The CRE Lending Black Hole

1. The CRE Lending Black Hole Rupert Clarke Chairman PIA Long-term Value Group Managing Partner, Lipton Rogers Developments February 2019

2. The Property Market is Cyclical

3. CRE Index Capital Value Trend line – Inflation Adjusted(Source Radley Associates)

4. The Cyclical Rise and Fall of CRE(Source Radley Associates)

5. CRE Lending Rises Rapidly through the Cycle

6. Rapid expansion of New CRE Loans through the Cycle(Source Bank of England, de Montfort survey)

7. Loans Outstanding rose from £31bn - £255bn (1992-2008)

8. Calculating Cumulative CRE Lending Profits Compared to End of Cycle Losses

9. CRE Industry Profitability Calculation Components • Gross Revenue • Ave. Margins: 2.5% - 1.1% • Ave. Arrangement Fee: 1.0% - 0.5% • Ave. Redemption Fee: 0.5% - 0.1% • Ave. Non Utilisation Fee: 50% of Ave. Margin • Overhead Assumptions:30% Cost/Income Ratio • Reg. Cap. Assumptions: 0.80% Sources: de Monfort Survey, Lending Organisation Executives

10. 2008- 2018 CUM. W/Offs = £19.3bn (Source Bank of England)

11. The 1992-2008 Cycle CRE Lending Black Hole Gross Revenue from Margin and Fees: £28.0 bn • Less Business Operating Costs:£ 8.4 bn • Less Regulatory Capital Costs:£12.5 bn Gross Profit through the Cycle: £ 7.1 bn • Gross profit as a % of Peak O/S 2.8% Reported end of cycle Write Offs:£19.3 bn • Write Offs as a % of Peak O/S 7.6% Overall Cycle CRE Lending Loss: £12.2 bn

12. But reported Write Offs do not reveal the full picture

13. Latent losses at market value low point substantially exceeded reported write offs • Timing of write offs and Market Recovery • £19.3bn of write offs occurred after market values had recovered • Bottom of the cycle latent write offs: c.£30bn+ • Holding on until things get better not an optionfor all • The impact of Mark to Market • The market value of distressed loans <face value • High LTVs +low margins = significant discounts • Mark to market impairment = an additional c.£30bn Latent write downs of loan assets could have been as high as £60bn

14. What other research has looked at CRE lending profitability and what has it found?

15. Other CRE Lending Profitability Research • Mckinsey (Nov 2009) • Data frommajor European CRE Lenders (40% of market), 2006-2008 • “the industryisnot covering its cost of capital” • “Conservative organisations pulled back in early 2007…..” • CBRE (Q2 2015) • “CRE Lending Industry performance negative 1988-2015” • Fitch (April 2017) and BAML (February 2018) • “All Loan losses from loans made 2005-2007”

16. Why do End of Cycle CRE Lending Losses Exceed Cumulative Profits?Mathematical Factors and Behavioural Factors

17. CRE Lending Cycle Losses - Mathematical Factors • Lending book expansion through the cycle • £31bn to £255bn in 14 years • The larger the growth the greater the probability of losses

18. Cum. Profit/O/S vs Annual Loan Growth (simulation)

19. Last Cycle Cumulative Profitability Vs Loans O/S

20. CRE Lending Cycle Losses - Mathematical Factors • Lending book expansion through the cycle • £31bn to £255bn in 14 years • The larger the growth the greater the probability of overall loss • End of Cycle Profit Margins too low

21. Profit margins evaporated in second half of the cycle

22. CRE Lending Cycle Losses - Mathematical Factors • Lending book expansion through the cycle • £31bn to £255bn in 14 years • The larger the growth the greater the probability of losses • End of Cycle Profit Margins too low • Volumes of End of Cycle new lending too high • £164bn of new loans in 2006 – 2007: 65% of the 2008 £255bn peak • c.75% LTV’s followed by a 42% average fall in values

23. CRE Lending Cycle Losses - Mathematical Factors • Lending book expansion through the cycle • £31bn to £255bn in 14 years • The larger the growth the greater the probability of losses • End of Cycle Profit Margins too low • Volumes of End of Cycle new lending too high • £164bn of new loans in 2006 – 2007: 65% of the 2008 £255bn peak • c.75% LTV’sfollowed by a 42% average fall in values • LTV’s need to be proactively managed • Lenders need “End of Cycle Strategies” to reduce LTV’s …....or • LTV’s need to be lower throughout the cycle

