UTI BANK Risk Department Central Office

SVP( Risk ) :

VP( Risk )

OCCASSIONAL PAPER :

29th November 2006

Understanding the dynamics of commercial real estate markets Empirical findings

Abstract : In this paper, we attempt to review relevant research literature on real estate markets in particular commercial real estate to understand stylized facts on commercial real estate assets, their pricing, demand supply dynamics, their financing and risk issues to lenders. This study is motivated by the growing importance of commercial real estate segment in India both to investors and banking industry in terms of their increased exposures.

Background Real estate investments have emerged as a specific asset class on account of growing urbanization and housing demand across the globe. Changing geographies, economic growth and townships have contributed to a an asset class such as real estate. Global markets for Real Estate differ in terms of their structural features, performance and risk dimensions across countries. Market reports as of FY2006 report the size and maturity of major markets as below :Real Estate markets Journal of Real Estate Research Region Market Size % of market maturity levels. Americas USD 4 trillion 91% Europe USD 2.4 Trillion 51% Asia Pacific USD 1.4Trillion 72% Maturity indicates that the availability of market information, market liquidity, political stability , financial market institutions , legal framework and transparency. Overall annual returns in direct real estate segment ranged between 8.8% to 12.9% across Europe and US. Current trends in real estate across the above markets can be briefly traced as under:Europe: Europe accounts for 37% of the global real estate market, 20% of the listed real estate market and only 15% of the global REIT markets. Although Germany is the largest European real estate market aggregating to USD 911 billion investible stock, it has one of the smallest listed real estate markets. However, as per change in legislation across Europe, property companies are being compulsorily made to convert themselves into REITs. Such structural changes are expected to increase the listed real estate portfolio as a percentage of the total portfolio. Although overall economic growth in Europe appears weak, the retail market continues to perform well thereby impacting rents on a positive side. Western European countries expect rentals to recover and be on the rise given that the increase in occupancy rates. Also with the current spread between capitalization rates and cost of financing real estate very narrow, it appears that rentals will recover during the current fiscal. Asia Pacific: With growing exports, investment and domestic demand, rising wages and increased retail spending, economic growth in Asia Pacific is reported to continue to be strong for the coming years. The Asian real estate markets such as Singapore, Hong Kong and Japan have grown by 8,10 and 5 times respectively over last three years. Much of this growth can be attributed to relaxation in FDI in this segment, establishment of REITs and increased liquidity and transparency. Economic growth lies at the heart of many real estate opportunities across the Asian region.

In case of India, with domestic investment and consumer spending growing with overall economic growth, the demand for quality real estate most particularly in residential, retail space and other commercial segments is high, whereas the supply of such quality stock is lagging behind. This demand supply imbalance is creating significant opportunities in this region with prices of commercial real estate increasing. According to RREEF (Real Estate Research division of Deutsche Bank A.G.) as against the global backdrop, the level of activity in Indian real estate markets has over the last three years shown an exponential growth. Total stock of commercial real estate worth in India is estimated at USD 300 billion of which USD 83 billion is suitable for investment products. However, market sources peg investment so far at USD 4 billion. Also it is reported that the current growth rate in real estate investment is at 30% per annum which is very high. In terms pattern of financing, around 61% of the property being financed is through debt while the rest 30% is by way of equity. Debt financing is predominantly through bank loans and this component has grown the fastest. Recent Deutsche bank research expects strong growth potential in all real estate segments with commercial real estate portfolio to grow by USD 66 billion and be worth USD 366 billion by 2010. For Indian cities demand is likely to continue to remain strong for good quality office space. Given the shortage of good quality office space, given the quality of good quality supply, positive rental growth is expected to continue over the forecast period, albeit at more moderate levels than seen in the last few years. Stronger rental growth is expected in the range of second tier cities that are experiencing lower levels of new supply than tier-one cities such as Mumbai. A snap shot of the Asian Real Estate Markets vs other Mature markets is presented below: Country Japan Hongkong Australia S Korea Singapore India Taiwan Malaysia Germany UK USA Total Real Estate Investment USD Billion 900 180 144 77 36 25 16 11 605 662 3500 % of Investments through listed property REIT type structures 13% 39% 58% 1% 61% Less than 1% 21% 65% 1% 10% More than 80%

