SCHRODERS PROPERTY CONFERENCE
THE AUDITORIUM,
MERRILL LYNCH FINANCIAL CENTRE
100 NEWGATE STREET, LONDON
11 FEBRUARY 2003
Howard Davies
Chairman, Financial Services Authority.

When Jeremy Willoughby and William Hill of Schroders asked me to speak to you today, I was more than happy to accept. I last spoke on property issues in May 2002 when I helped to launch the latest De Montfort University study of lending to the property market.

So it is a good time to update.

But when I saw the shape of the programme, I was somewhat intimidated to find myself the lone layman among a constellation of property panjandra. Some indeed, have written the book, as they say. In particular, I well remember reading Alastair Ross Goobey’s work on the property market, very wittily entitled, ‘Bricks and Mortals’, a few years ago. I can offer nothing so profound, nor so elegantly constructed. This is very much a system built speech, I am afraid.

Some may ask why the Chairman of the FSA should be interested in the property market, and invited to speak. After all, we do not regulate property companies themselves. And much direct investment in property is outwith our regime, which covers investments in financial instruments.

But, in spite of that, our interests touch on the property market, and vice versa, in a number of important respects. Our overall market confidence remit gives us an interest in the state of the market as a whole. Our responsibility as the prudential regulator of lenders gives us a second important interest. We want to ensure lenders don’t overstretch themselves. We also watch for unhealthy risk concentrations. And our investor protection responsibilities require us to look closely at the types of property investment being promoted, and the kinds of investors being attracted into those vehicles.

This morning I would like to offer a few thoughts on each of those three dimensions of our investment in property.

Market conditions

Over the last year or two one has scarcely been able to pick up a newspaper without reading about the vertiginous rise in house prices. Both we, and the Bank of England, have made clear our view that the recent rapid pace of change is unsustainable. In our Financial Risk Outlook, published a couple of weeks ago, we explained the economic significance of the way in which the housing market eventually adjusts. Consumer spending has been significantly enhanced by the volume of mortgage equity withdrawal over the last couple of years. Last year it represented fully 10% of all consumer spending. Will only continue if prices continue to rise. We are seeing early signs of a correction, at least in the London residential market. We can only hope that the needed readjustments are relatively smooth.

We have heard less in the public prints about the commercial property market. Yet, if we look at what has happened, there is another remarkable growth story. Cumulative commercial property returns over the last 10 years beat equities bonds and gilts, over the whole period and indeed over sub-periods of one, three or five years. Gilts come closest with a 10-year return of just under 150%, against almost 190% on commercial property. And of course the 50% fall in the equity market since the bubble burst in early 2000, and the more recent deterioration in gilt prices, has further enhanced the attractiveness of commercial property as an investment class. Commercial property prices often seem to move contracyclically to equities, which is one of the characteristics which makes real estate an attractive option for portfolio diversification. And anecdotal reports suggest that long-term institutional investors are increasingly looking to raise their commercial property holdings.

So the industry can look back on an exciting decade. Does the future look as bright?

One would have to say that there look to be a number of risks on the horizon at present. In the first place, rents have continued to come under downward pressure. For the last 12 months the RICS commercial market survey has reported a net balance of surveyors expecting rents to decline, and London rents, at least, are now falling in absolute terms. The London City office market has experienced some sharp declines, though they have not been fully reflected in prime rents as rent-free periods have once again become more common. At the same time, vacancy rates have risen to around 10%, and weakening economic conditions in London seem to suggest that vacancies could rise further in the short-term.

So far, the London market has been significantly weaker than that in the rest of the UK, though there is some evidence of softening conditions in the M25 area as a whole and in the M4 corridor, which could be an early warning of weakness in other parts of the UK. For the time being, though, current rents outside the Southeast are generally holding up.

However, the general result in this decline in London rents, which has not so far been significantly reflected in falling capital values, is a growing imbalance between capital values in the market and those which might be implied by discounted rental income streams. Capital values seem to have been supported by increased investment into commercial property to exploit the attractive yield gap. They are vulnerable to a correction if investors were to shift back into equities – which may happen – or if economic conditions deteriorate significantly, or if rents continue to fall, exacerbating the imbalance. And that correction may not be smooth.

Let me emphasise one point. It is not the FSA’s job to forecast the central outcome for the property market, or indeed any other. But we think it is right for us to analyse risks, so that financial institutions and others may compare with them with their own assessment and take appropriate precautions where they believe the risk justifies them.

