Why we need to predict the next real estate crash

COMMENT: The quarterly publication of an adjusted market value of UK “all property” is the first real attempt at introducing a mainstream metric that can be used to assess the likelihood of a UK commercial real estate market crash, says Rupert Clarke, chair of the PIA debt group and managing partner at Lipton Rogers. Properly applied, AMV has significant potential to minimise CRE lending risks as the market trends towards the end-of-cycle peak and crash, a period where, historically, the banks have lost their shirts. [caption id="attachment_896435" align="alignright" width="150"] Rupert Clarke[/caption] Up until now, market commentators and participants’ use of quantitative proof points to call the end of the cycle has been limited or non-existent. Contradictory, unclear or uncertain commentary on where the market is or is not going allows market momentum to build to its inevitable end-of-cycle outcome relatively unfettered. Incontinent end-of-cycle behaviours have had consistently disastrous consequences for CRE lenders, almost all of whom tend to still have their foot firmly pressed to the floor as the market goes over the cliff. In the last cycle, CRE lending contagion conflated with other excessive financial exuberance, bringing the UK and global banking system to the brink of disaster. Ironically, increasingly sophisticated financial markets, attracting the brightest and the best minds, have exacerbated the risks at the same time as the Western economy financial systems have significantly less capacity and latitude to absorb future financial shocks. Unless the next wave of end-of-cycle overexuberance can be contained, the consequences will be dire. So is adjusted market value the silver bullet? Will AMV guarantee a much softer landing next time? Not necessarily. Firstly, and most importantly, the market needs to take the measure seriously and respond when the warning lights start flashing. In particular, CRE lenders will need resolute determination to walk away from the end-of-cycle drug of booming CRE lending profits – they are hallucinatory and a potentially fatal poison. Secondly, there can be no guarantee that AMV will be exactly “right” every time. Certainly, it is a huge improvement on and will work far better than market value as a predictor of future values, but it would be wrong to assume that it is infallible. CRE lenders and regulators will need to recognise that constraining loan-to-values at 65% or lower when AMV is trending up is important, alongside attention to maintaining the usual asset by asset underwriting standards. Currently, CRE lending organisations seem to be behaving responsibly. This is principally because the impact of the global financial crisis still remains vivid in individual and organisational memories. However, these memories have a half life. The bigger the previous crisis, the longer the half life. It is no coincidence that Barclays, which was taken to the brink by its CRE exposures in the early 1990s, was one of the least exposed in 2007. The current cycle’s half life looks as though it will be far longer than usual because of the magnitude of the GFC. However, in time, grey hairs will retire and organisational memories will fade. And unless lending organisations have hard-wired a metric such as AMV into their risk systems, everyone knows what will happen next. PIA warns of 50% chance of crash in the next five years.