Bank lending and real estate exposure Real Estate Exposure of Banks as a percentage of total credit has increased steeply from 0.40% of the credit book to 1.80% of the total credit book as on FY 2006. It is important to note that as compared to levels of Banking system exposure to Real Estate during the Asian Crisis which was around 40 to 56% of the total credit deployment, the proportion of exposure of Indian Banks to this segment is very less. The major drivers to real estate activity has been, growing industrial requirements for commercial space, increased demand for commercial space for Retail shopping formats due to rise in retail spending including dwelling and investment demand for housing from the salaried class. However, the concerns surrounding real estate activity is on the steep rise in prices of commercial and residential real estate. As the macro and regional economic growth has been on the rise over past three years, structural changes such as increased consumer spending in life style, retail purchases and also search for quality residential requirements, townships, etc. has pushed up the demand for real estate. Although demand has increased during the short run, supply of quality residential and commercial real estate lags far behind resulting in the steep rise in prices. Special aspects of commercial real estate market: Although overall real estate exposure of the Indian Banking system is on the rise, expectations of a price bubble and heated economic activity in the commercial segment is of critical concern. Therefore a review of stylized facts pertaining to generic risks associated commercial property segment will be of interest prior to raising concerns about the real estate lending by Banks in the Indian context. Commercial property market has a number of distinctive features relative to other asset markets. These include heterogeneous supply, the absence of central trading market, infrequent trades, high transaction costs, lack of price transparency owing to the role of bilateral negotiations, rigid constrained supply and the use of real estate as collateral for lending. Contracts underlying commercial property are generally of long term in nature and have a two fold reliance on external finance : short term finance to cover the construction phase and long term finance to fund the operations during the occupancy period. Although equity financing is feasible, generally the commercial real estate properties are debt financed. Based upon applied research findings in the real estate segment, a detailed discussion of specific aspects of commercial real estate markets is presented below.

Economic aspects of commercial real estate Demand Supply dynamics :The market demand function for commercial real estate depends upon a) the number of optimistic buyers b) the reservation price perceived by the investors/purchasers c) borrowing capacity of these buyers d) the lending attitude of Banks and financial institutions. Supply side :- On the supply side of commercial real estate, the major influencing factors empirically observed are a) the stock of near to or completed new construction (which would have commenced in an earlier period),the depreciation rate. The supply side dynamics is viewed to be more of an adjustment function and is usually lagged as compared to the demand growth. The new investment component is in turn a function of bank lending for new construction projects which is influenced by the borrowers endowment, interest rate, current prices of property and the lending attitude of banks. Bank lending channel Linkage with commercial real estate Bank lending channel is a major influencing factor of demand and supply forces for commercial real estate. Therefore bank lending to commercial real estate segment has implications for property prices and also for the cyclicality of real estate We explore some specific aspects of these linkages in this section. Bank Lending : At first property prices affect the volume of bank credit for various reasons. From the borrowers point of view, changes in property prices are expected to have an impact on their wealth and their borrowing capacity inducing them to change their borrowing plans. This pushes the credit demand by borrowers during rising property prices. Banks are involved not only in direct lending in real estate but also providing loans against collaterals involving property. Lending to property companies alone is influenced by this collateralization apart from the cash flow argument. Many a corporate with adequate reserve assets as property reduce the cost of external financing by leveraging on commercial real estate assets during times of increasing property prices. It is generally observed that Banks are willing to provide more property related loans at cheaper terms when property prices are higher, thereby generating a propagating mechanism through which property and credit cycles are strongly linked with each other. Changes in credit availability and lending attitudes have a sizeable impact on the demand for real estate and investment decisions on new construction, which will ultimately lead to changes in property prices. It has been widely documented by various researchers that capital seeking investment opportunities and the competition among financial institutions after financial deregulation helped to stimulate the building frenzy phenomenon in a number of countries in the 1980s to 1990s. Due to lack of time series data available in commercial real estate segment, most of the empirical work on bank lending and its impact on property prices have been based upon housing price data. Country specific research reveal strong evidence of

