Leading indicators: Will bank collapses trigger further belt-tightening in real estate?

Leading Indicators is a column written by RICS Chief Economist, Simon Rubinsohn. In this article, he considers how the recent collapse of SVB, Signature, and Credit Suisse might impact upon interest rates, stability in financial markets, and the real estate sector.

Central banks have made their big calls over the past few weeks. The priority, it appears, remains the fight against inflation. The US Federal Reserve, the European Central Bank, and the Bank of England have all chosen to lift interest rates further despite the uncertainty fuelled by the turmoil in the banking sector. That said, there does now seem to be a sense that the pause button is likely pushed sooner rather later. This would provide policymakers with the breathing space to assess the impact of the measures already sanctioned. It would also allow space to determine if there will be any contagion from the fallout at SVB, Signature and Credit Suisse.

Despite the odd hiccup or two on the inflation numbers (the February rise in the UK to 10.4% was a case in point), base effects will see annual rates (of inflation) falling sharply over the coming months. But critically, that doesn’t mean inflation is heading back to the targets set either by, or for, the key central banks. Indeed, the ongoing resilience of economic activity, and more specifically the labour market, continues to pose a particular and peculiar challenge. In many ways, a ‘job-rich’ downturn is the holy grail for policymakers; a slowing in economic activity helping to squeeze an inflation shock out of the system with little broader collateral damage (and with unemployment remaining at historically low levels). Whether this represents a plausible set of outcomes is now the key issue that monetary authorities are grappling with. Concerns about what is described as ‘core’ inflation are indicative of the threat that a somewhat higher (than target) inflation rate risks becoming embedded in the psychology and behaviours of both households and businesses.
 

Meanwhile, the consequences of the latest set of bank failures have yet to cast a shadow over the economy beyond what appears a relatively modest pullback in equity markets to date. It remains to be seen whether this tremor turns into a full-blown banking crisis. The consensus currently seems to be solidly behind the position that it won’t. This is partly because the industry is so much better capitalised than it was running into the Global Financial Crisis (GFC). It is also frequently pointed out that the quality of loan books is in better shape with lenders generally much less cavalier in terms of lending multiples and loan to values. That said, what is clear from recent events and indeed, the turmoil in the UK pension sector last autumn, is that the tightening in monetary policy and the impact this is having along the yield curve has the scope to cause considerable disruption to risk strategies built around the perception that a low interest rate environment was ‘here to stay’.

One very likely outcome from this is a probable tightening in lending standards as banks seek to respond to the increasing strains they are encountering. To put this prospect in some context, the evidence suggests this is a process already under way prior to the events of recent weeks. Take the Senior Loan Officers Survey from the US as a case in point. A net balance of over 40% of the respondents to the quarterly questionnaire run by the Federal Reserve was adopting stricter lending criteria in the early part of this year when it came to Commercial and Industrial lending. With the exception of the early period of the pandemic, this was the highest reading for this indicator since the GFC. Moreover, when it came to commercial real estate, the proportion of loan officers following a similar approach jumped to nearer 60% (in net balance terms). For the record, this was even higher for construction and development.

One way to assess how this may be playing out in the wake of recent events is to have a sneak preview at the responses coming into the Q12023 RICS Global Commercial Property Monitor (GCPM). The survey field work began in the middle of the month (March), so after the banking problems had begun. On the basis of a 25% sample (so the number needs to be treated with some caution), a net balance of 35% respondents to the Q1 2023 GCPM are already pointing to a further deterioration in credit conditions.

The probability that this tightening in lending standards will become even more pronounced raises an interesting question around the potential drag on output and unemployment. Significantly, the threat of a credit crunch is now the number one concern amongst investors according to the monthly survey of fund managers by Bank of America. Work by Oxford Economics suggests that it could take the best part of a year for the tougher lending criteria to be felt more widely. This makes the high wire balancing act that central bankers are currently having to perform around the inflation challenge look even more treacherous.

As for real estate, while the turmoil in the banking industry has not been a result of ill-judged property lending this time around, it is hard to believe this sector will not be disproportionately impacted by the legacy of the response, particularly in the US. Interestingly, I have already seen calls for regulators to reinstitute a ‘troubled debt restructuring programme’ for commercial real estate that would provide financial institutions with greater flexibility to refinance loans. This partly reflects the important role that smaller banks play in the real estate industry in the US. Of the $4.5tr on their bank balance sheets, loans to commercial property account for close to half of the total. In the case of the UK, the story is fortunately a little different. Bank exposure to real estate debt is relatively low, at around 6% of all loans outstanding compared with around double this at the time of the GFC.

Even so, a more cautious approach from lenders is still likely to weigh on investment volumes. Having plummeted to their lowest level in Q4 2022 since the GFC (which the exception of the Q2 2020), activity continues to bump along the bottom. Recent data from Savills show transactions running at just over £3bn in the first two months of the year which is roughly 50% of the average over the past decade. And an early uplift in activity seems implausible against what looks likely to be an increasing tight financial backdrop.