24. CRE Lending Cycle Losses – Behavioural Factors • Peer Pressures • Fear of moderating lending “too early” and losing out • Organisational inertia • Collective complacency, kicking the can down the road • Short term horizons • Business plans and profitability targets are short term • Organisations do not look at the whole cycle profitability • Lack of clear end of cycle CRE lending strategies • The need for an unambiguous “End of Cycle Strategy” is not recognised

25. Relevant Last Cycle Statistics • Lenders consistently fail to recognise end of cycle risks: After making a record breaking £82bn of new loans in 2006, 89% of CRE lenders planned to increase their new lending activity in 2007 (de Montfort) • Lending activity usually rapidly increases as values increase and the end of the cycle nears: • New CRE loans 1994-1997: £22bn. • New CRE loans 2004-2007: £234bn (de Montfort/Bank of England) • The majority of losses are linked to end of cycle loans: All last cycle CMBS write offs related to issues 2005-7 (Fitch) • End of cycle CRE lending losses swamp all of the lending cycle profits…...........

26. The 1992-2008 Cycle CRE Lending Black Hole Gross Revenue from Margin and Fees: £28.0 bn • Less Business Operating Costs:£ 8.4 bn • Less Regulatory Capital Costs:£12.5 bn Gross Profit through the Cycle: £ 7.1 bn • Gross profit as a % of Peak O/S 2.8% Reported end of cycle Write Offs:£19.3 bn • Write Offs as a % of Peak O/S 7.6% Overall Cycle CRE Lending Loss: £12.2 bn

27. Why has the Regulator not acted in the past?Wasn’t it just the Scottish, Irish and Icelandic banks?Was 1992-2008 a repeat of previous cycles?Can’t you predict a potential crash?Will it be different this time/next time? Some other obvious questions

28. Why has the Regulator not acted in the past? • A lack of clear guidelines/no CRE specialists • How can the regulator possibly decide when to act? • A micro approach to macro problems • Market failures are macro. The regulator preoccupation with micro is a misleading distraction • Regulators should not worry about taking action too early • Better for everyone too early than far too late • Clear roles and responsibilities • Treasury, Bank of England, FSA – who was in charge?

29. Wasn’t it just the Scottish, Irish and Icelandic banks? • Scottish, Irish and Icelandic banks: loss ratios of up to 20% compared to the industry average of 7.6% • “Median banks” experienced a 3.5% loss ratio (B of E data) – profit levels were still insufficient to cover their losses • 89% of banks wanted to increase CRE lending in 2007 after a record year in 2006, the worst possible time to be lending. • New lending in 2007 increased £84bn (another record year) with 62% increasing their new lending volumes The obvious conclusion is that the vast majority of CRE lenders suffered through the cycle losses

30. Was 1992-2008 a repeat of previous cycles? Rapid lending growth = Major CRE Write Offs and through the Cycle losses

31. Cum. Profit/O/S vs Annual Loan Growth

32. Was 1992-2008 a repeat of previous cycles? Rapid lending growth = Major CRE Write Offs and through the Cycle losses Growth in CRE lending cycles • 21% pa in the 8 years up to 2008 • 28% pa in the 8 years up to 1990 • 92% pa in the 3 years up to 1974 Not explained by growth in market values over the same period • 4.5% pa in the 8 years up to 2008 • 6.9% pa in the 8 years up to 1990 • 19% pa in the 3 years up to 1974 Conclusion: The UK CRE Lending Industry has been loss making for over 50 years (a pattern that is likely to have been repeated in other developed CRE Lending markets)

33. Can’t you predict a potential crash? 1934 1970 1988 2004

34. Will it be different this time/next time? • The Good News • Currently average LTV’s are 60% or less and have come down • Loans O/S are c.35% lower than 2008 O/S (vs.1992-2002, 200%+ O/S increase) • New “slotting” approach to Reg. Cap. is holding lenders back • Lending organisations are also generally being more cautious • The Bad News • Market values (ex retail) are substantially above long term trend • Unregulated lenders and other below the radar lending is increasing • Lending organisations still do not have explicit end of cycle strategies

35. The 1992-2008 Cycle CRE Lending Black Hole Gross Revenue from Margin and Fees: £28.0 bn • Less Business Operating Costs:£ 8.4 bn • Less Regulatory Capital Costs:£12.5 bn Gross Profit through the Cycle: £ 7.1 bn • Gross profit as a % of Peak O/S 2.8% Reported end of cycle Write Offs:£19.3 bn • Write Offs as a % of Peak O/S 7.6% Overall Cycle CRE Lending Loss: £12.2 bn

36. The CRE Lending Black Hole Rupert Clarke Chairman, PIA Long-term Value Group Managing Partner, Lipton Rogers Developments February 2019