dynamic interaction between house prices and bank lending in Hong Kong, the Netherlands and United States . It is observed that in the short run, there is significant two way interaction between house prices and bank lending where as in the long run, the causality is from house prices to bank lending. It is clear from the above that property prices and credit growth are interlinked strongly. Real estate Cycles : Commercial real estate cycles and credit cycles are driven by the same economic factors. On the one hand credit cycle behaviour is largely determined by economic conditions and prospects ( GDP and interest rate expectations). In the short run, the supply of commercial property is fixed and in the long run, the supply adjusts gradually because of lags in the delivery of new construction and also obtaining licenses for development of land for additional supply of commercial space. Due to the supply lag and also because commercial real estate asset is predominantly financed by banks, commercial property prices are linked to future expectations of returns. Further commercial property prices adjust quickly to any changes in return expectations. As return expectations are dependent upon common economic factors such as GDP growth, interest rates, vacancy rates etc, commercial property prices are also subject to the vicissitudes of business cycles. The anatomy of a real estate cycle generally exhibits the following pattern: Supply of commercial property is fixed in the short run. Therefore when economic growth and utility demand for commercial real estate increase such that reservation price ( the perceived price for utility of the property) is more than the current price of real estate, builders tend to initiate new development/construction by availing bank borrowings. While demand keeps increasing, the supply curve adjusts with a lag due to time taken to obtain approvals and deliver the new property. The pressure on price therefore is high. Research findings indicate that investment decisions show a high degree of dependence on current prices rather than future property prices. At first adaptive expectations induce bankers and investors to extrapolate the current property price assuming that past growth rates to be maintained in the future. Therefore there is tendency to determine future property prices based on current prices. During a buoyant period, higher property prices as mentioned earlier causes increased bank lending due to comfort of collateral value. Although it is difficult to segregate the bank lending to purchase of property and that for development of the same and their lagged impacts on price of property, it is generally believed that increased bank lending for purchase of property pushes demand and thereby prices as supply although equally financed by banks adjusts only after a lag. Therefore bank lending on the supply side results is delivery only in medium to long run thereby depressing prices at that time. The difficulty for lending institutions to adjust their lending for purchase of property in accordance with actual percentage of completion of real estate projects and the resulting short term supply, there is a scope for cyclical fluctuations.

 Other explanation to volatile property prices/asset bubbles is in the context of financial liberalization. In many cases financial liberalization causes increased competition among lenders which in also increases the quantum of credit available to investors and therefore price climb. The boom period could last longer if increase in property prices encourage inflows of foreign capital. However when the impact of building frenzy starts kicking in and the supply of new construction cannot be absorbed, property price start falling. Given that bank credit is sensitive to property price movements, subsequent rationing cause the contraction of the cycle. Empirical studies establish strong links of credit to commercial property across countries that experienced crises linked to property losses. Through the period 1985 to 1995 Conceptual model of real estate dynamics Conceptual model of real estate dynamics can be summarized by a generic structural equation model as below

Dt =

N[1-f(PT)]. L[Yt,i t,Pt,Wt] Pt

where

Ly>0,

Li<0,

Lp>0

Kt=(1- )Kt-1+It-1

It-1=. t-1(Yt-1,i t-1,Pt-1,Wt-1) y>0, I<0, p>0 Dt=Kt

D- Demandfor commercial realestate N= No of borrowers P= property price F(P)= cumulative distribution function of reservation prices. L= borrowing capacity of investors Y= income proxied by real GDP. i= Interest rate W= lending attitude K=adjustment function of the stock of market supply of buildings. = depreciation rate I= completed new construction. =new construction financing by banks. The capacity to borrow ( of investors ) is an increasing function of real income, and property prices but an decreasing function of interest rates. The financing of new construction by lenders is an increasing function of real GDP growth and property prices by a decreasing function of interest rates.

