Not Very Well Known Facts about the Noughties Commercial Property Boom and Bust
December 2017 saw the release of Prof Colin Jones, Stewart Cowe and Prof Edward Trevillion’s book ‘Property Boom and Banking Bust: The Role of Commercial Lending in the Bankruptcy of Banks’. Here, Professor Colin Jones gives us an insight into some of their research findings.
The commercial property boom and bust of the last decade was a commanding global phenomenon. In Ireland the capital values of commercial properties in the boom rose by 70%, while in the UK and the USA they grew by just over 50% and almost 40% respectively. The subsequent bust precipitated by the global financial crisis (GFC) wiped away all these gains and still casts a shadow on the property market a decade later. But have we fully understood how it happened and what lessons are to be learned for property investors, banks and governments? Our book “Property Boom and Banking Bust” sets out the detail of what happened, including the market and institutional changes that led up to the boom and the consequences of the bust in particular for banks.
The book also reviews the boom and bust years in the context of previous booms and busts, particularly in the 1970s and 1980. It offers an assessment of the consequences of the GFC for the banking system and the commercial property industry and examines strategies banks have used to recover their positions and manage the overhang of indebtedness and bad property assets.
It demonstrates how the commercial property boom was supported by a change of investment sentiment following the collapse in share prices with the bursting of the dot-com bubble at the beginning of the decade. Investors turned away from shares to the bricks and mortar. The establishment of ‘retail’ commercial property investment funds marketed to small investors was a further important ingredient. Vast investment sums flowed into commercial property as the boom gathered pace.
At the same time banks underpinned this investment surge, the book shows, by frantically expanding their lending for commercial property, offering more and more generous terms. Loans to investors of commercial property were seen as offering secure and better returns than residential lending. There was a blissful ignorance of the scale of the risks. It was the culmination of an era that had seen the emergence of an entrepreneurial and deregulated banking sector, often referred to as casino banking, that developed from the late 1980s on.
To meet the increased funds needed the noughties saw a fundamental transformation in the business model of most banks that saw an overwhelming dependence on issuing bonds on a global basis to raise capital. This is known as wholesale funding and the book charts its rise. Removed from the historic constraints of raising funds mainly by (retail) high street savers the expansion of lending was supported by incentive based remuneration packages designed to maximise growth. The consequence was a frenzy of investment deals as the boom took hold supported by a mountain of debt. Heavily indebted (geared) investors saw their returns skyrocket as capital values soared. These returns are estimated in the book as more than 200% for many investors between 2004 and 2006 in the UK at the height of the boom.
The problem was that there was not sufficient rental growth to justify the rising capital values. Investors were extrapolating capital values in an irrational way unhinged from fundamental pricing. It was not just the new to the market, small inexperienced, investors but major investors such as financial institutions and advisors/agents/valuers were all complicit in this unfounded optimism. The wheels were inevitably going to fall off this investment bandwagon. The catalyst for the collapse was the GFC stemming from the subprime residential lending crisis in the USA.
The banks whose lending had been critical to supporting the boom then turned off the funding tap. This credit crunch led not only to the collapse in property values but the ramifications for many banks were deadly. To begin with there were their well publicised problems of liquidity as banks found it impossible to refinance their bonds coming up to their redemption date. The more fundamental trouble as the book explains was that the disintegration of commercial property values created a mass of highly indebted investors in negative equity as values fell to less than money owed on buildings.
Many of these debtors were unable to continue to repay their loans because their properties were empty or they were unwilling because their equity in these premises had evaporated. For some banks all the profits made in the euphoria of the boom the book demonstrates were wiped out by the subsequent deficits on commercial property lending (but not residential). Even worse, the extent of the losses was such that the capital bases of many banks were comprehensively exhausted and they went no longer viable. Many banks were ‘saved’ by governments, although some closed, and in the decade that has followed those continuing focused on reconstituting their capital base. Over this period since the credit crunch bank lending has been minimal and their attentions were on trying to revive or resolve their bad debts.
The challenge of addressing this task was monumental. The book shows that the extent of success by banks has been opaque with many debts completely written off and others sold on at a considerable discount to their paper value. A particular reason was the subdued property market and muted global economic recovery from the GFC, as governments in Western Europe turned to fiscal austerity policies to solve their fiscal deficits.
Overall the book explores the philosophical and behavioural factors that propelled irresponsible bank lending and the property boom; how it led to the downfall of the banks; the catastrophic effects the property bust had on property investors, both large and small; and how financial institutions have sought to recover in the wake of the financial crisis.
*Colin Jones (Professor, The Urban Institute), Stewart Cowe (Formerly (formerly of Scottish Widows Investment Partnership) and Edward Trevillion (Honorary Professor, The Urban Institute)