Although the evidence suggests that the fragility of the sector is well short of that seen in the late 1980s, we still have some cause for concern that the risks associated with commercial property lending have increased in the last few years. What does this mean for our prudential responsibilities?

Prudential regulation

I should first emphasise that not all of the major lenders to the UK property market are subject to our tender care. Although they have been reducing their involvement recently, German lenders have been in important parts of the market in the last two decades, as have the Japanese in the past.

If we look specifically at UK resident bank lending to real estate, which is part of our responsibilities, we can see that it has been growing strongly since 1998. While lending growth has moderated from over 24% year-on-year in the first quarter of 2001, to 20% year-on-year in the third quarter of last, this growth rate remains strong by historical standards. And total lending to real estate now accounts for 6.7% of loans outstanding, up from 4.7% at the end of 1998. During that period building societies have continued to be more active, taking up some of the slack left by the Germans, though the UK clearers still remain by far the dominant lenders.

Another trend we have noticed during this period is that average loan term periods have continued to lengthen. At the same time average leases have fallen to around 10 years or less. We have seen some examples of smaller lenders prepared to extend long-term loans against short leases. While there are still some even longer, 25-year leases around, lenders are now more often prepared to match such long lease terms exactly. That, in our view, is a risky proposition, in that there is no leeway for renegotiation, and a more prudent approach is to agree a term which is significantly shorter than the lease or at least matches it more closely. Residual values are becoming an increasingly important element of loans, raising the risk profile of commercial property lending. Some less experienced lenders or indeed more aggressive lenders may be mispricing their commercial property loans relative to their risk profile, to generate increased business in a competitive market.

I should emphasise that our assessment does not suggest that large numbers of institutions are potentially in trouble, or indeed that any have their viability threatened by their commercial lending book. And we should not forget that there is not nearly the amount of speculative development that there was in the 80s. Moreover, economic conditions are benign by comparison. Nonetheless, given the overall softening of the market, especially in the Southeast, and the volume of money looking for a more profitable investment home than the equity market, it is right for us to be on the alert. At a time when direct commercial property lending is close to its previous peak reached in 1991, we think it right to draw lenders’ attention to the possible risks for them of a market correction.

Retail investment

Major lenders, you may argue, should be able to reach these judgements for themselves, and I agree. Though the evidence here, and elsewhere, suggests that there is some value in prudential regulators uttering a cautionary word from time to time, to warn of irrational exuberance – which can affect the property market just as it can the stock market.

Our bigger concern, however, is the risk that retail investors are attracted into the market, without properly understanding the nature of the risks they run, or perhaps without appropriate diversification, given the size of their portfolios in relation to their overall net worth.

There is considerable evidence that smaller investors are increasingly looking to invest in commercial property, and indeed in the buy-to-let market. That is not surprising in view of the relative returns on property and equity investment in recent years.

The method by which such investors choose to enter the market defines the degree of risk involved for them. Attention has recently focused on private property vehicles, especially limited partnerships and to a lesser extent property unit trusts, private corporate vehicles and offshore company structures. This market seems to have grown rapidly in importance, with limited partnerships growing from just over £1 billion of gross assets in 1996, to over £13 billion in 2001. It is not clear just how much of this increased investment represents retail money, but we must assume that some of the increase comes from smaller investors.

In general, the degree of risk of loss attached to property investment will depend on whether the type of underlying investment is real property, property company shares (or a mix of the two), the spread of investments in the funds and the level of gearing.

We therefore have three areas of concern in the retail market.

First, while residential property investment is familiar to many householders the complexities of a packaged investment product and the associated risks may be far from transparent. The financing structures of indirect commercial property investments can be complex and there is ample scope for retail investors to fail to understand the risks involved. The price references are not always robust. There can be a lack of liquidity and high transaction costs. And we are seeing some anecdotal evidence of highly geared investors being funded lenders who then refinance to gear up against increased values, with equity being reinvested as a small deposit on the next investment.

Second, some investment vehicles such as single property leveraged investment schemes may promise to be low risk, with a "blue chip" corporate client renting your building. However, such schemes can turn out to be high risk, unless they form part of a diversified investment portfolio. Your blue chip corporate may turn out to be the next high profile corporate failure and, given a lack of liquidity in this segment of the market, it can be difficult to re-let or sell the property.

