The UK is facing a prolonged recession while transactions are drying up and banks in turn are writing fewer loans, but there are many reasons to be upbeat about UK property's ability to see out tougher times.

That was the key theme of this year's key annual conference for commercial real estate lenders in Europe, the CREFC 2022 Conference in London.

During the Global Financial Crisis (GFC) real estate lending liquidity evaporated setting in motion a vicious circle which destroyed balance sheets. So, when Europe’s lenders convened at the hybrid virtual and in-attendance conference just three weeks after Bank of England governor Andrew Bailey announced that the UK would face its longest recession in 100 years, attendees might have been expecting a bit of panic. Instead what ensued was calm and sober analysis.

Rather than denying the situation as so many in the industry did in 2007, the panels confirmed what the brokers have already reported in their third quarter results announcements: transactions are drying up and investors are taking a wait-and-see approach among rising uncertainty. As a result, banks are writing fewer loans which confirms the messaging from Expo Real where limited visibility and further price corrections caused real estate investors to pause.

Panellist Andrew Burrell, Chief Property Economist at Capital Economics, summarised it well: "A recession is now almost inevitable and interest rates would rise from a historically low base and would stabilise most likely at a higher level than previously expected. This would be the new reality to which real estate markets need to adapt."

Consensus at the panels arrived at a shallow but prolonged recession, essentially a “Hail Mary” scenario where the offence accepts beforehand that the ball will be dropped. As economists argued in ”Hard Knocks or Hail Mary: Economists on Both Sides Like Real Estate As a Hedge”, capital would still be attracted to real estate in this case which could provide a floor under valuations well above senior debt loan-to-values.

However, this is not the main reason for the calm and confidence. Instead, lessons have been learned from the fallout from the GFC and the current property lending industry is unrecognisable from the one that almost blew up fifteen years ago.

So what were the key themes to emerge this year?

Firstly, the practice of “active debt management” has lender and borrower share real-time information about cashflows, vacancies and other operational metrics, while lenders also gain better insight on current market valuations. These early forewarnings allow remedies to be sought earlier avoiding more dramatic solutions and potential foreclosures.

Current falls in asset values were roughly between 15-30% according to panellists, which is in line with other market sources. Loan-to-values for senior debt are 40-60%, so lenders felt comfortable with ongoing loans. Potential issues could arise at refinancing as the cost of debt has moved up significantly and as a result focus has shifted from loan-to-values (LTV) to more dynamic debt service cover ratios (DSCR).

And this is a second lesson learned from 2008: many term sheets include “cash-trap” clauses enabling the lender at early covenant breeches to stop cash leaving the business through fees and dividends. Banks have therefore more time to work out and restructure loans before foreclosure looms.

Stricter regulation and “slotting”, which requires banks to assign one of four different risk weights, ranging from 50 to 250%, to all property loans on their books. is a third lesson learned from the GFC. As a result, bank balance sheets and industry leverage are much healthier, which should limit fire sales of massive non-performng loan portfolios.

Instead, buyers of bank enforced assets are more likely to be industry buyers this time. Whereas in 2009-10 liquidity was concentrated in large pools of opportunistic private equity capital, the same funds now have large pools of core real estate capital often managed on a permanent capital basis. This capital is likely to pounce on deals at levels above full distress to not miss a deal.

Hence the bankers see some stress appearing in the market, but distress is likely to be concentrated in pockets. For example, assets such as secondary offices in weak locations with a massive ESG upgrade requirement could become obsolete and large write-downs can be expected.

Development financing is another victim with few banks currently willing to underwrite loans. With equity expensive this gap could be filled by non-bank lenders offering mezzanine or junior financing. Nevertheless, many delegates thought development would slow supporting valuations of those standing assets underpinning their loans.

Finally, a good point was made that even if the real estate lending industry was in good shape the hit could come from somewhere unexpected. Small and medium enterprise (SME) lending has increased throughout the pandemic and these loans are coming due in the middle of a recession with inflation at 40-year highs. Tenant risk therefore might be the thing that keeps lenders awake at night in the coming months and CoStar data shows that UK rent growth is slipping amid faltering demand for smaller warehouses.

The mood was sober but confident at the CREFC Conference and the lending sector seemed prepared for the upcoming recession. However, it is one thing to be confident and another to be right and only time will tell if real estate lenders have indeed learned the lessons from the GFC.