Later this week, a deadline for submissions to the Central Bank on a proposed leverage limit for all regulated property funds closes.
Most interested parties will have aired their concerns, observations and suggestions in detail to guide the consultation process for the regulator. These views include a mixture of shock and genuine concern over the potential impact this limit will have on investment in Irish property, at a time when supply has been widely identified as the crucial factor in alleviating the housing crisis.
The Central Bank’s intervention proposes setting a rigid 50 per cent leverage limit on the ratio of total debt to total assets for all property funds in Ireland. The proposal is aimed at minimising macroprudential economic risks from leverage and potential liquidity mismatch from disorderly asset disposal caused by loan covenant breaches, investor redemptions or refinancing risk.
The first two causes evolve from the risk of a reduction in valuations, which can impair leverage ratios and risk breaching covenants, which prompts investor fear and leads to redemption requests.
This begs the question as to how the valuation process will be enforced and how often it will be required; does valuation mean standard red book valuation or what an asset could realistically achieve if sold immediately?
Refinancing risk can be gauged by the weighted average tenor of debt within the fund and the tenor profile of income generated by it – the weighted average unexpired lease term. At the safest end of the scale are social housing funds, with 25-year quasi-sovereign income, which can achieve 15-year funding terms or longer.
This secure income profile, and term financing, equates to the lowest category of risks identified by the Cental Bank – even if valuations fall, the income/funding profile minimises any risk of investor redemption, while the reduced refinancing risk means they can easily ride out an entire economic cycle.
This refinancing risk ranges all the way down to assets with short tenancy income and short-term funding.
Leverage enables investors to magnify returns from low-yielding assets, which is crucial for certain cohorts with high investment return hurdles like private equity
Rather than a single leverage limit, it makes more sense to apply a sliding scale for leverage based on income and financing tenors, which would more appropriately and fairly mitigate macroprudential economic risk.
Ultimately, liquidity risk is driven by the market an asset trades in and the speed of execution required. In a falling market, assets become inherently illiquid with fewer buyers looking to catch the falling knife.
In 2007, as US subprime mortgages soured, contagion caused a slight, but significant, repricing in European ABS bonds. This caused a corresponding reduction in the net asset value (NAV) of structured investment vehicles (SIVs), whose rigid structure required immediate deleveraging once NAV limits were triggered.
This meant asset sales which, in a risk-averse market results in the best quality assets getting sold due to their superior liquidity.
These programmatic sales caused a repricing of high-quality assets, which repriced all lower quality assets to an even greater extent, further reducing NAVs, causing more leverage triggers and more asset sales, etc. SIVs essentially entered a death spiral.
These rigid structural leverage limits and triggers resulted in self-cannibalisation and dragged the ABS market down with them.
Leverage enables investors to magnify returns from low-yielding assets, which is crucial for certain cohorts with high investment return hurdles like private equity. Most Irish people with pensions have exposure to real estate and almost all rely upon leverage to ensure they can retire with secure income in their old age.
Hurdles
When core residential assets are yielding only 3.5-3.75 per cent, 60-70 per cent leverage creates a 2.5-3.3x multiplier, which can boost returns to as high as 7.5-11 per cent net equity yield for investors.
Without that multiplier, large cohorts of the investor community simply won’t consider Irish property as a viable investment to clear their return hurdles. Many may exit Ireland, and many more may completely write us off for the longer term.
The law of unintended consequences dictates that artificially intervening in a free market invariably leads to adverse outcomes
The supply Irish housing craves will hopefully make it more affordable for the average household income, which the Housing for All policy document was introduced to achieve. But the rigidity of this proposed leverage limit could easily catch out funds sailing close to the 50 per cent ceiling, should even a modest reduction in Irish house prices occur.
The catch-all nature of the leverage limit means any programmatic forced deleveraging from a repricing could hit every sector of the Irish property market, or even beyond.
This proposed leverage limit could easily turn a housing market repricing into a wider market crash. The preventative measure could cause the very outcome it is designed to protect against, and is arguably incongruent with Government policy.
The law of unintended consequences dictates that artificially intervening in a free market invariably leads to adverse outcomes. While the banking crisis and the global financial crash in 2008 remains a particular bête noire for the Irish financial sector, it should also serve as a valuable lesson. More nuance is needed.
