Over the last decade or so, the UK has enjoyed not one but two property bubbles. While residential property prices received all the attention, commercial prices have also shot into the stratosphere.
Both markets are in deep trouble. While denial remains pervasive in the residential sector, the commercial property suffers from very little irrationality. Prices are down massively, perhaps 15-20 percent from the peak.
As prices have tanked, investors and banks are desperately trying searching for the fire exit. As investor confidence collapsed last summer, net flows into property funds suddenly went negative. As banks woken up and realized that they are deeply implicated in a crashing market, they have belatedly increased interest rates and cut their maximum loan-to-value ratios. In short,panic has gripped the market.
This sudden change in sentiment may have arrived too late for UK banks, who continue to be heavily exposed to commercial property. According to the Bank of England, commercial property lending accounts for 38 percent of UK bank lending to private non financial companies. Back in 1998, this figure was just 19 percent. Last year, banks were holding around ₤247 billion of loans issued against commercial property. That is around 17 percent of GDP - so we are talking big numbers here.
This debt number hides a more interesting figure. Last year, banks saw a 16 percent jump in this kind of debt on their balance sheets. The reason? The securitization market broke down, forcing many banks to hold onto loans that they would have preferred to bundle up and sell to other investors. Instead, this debt sits like a rancid Kebab on bank balance sheets, preventing a recovery in commercial property lending.
Looking forward, the situation is bleak; prices are dropping, credit has dried up, and defaults are expected to rise. So far, the market hasn't seen a significant rise in bad loans. Defaults rates are currently less than one percent. However, it is still early days. If a recession takes hold, that rate will begin to rise, and then banks will really begin to sweat.