The third area of concern, even though it is not covered by our regulatory regime, is the buy-to-let market. This has been a remarkable growth story. Outstanding buy-to-let mortgages have grown from just under 1% of outstanding loans in 1999 to just over 3% now, at a time when total mortgage lending growth has been exceptionally strong. Yet recently the demand/supply balance seems to have deteriorated and rents have fallen in London for five successive quarters. As rents fall some borrowers are finding that rental incomes are not covering the cost of servicing the mortgage, leaving them reliant on capital growth to maintain their investment. If property prices fall, some could be exposed to negative equity and they find they are unable to repay their loan principal. Before they enter this market, it is important for investors to understand the potential risk – recognising that for many this has been a successful strategy in recent years.

But while the FSA may warn about risk, in general terms, the key for many investors to a successful investment strategy is good quality advice. The appropriateness of advice given in the retail market is a generic concern for us, and an increasing one given the complexity of products on sale. Have the understanding and sophistication of both the retail investor and the financial adviser kept pace with growing product complexity?

There are, of course, strict controls on the marketing of property-related collective investment schemes for the general public. In general it is not possible to market unregulated schemes to retail investors and the sale of regulated schemes is subject to the conduct of business rules on ‘know your customer and suitability’. An advisory firm has to conduct a fact-find and assess the product’s suitability for the individual concerned, before selling a scheme to a private customer. These safeguards help to minimise the risk of mis-selling. But, nonetheless, people in the market tell us they know of examples of IFAs active in the market with a poor knowledge of property investment and therefore a poor ability to advise on suitability. Some see a case for formal training, perhaps via the Royal Institute of Chartered Surveyors. Others believe that some of the collective investment scheme rules are too complicated, and tend to push investors into offshore vehicles which might not be so effectively regulated.

We have reflected on these concerns, which are largely anecdotal at this stage and, as a result, we have recently launched a project which aims to look at the risk to retail consumers from investing in property funds. Some of you may be aware that part of our new strategic approach is to carry out thematic projects in the retail market, rather than focusing our effort on making firm by firm visits which can be less than fruitful in identifying emerging market trends.

What we are looking at in this project is the nature of property funds currently being marketed, the information available about those funds, the risks in each category, and the extent to which financial advisers understand, and properly advise on this type of investment. So we will be looking at unit trusts and investments trusts, offshore closed-end companies which can be incorporated in ISAs, limited partnerships, single property syndicates etc. The overall aim is to ensure that consumers are properly informed of the risks associated with property funds. To do that we need to improve our own understanding of the wide range of investment products that now make up the sector. I should emphasise that this is preventative, not curative work at this stage. We also have no evidence of extensive mis-selling.

A second important initiative we have under way, in response to these concerns, is a review of the rules relating to authorised collective investments schemes investing in property. The rules in force date back to 1991. The approach is that funds should remain open both for issue and redemption of units at all times, and should operate with spread rules on the lines imposed on normal security-style funds. At least 20% of the fund must be invested in property related assets, such as property company shares, that are easily redeemable. In addition there are limits on the types of property in which the fund may invest.

We need to look at whether these existing rules remain appropriate for funds sold to retail investors, or whether some limited relaxation of them might best meet investors’ needs. For example, we might allow redemption at discrete intervals, rather than continually. We are currently taking soundings from the industry and we will be putting forward some proposals for possible change in due course.

At the same time we are looking at how our rules, which currently provide for a one-size fits all approach to consumer protection, should differentiate between the needs of retail investors and of institutional investors. One possibility is to consult on a new type of authorised scheme that can only be sold to institutional investors. As such a fund would not be available to retail investors, the level of product regulation could reasonably be reduced. We are working with the trade bodies, the Treasury and the Inland Revenue to see if we can design a suitable regulatory structure which will meet the needs of the market in the longer-term.

Conclusion

I am aware that, this morning, I have been able to do little more than skate across the surface of some complex issues. I am sure that the sessions later in the day will explore the dynamics of the market in greater depth. Perhaps you will conclude that my risk warnings are misplaced – or you might conclude that they should be louder. We’ll be interested to hear. More importantly, I hope that you will address yourselves to the question of what kind of regulation is appropriate for the property market in the future, what kind of collective vehicles we should be encouraging, and how best we can ensure that the investment opportunities match the risk appetite of investors, and vice versa. We would like to promote a closer relationship between the FSA and the property industry, broadly defined, and I hope that my appearance here today can give a stimulus to that developing relationship.

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