Risk issues in Analyzing Real Estate A Lenders perspective In addition to the above generic economic aspects of commercial real estate segment, lenders concern surround the effect of financial accelerator on asset prices. Financial accelerator mechanism-Implication for asset price :The financial accelerator mechanism essentially is the linkage between bank credit and asset pricing. During a growth phase, increased credit towards purchase of property and development, pushes property prices up. As mentioned earlier, banks are willing to provide more property related loans at relatively relaxed terms and conditions by basing their decisions on higher values of collateral. This implies that banks become less concerned about adverse selection and moral hazard problems during the upswing. This myopic lending approach although applies to all types of lending is more pronounced in case of real estate due to the influence of collateral values. The financial accelerator channel becomes more amplified and can drive the asset price bubble if banks tend to underestimate the default risk of property related loans while borrowers subject themselves to a moral hazard by trying to leverage their property values ( by offering them as collateral) to reduce the cost of external finance. Empirical research studies report that countries where borrowing constraints are higher, the impact of financial accelerator mechanism on real estate asset prices is also high. This why it is reported that firms facing higher borrowing constraints generally show higher sensitivity to changes in net worth ( due to higher prices of real estate ) resulting in investment spending based upon real estate collateral. Opaqueness of supply side situation : Lenders often are left with paucity of data in respect of actual proportion of completion of commercial real estate space irrespective of the segment of interest. Unlike manufacturing industry where some level of macro metrics are available on installed capacity, operating rates and the current stocking levels, real estate being regional and local in its dynamics despite common economic factors that drive its overall growth does not enable collection of this data. In emerging markets this opaqueness is even more severe leading to errors in expectations of demand, rentals and supply side adjustments. Therefore banks base their lending decisions on current price levels and extrapolation there of which may not be sensitized to possible supply demand adjustments in the currency of the exposure. Therefore future projections about real estate trends have a great deal of uncertainty. Underwriting Standards : Differentiation factors as between banks and financial institutions that survived the real estate cycles in the US and other parts of developed markets were a) conservative underwriting standards and b) the ability to retain those standards of lending despite stiff competition in credit markets in the property segment. We briefly discuss some of the critical credit risk metrics used to set underwriting standards by different banks internationally.

The basic purpose of setting underwriting standards is to assess the probability of default and correspondingly enable pricing the risk. Conceptually the Default Risk can be defined as a function of the following

PD = f ( LTV , DSCR, NOI , )

PD- default probability is a function of LTV-loan to Value ratio. DSCR-Debt service coverage ratio NOI- Net Operating Income. -Set of other variables that contribute to default risk. Loan to Value Ratio ( LTV) : The LTV ratio measures the equity participation required of borrowers in projects. LTV is endogenous to the loan underwriting process and lenders usually adjust the LTV by cutting the exposure depending upon the severity of other risk dimensions. Of particular importance to lenders will be to observe the time varying LTV along the currency of the exposure. LTV also reflects upon the risk appetite of the lender. However research studies show lack of strong association between LTV and credit risk spreads contrary to expectation. It is important to note that a lower LTV necessarily does not signal a safe loan as the lender has required the borrower to enhance his equity component given the level of risk reflected by other factors. Although in theory we expect that mortgages with higher LTV should ideally have higher credit risk spreads, statistical studies on various commercial mortgage portfolios in mature markets indicate that this relationship is not robust. Certain regression type studies done to test whether the relationship between LTV and credit spread is monotonic indicate that spreads increase with LTV ratios for LTV ratios up to 70% while they decrease with LTV ratios for LTV ratios beyond 70%. The mortgages with highest LTV ratios of 90% were found to have lower spreads. These results indicated that the relationship between LTV ratios and mortgage spread is complicated as lenders choose a lower LTV ratio in case risky borrowers rather than have higher spreads as it would only aggravate the default risk due to lower DSCR. Debt Service Coverage Ratio( DSCR) : Adjustments to LTV given the Net Operating Income results in higher DSCR. Internationally lending banks focus on LTV and DSCR as they are considered to be the key proxies for risk. Uni variate studies of DSCR on commercial mortgage portfolios indicate that although the signs of the co efficient of DSCR is negative indicating an inverse relationship between the default risk and DSCR thresholds, the co- efficient are not statistically significant from zero. One alternative to improvise over the effectiveness of the above two measures is to observe the Time-Varying LTV and the Time-Varying DSCR thresholds. In mature markets, lending institutions develop a property index based upon prevailing rental movements or use updates in property values or Net Operating Income in order to recomputed the change in the LTV and resulting DSCR.

