Mind the Gap – The Rise of ‘Shadow’ Banking in Real Estate Lending
There is no doubt that real estate lending has become an increasingly vexed issue for the prudentially regulated banking industry in the last 12 months.
A series of measures by APRA to curb lending to investors, tighten construction lending and rein in ballooning household debt has, amongst other things, lead to a number of banks (and particularly the larger ADIs reducing residential mortgage lending to foreign investors, putting the brakes on development finance for new residential developments and, most recently, increasing pricing on interest only loans. However with investor demand (both foreign and domestic) for residential property in major urban centres remaining high, a funding gap has opened up on both the supply and demand side of the equation presenting an unprecedented opportunity for non-bank lenders.
So how did we get here? For the past few years APRA has been focussed on addressing prudential risks in the housing market arising largely from historically low interest rates, high levels of household debt relative to earnings, strong demand for credit from property investors and a large and growing concentration of residential loans on many bank balance sheets. In response to these concerns, APRA has taken a number of measures, including (amongst other things):
- setting a benchmark limit of 10% annual growth in residential mortgage lending to investors in December 2014;
- increasing the average risk weighting applicable to residential mortgages to 25% in July 2015;
- limiting new interest only loans to 30% of total new residential mortgage lending; and
- imposing restrictions on the number of residential mortgage loans with a loan to value ratios greater than 80%.
Whilst some of these measures are in the form of ‘guidance’, rather than being enforceable limits (eg the 10% ‘speed’ limit on investor loans), the APRA-regulated banks are adopting these measures. This has in turn resulted in a tightening of lending criteria for investor loans (particularly to foreign investors) and, more recently, increased pricing on interest only loans for both investors and owner-occupiers.
At the same time, the banks are retreating from financing developers to construct new residential projects. This creates an interesting tension within the banks where, by limiting credit to investors, there is a heightened risk (particularly within the apartment market) of such investors failing to complete on purchases, which in turn may affect the serviceability of development loans advanced by the banks to construct the affected apartment buildings.
The non-bank lending industry are seizing the opportunity created by this funding ‘gap’ and stepping up to provide finance to both developers and purchasers. Firms such as Qualitas and Gresham have recently closed new funds specifically mandated to provide development finance for new projects. On the purchaser side, the press have reported that private equity behemoths Blackstone, KKR & Oaktree are setting up residential mortgage platforms to cater to investor demand. These non-APRA regulated institutions, as well as others, have the risk appetite to go where the banks are no longer allowed or encouraged to go by the regulator, and the flexibility to provide products that the banks are largely unable to provide (eg stretch senior development loans). Although this comes at a price for the customer, the credibility of these institutions and their ability to raise capital in the wholesale market to finance these products means that the pricing is not so far removed from bank pricing so as to act as a deterrent.
With non-bank lenders racing to fill the funding gap in the real estate market, will APRA’s various efforts to address the risks associated with real estate lending have been in vain? I do not believe this will be the case. Although not regulated by APRA, there are a number of regulatory and commercial factors that operate to keep non-bank lenders in check, particularly in the consumer lending business, such as responsible lending and consumer credit laws. Additionally, many non-bank lenders raise capital in the wholesale lending market, often through warehouse facilities funded by APRA regulated institutions which, as a condition of funding (and in order to ensure they comply with applicable regulations governing such investments), impose specific eligibility criteria for the loans that can be made by such non-bank lenders.
Interestingly, as part of the 2017 Federal Budget, the Federal Government announced it would provide APRA with A$2.6million of funding over four years for APRA to exercise new powers over non-bank lenders. Although it is currently unclear what those powers will be, it would be fair to assume that APRA will use this mandate if it forms the view that the growth in non-bank real estate lending is undermining the effectiveness of the measures taken with respect to ADIs.
Watch this space!!
Nikki Smythe (LinkedIn) is a Senior Associate at Herbert Smith Freehills, specialising in banking and financing with a particular focus on distressed debt and special situations.