New Zealand's commercial property lending less risky now due to lower debt funding

The Reserve Bank says New Zealand's $180 billion commercial property sector has become less risky since the global financial crisis because a reduced amount of debt is being used to fund new developments and purchases.

In a bulletin today, the bank said commercial property lending has been the main reason for defaults worldwide during most financial crises.

There was a major commercial property bust in the late 1980s in New Zealand after the 1987 sharemarket crash, when a large supply of properties came on the market, forcing vacancy rates in Auckland to more than 30% while prices fell more than 60% from their peak.

Most people link the implosion of sub-prime lending in the US residential property market to the global financial crisis (GFC) but the Reserve Bank said commercial property prices also fell significantly in many OECD countries, at rates almost universally higher than for residential property.

New Zealand's commercial property sector is again in expansion mode, following a 30 percent drop in property values after the GFC. Over the past two years, prices have risen at more than 6 percent annually, vacancy rates have dropped, sales have increased, and several major developments are now at the consenting phase.

One reason the commercial property sector tends to be a catalyst for defaults in tougher economic times is that there are significant swings in commercial property values over time and more borrowers in the sector tend to suffer financial stress and default on their loans during downturns, the bank said.

Other factors include irrational exuberance – where investors over-pay for property due to misplaced optimism about returns, which can lead to long periods when prices are higher than implied by the economic fundamentals of rental returns, vacancy rates, and interest rates.

At least two-thirds of commercial property stock in New Zealand is held by investors, with the rest mainly by owner-occupiers.

The sector accounts for about $30 billion of mainly bank debt and 9% of total bank lending. Because of its higher risk it plays an important part in the capital required to cover that bank lending.

Tighter lending standards were brought in by the banks after the GFC and with the near collapse of property finance companies, which also pushed commercial property prices down.

Although access to finance has improved in the past four years and development activity has picked up again, those tight lending standards remain. Banks are typically requiring loan to value ratios of 60% for new loans and some restrict borrowers taking out additional mezzanine finance, which gives the lender rights to take equity in the borrowing company if the loan isn't repaid on time.

Those lending restrictions have led to the supply pipeline being mainly funded by wealthy individuals and listed property trusts, who accounted for 30% of purchases in recent years.

Offshore investors also account for a relatively large and growing share of purchases due to comparatively high yields for the sector here compared to other parts of the world while institutional investors have reduced their holdings.

The Reserve Bank said that means the balance sheets of commercial property investors are in much better shape than before the GFC and debt to earnings ratios, including for the listed property trusts, have improved.

"This increase in equity buffers, along with the exit of riskier deposit-taking finance companies from the sector, has reduced the direct risks to the financial system associated with development lending. Moreover, the scale of the supply pipeline is forecast to remain well below that seen before the late 1980s crisis and the GFC, " the bank said.

(BusinessDesk)