This enables tracking of time varying measures of LTV and DSCR. In some default risk models, the change in LTV including the original LTV at the time of taking the exposure is imputed to effectively capture the impact of change in LTV on account of change in NOI or property value etc on default risk of commercial mortgages. Since there is a correlation between LTV and the DSCR at the origination of the loan, by including the changes in LTV over time in the default risk model, such multi correlations are also taken care off. Other measures are based upon the general characteristics of the mortgage such as mentioned below Net Operating Income : The level of Net Operating Income generated from the commercial mortgage as a percentage to the appraised value of the mortgage after having adjusted for operating expenses and depreciation rate is a good indicator of performance. However if this ratio is computed as its impact on property prices. Occupancy Rate : For most of the commercial property mortgages other than owner occupied, the vacancy rates or occupancy rates are of critical concern. However the availability of data on average level of occupancy across regions and segments of commercial mortgages is difficult to obtain. Average occupancy rates serve to be of critical importance when applying the relative valuation approach to properties. Other risk measures include the average age of the property, location, maintenance costs , cross correlation of income/rentals with other commercial real estate segments etc. Risk Measures -Portfolio Level Understanding the portfolio composition , along with the banks credit culture, risk appetite, historical performance in this sector is crucial to the risk assessment process of real estate portfolio. Portfolio analysis of real estate exposures require assessment of risk following dimensions :Composition by asset class : Of primary concern is to compare the individual lending institutions composition of commercial real estate exposure as between Retail, Office , Hotels and Industrial space with the overall banking systems lending pattern to commercial real estate segment or at least set against the peer group banks and financial institutions. The key risk to identify will be whether there exists sub-segments within the commercial property segment as mentioned above that behave differently such that prices of these properties among asset classes would not tend to fall simultaneously. A correlation analysis of rentals, occupancy rates and property values over time across these segments will help enhance information on the above. Also apart from mere co across the

NOI it will help track cyclical effects and VALUE

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movements, correlation among volatilities in real estate value, rentals etc will be of primary concern. Geographic diversification : Location of commercial real estate assets help to determine the extent of vulnerability of to regional economic downturns. Just as diversification among asset classes is of critical importance to mitigate risk, diversification in commercial real estate portfolio across geographies is equally risk mitigating. Correlations across business cycles : Although there may be a high degree of correlation as between asset class or geographies at a given point in time in the commercial real estate portfolio, the concern remains that for those geographies and asset classes where magnitude and significance of correlation among rentals, property value are currently low may tend to be high during economic downturns. Therefore it is important that correlation measures are tracked across business cycles. An Irish study of commercial bank real estate portfolio over period 1970 to 2005 indicated that magnitude of correlation as between retail, industrial and office space is higher during economic downturns than during a economic growth phase. These type of findings will be useful in taking risk based lending decisions. Maximum loan size exposures, loan size limits to a developer/investor relationship/project and commercial real estate in aggregate and other constraints are important to assess the loss severity and the risk attitude of lending institutions. Loss Characteristics : Moodys analysis of commercial bank real estate portfolios pegs loss rates across asset classes as under. Loans financing existing structures is assumed at 50%. Single family construction loans 20% Other development and construction loans 60%.

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Conclusions : The challenge for banks and regulators is to understand the dynamics of commercial real estate at a macro level and to detect deviations from fundamentals. Banks need to appropriately price and ration credit such that the bank is able absorb the cyclical volatility in property prices which may be persistent over time and market across cross country correlations. An interesting finding is that use of real estate as collateral provides a channel through which property prices are influenced and this mechanism stimulates itself during an economic growth phase. While the financial accelerator mechanism presents the underlying currents that spiral an asset price bubble, it is important to note that in countries such as Hongkong, although asset prices dipped sharply by 70% from the peak levels, the banking system was remained resilient. Stringent LTV norms imposed by regulators and strong capital base attribute to the strength of the banking system. Banks must take into account time varying value perspective in respect of LTV, DSCR and NOI apart from other risk factors and thereby adopt a long term approach to project evaluation. Of special interest would be to research the impact of commercial property cycles on the profitability of the banks. Submitted for discussion

Krishnan Chari Asst Vice President( Risk)

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REE-TOTAL CREDIT 2.00% 1.80% 1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% 2001 2002 2003 2004 2005 2006 REE-TOTAL CREDIT

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