Thursday, May 19 2022

Later this week, a deadline for submissions to the Central Bank on a proposed leverage limit for all regulated real estate funds ends.

Most interested parties will have expressed their concerns, comments and suggestions in detail to guide the regulator’s consultation process. These views include a mixture of shock and genuine concern about the potential impact this limit will have on investment in Irish property, at a time when supply has been widely identified as the crucial factor in mitigating the housing crisis.

The Central Bank intervention proposes to set a hard leverage limit of 50% on the ratio of total debt to total assets for all property funds in Ireland. The proposal aims to minimize macroprudential economic risks related to leverage and potential liquidity mismatch resulting from the disorderly disposal of assets caused by breaches of loan covenants, investor redemptions or risk of refinancing.

John Buckley is Director of Corporate Finance at CBRE

The first two causes stem from the risk of a fall in valuations, which can deteriorate leverage ratios and risk breaching covenants, which instills fear in investors and leads to redemption requests.

This raises the question of how the evaluation process will be applied and how often it will be required; does the valuation mean the standard red book valuation or what an asset could realistically achieve if sold immediately?

Refinancing risk can be measured by the weighted average duration of the debt within the fund and the duration profile of the income generated by it – the weighted average duration of unexpired leases. At the safer end of the scale are social housing funds, with a quasi-sovereign income of 25 years, which can reach funding terms of 15 years or more.

This secured income profile and term funding is the lowest risk category identified by the Central Bank – even if valuations fall, the income/funding profile minimizes any redemption risk for investors, while the risk of Reduced refinancing means they can easily weather an entire economic cycle.

This refinancing risk extends to assets with short-term rental income and short-term financing.

Leverage allows investors to amplify returns on low-yielding assets, which is crucial for certain cohorts facing high investment return hurdles, such as private equity

Rather than a single leverage limit, it makes more sense to apply a sliding scale for leverage based on revenue and funding tenors, which would more appropriately and fairly mitigate macroprudential economic risk.

Ultimately, liquidity risk is determined by the market in which an asset is traded and the speed of execution required. In a falling market, assets become inherently illiquid and fewer buyers are looking to catch the falling knife.

In 2007, as subprime mortgages in the United States deteriorated, the contagion led to a slight, but significant, revision in the prices of European ABS bonds. This led to a corresponding reduction in the net asset value (NAV) of structured investment vehicles (SIVs), whose rigid structure required immediate deleveraging once NAV limits were triggered.

This meant asset sales which, in a risk-averse market, results in the sale of higher quality assets due to their superior liquidity.

These programmatic sell-offs caused a repricing of high-quality assets, which re-priced all lower-quality assets even more, further reducing NAVs, causing more leverage triggers and more asset sales, etc. SIVs have essentially gone into a death spiral.

These rigid structural limits and triggers for leverage have led to self-cannibalization and dragged the ABS market with them.

Leverage allows investors to amplify returns on low-yielding assets, which is crucial for certain cohorts facing high investment return hurdles, such as private equity. Most Irish pensioners are exposed to real estate and almost all rely on leverage to ensure they can retire with a secure income in their old age.

Obstacles

When core residential assets only yield 3.5-3.75%, 60-70% leverage creates a 2.5-3.3x multiplier, which can increase returns by up to 7, 5-11% net equity return for investors.

Without this multiplier, large cohorts of the investing community simply will not view Irish property as a viable investment to overcome their return hurdles. Many may leave Ireland, and many more may strike us out altogether in the longer term.

The law of unintended consequences states that intervening artificially in a free market invariably leads to negative results.

The supply of housing that Irish people need will hopefully make it more affordable for the average household income, which the Housing for All policy document has been introduced to achieve. But the rigidity of this proposed leverage limit could easily catch up with funds sailing near the 50% cap, even if a modest reduction in Irish property prices occurs.

The catch-all nature of the leverage limit means that any programmatic forced deleveraging from a price review could affect all sectors of the Irish property market and beyond.

This proposed leverage limit could easily turn a housing market price revision into a broader stock market crash. The preventive measure could lead to the very result against which it is intended to protect and is arguably inconsistent with government policy.

The law of unintended consequences states that intervening artificially in a free market invariably leads to unfavorable results. While the banking crisis and global financial crash of 2008 remains a particular bugbear for the Irish financial sector, it should also serve as a valuable lesson. Need more nuance.

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