Does diversification of lenders also mean a diversification of risk?

As the “traditional” high street lenders retrenched during and following the global financial crisis, and have become (relatively) hyper-sensitive to risk, they are more cautious in their real estate lending. But demand for debt in the commercial property market still exists, and indeed the UK government has encouraged the emergence of a wave of new debt providers that has seen an opportunity to fill the void which has appeared.  While the big five high street lenders still dominate the market for transactions with a low credit risk, the hole that has been left at the riskier end has provided opportunity for higher margin lending. The advent of this wave of new debt providers, combined with an increased appetite for risk exhibited by some of the private investors in them, is beginning to create some challenges. Indeed, the Bank of England flagged its concerns about the potential risks for challenger lenders earlier this month. Peer-to-peer lender Lendy Finance has succumbed to administration, and so has the more “diversely” invested London Capital & Finance. And before that, Amicus Finance.  Lendy has no doubt become unhinged by its apparently “scatter gun” approach to lending, both geographically and by asset class, in addition to its evidently poor underwriting. While claims against solicitors and valuers may recoup some of its potential losses, the underlying challenges of the assets against which its investors have security will doubtless lead to a substantial shortfall. The diversity of lenders has grown significantly. The 2018 CASS CRE Lending Survey showed a 47% increase of loans originated by what it classified as ‘other banks’. While this relative explosion is largely down to an increase in the sample size of lenders now included in the survey, this in itself underlines the relative growth in diversity of participants in this market. Our own analysis indicates that while real estate insolvencies remain relatively low compared with the long term, more recently there has been a tangible increase of appointments – a rise of 22% between Q1 2017 and Q1 2019. Perhaps more interesting is the make-up of lenders enforcing. In Q1 2017, the split between “mainstream” lenders and the “challengers” was about 50:50. In Q1 2019, the ratio was 21:79. At least to some extent, this will reflect the relative decline of activity by traditional banks in real estate finance. But given that according to CASS, “mainstream” lenders still hold circa 60% of the UK market, the challengers appear to be having disproportionately more problems – or perhaps are more comfortable enforcing. However, this implies that the diversification of lenders has not necessarily led to a diversification of risk. Increased caution Of course, it may be that this is to some extent part of the learning curve for the challengers as they mature into the market. But as loan books grow and settle, issues will inevitably arise, and some loans will not got according to plan.  For smaller lenders, or some of the P2P platforms that don’t necessarily have the balance sheet or capital to fund the losses or to support a longer term work-out, the problems can be very real. As almost everyone accepts, we are now late in the property market cycle. This is combined with ongoing Brexit uncertainty, genuine declines in certain markets and fundamental structural changes in others. Therefore, as the loan books of new entrants start to settle, challenges are going to become apparent and will increase in quantity. Going forward, we are likely to see an increased level of caution being exhibited by both new entrants as well as established lenders. This will mean that the re-finance option will not be so readily available to borrowers (nor will it come to the rescue of their existing funders) as a means of moving a problem on. We will likely see a steady increase in defaults in the real estate debt sector, both on a loan-by-loan basis and amongst some of the lenders themselves. However, the reality is that while in each case a small group of investors may get hurt – and some with more than just their fingers burnt – it will be a diverse enough collection for the ripple on the pond not to reach government or the wider public. Joe Pitt is head of recovery and restructuring at Fraser Real Estate