has a place in a portfolio for both capital and income diversification. “We are not huge fans of retail and offices, unless at large discounts through an investment trust, but we like some specialist property areas like care homes”, he said.
Only when interest rates and bond yields rise can we expect to see some income-seeking investors leaving commercial property behind, Khalaf said. After months of heavy outflows, property funds attracted £117m in net retail inflows in January.
Winners and losers
Covid has also created winners, and demand for different types of commercial property. The industrial sector – including storage and warehouses – is doing very well due to a surge in the internet economy, Murphy pointed out, a key ongoing structural trend towards online shopping and a rebalancing in value away from physical retail. Some permanent shift in demand for office space as a result of more employees working from home is possible, if companies decide they need less space. “However there are offsetting factors to this, as companies may choose to have more meeting space, or need more space per person,” Murphy said.
The government, at least in the short to medium term, seems determined not to let property markets, and the institutions that invest in them, down, while shifts in commercial demand and post-pandemic work patterns have yet to be established. Immediately, banks, insurers and asset managers seemingly have little cause for concern.
That may all change, “but ultimately, the South East will still be a driver of economic activity,” said Murphy, creating an ongoing demand for its property.