Following the 2008 financial crisis and it consequences, a number of financial regulation has been changed in an attempt to prevent another financial crisis from taking place in future. Some of the most notable financial regulation changes are related to Basel III and they include changes on bank’s capital requirements, liquidity requirement and leveraging requirement. This financial regulation changes will impacts different sectors of the economy in various ways. This paper focus on the potential impact the financial regulation changes will have on the real estate.
2.0 Recent changes in financial regulation
In the wake of the world most devastating financial crisis, many governments across the world responded by introducing tougher change to the financial regulation. The European countries are not exception on this. They also made some significant and notable changes to the financial regulations with the aim of prevent future crisis. In UK and other European countries, the Basel II accord was adopted in response to the financial crisis that occurred in 2008. The Basel II contain a set of financial regulation framework that is based on three pillars. 1) Minimum capital requirement regulation, 2) supervisory review and 3) market discipline. However, the Basel II has since then be replaced by a new set of financial regulation commonly known as Basel III. Basel III has introduced a number of financial regulation requirement including minimum capital requirement, liquidity reform and leveraging ratio (Church, 2016, IBM 2019).
2.1 Minimum capital requirement
One of the financial regulatory requirement introduced by Basel III is the minimum capital requirement. The Basel III requires banks reserve a minimum adequacy capital of 8 percent of it risks-weighted assets. Out of the 8 percent of minimum capital adequacy, 4.5 percent of capital should be in form of common equity, which is an increase from 2.5 percent as previously required. In addition to this, banks will also be required to reserve additional capital namely, conservation buffer at a rate of 2.5% and must be met by common equity. Banks will also be required to reserve additional capital named countercyclical buffer within a range of 0-2.5% of common equity
2.2 Leveraging ratio
The adoption of Basel III by European countries (including UK) has led to the introduction of leveraging ratio in the financial regulation. Leveraging ratio is calculated by dividing Tier 1 capital by the bank's average total consolidated assets. As per Basel III, banks are expected to maintain a minimum leveraging ratio of 3 percent (Bank of international Settlement, 2017). In UK, the leveraging ratio has been set at 3.25 percent.
2.3 Liquidity requirement
The Basel III has also introduced a number of liquidity reform, which are meant to ensure that banks are able to survive in stress scenarios. These are liquidity coverage ratio and net stable funding ratio. Banks are now required to ensure they have sufficient high-quality liquid assets to cover at least one-month survival in a severe stress scenario (Bank of international Settlement, 2017; IBM, 2019). Therefore, the liquidity coverage ratio required can be express mathematically as follow
LCR= liquid high quality asset/cash outflow over 30 days (in stress scenario ≥ 100%
The second requirement is the net stable funding ratio. This reform is meant to ensure banks fund their activities with more stable sources of funding on an ongoing structural basis (IBM, 2019)
3.0 impact of financial regulatory changes on real estate
The adoption of Basel III in UK has led to introduction of changes to the financial regulation. As explained in the section above Basel III has introduced several changes to the financial regulation touching on area of minimum capital requirement, liquidity requirement and leveraging issues. Banking institution has been given up to this year i.e. 2019 to comply with these changes. Once they become operational, these changes in financial regulation will definitely affect real estate in several ways as explained below;
3.1 Liquidity reform and its impact on real estate
The Basel III accord has introduced liquidity reform in the financial sector. One of such reform is the liquidity coverage ratio. This reform requires banks to hold adequate high quality liquid assets that can be used to cover cash outflow for a period of 30 days in a high stress scenario (Bank of international Settlement, 2017). The real estate loans cannot be term as liquid. This simply means that the liquidity reform as introduced by Basel III accords encourages banks to hold more of liquid assets to ensure they remain afloat even under severe stress scenario. Unfortunately, real estate’s assets are not liquid assets and as such, banks will not focus on them when trying to meet the liquidity coverage ratio requirement. Instead, the capital that banks should have allocated to real estate’s assets (loans) will most likely be reallocated to other assets that are liquid in an attempt to meet the liquidity requirement as introduced based III. As result, the capital available to the real estate will be negatively affected and this will in turn affect the development of new properties in the sector (Hoesli, Milcheva & Moss, 2017).
3.2 Impact of financial regulation changes on real estate borrowing
The financial regulation changes as introduced by Basel III accord will have indirect impact on the real estate borrowing through bank lending channel. On one hand, the financial regulatory change will have negative impacts on the real estate borrowing while on the other hand; it will have some positive impacts on real estate borrowing for some type of property. On the negative side, the financial regulation change will affect the availability of capital to real estate and the cost of borrowing. The main objective of financial regulation introduced by Basel III accord is to avoid future bank failure and systematic risks in the economy by requiring all banks to hold more capital against expected losses. Basel III financial regulation has tighten the definition of what can be included in the calculation of bank capital and has also made the methodology of calculating risk-weighted assets more sensitive to risks. The later has significantly affected the risk assessment of some type of real estate loans/assets. For example, under Basel iii, a new category of real estate loan know as high volatility commercial real estate (HVCRE) loans, has received a risk weighting of 150 % compared to 100% under the previous financial regulation that had been introduced by Basel II accord. A loan will be classified, as high volatility commercial real estate (HVCRE), if it purpose is to finance the acquisition, development or construction of real estate property with a loan-to-value ratio above 80 percent (Rubin et al 2013). In addition, the risk weighting of project loan has also been affected. As explained by Hoesli, Milcheva & Moss (2017), under the changes made to the financial regulation by Basel III accord, project loan could receive a risk weighting of up to 250 percent. Project loans is one of the most common way used to finance large-scale real estate and infrastructure project (Hoesli, Milcheva & Moss, 2017). Since the changes made to the financial regulation by Basel III accord requires banks to hold more capital against their risk-weighted assets, the revised risks weighting of commercial real estate loans means that banks will need higher regulatory capital of up to 12 percent instead of the current 8 percent. As noted by scholars (Hoesli et al 2017; Rubin et al 2013), such requirement will affect real estate borrowing in two ways as explained below
Availability of capital to commercial real estate.
As explained earlier, under the Basel iii financial regulation, banks are required to hold higher capital against their risk-weighted assets. Under the changes introduced to financial regulation, the risk weighting allocated to most of commercial real estate loans has been revised upward. As result, banks will be required to hold higher regulatory capital requirement when carrying such real estate assets. Empirical study conducted by Wieladek (2017) on behalf of the European central bank shows that a rise of a 100 basis points in capital requirements results to 5.4 % decline in loans given to individual. This is the mostly likely scenario in the real estate. As pointed out by Rubin et al (2013), these changes will affect banks willingness to finance commercial real estate loans due to lower return on capital and the overall profitability of the banks. Banks will therefore be tempted to reallocate capital away from commercial real estate sector to other assets with favorable treatment and superior return on capital. This will likely be the case with smaller banks as they do not have much resource to raise additional capital needed. They will avoid anything that resembles the high volatility commercial real estate (HVCRE) loans. As a result, the capital or liquidity available to the real sector will reduce significantly, as banks especially the smaller ones will chose to invest in others type of assets that have higher return rather than commercial real estate loans/assets. This will in turn lead to a market imbalance between capital demanded by real estate and the capital available to the real estate industry.
Higher cost of commercial mortgages
As highlighted by Rubin et al (2013), in the wake of revised risk weighting of commercial real estate assets and the changes to the capital requirement, smaller banks will most likely avoid commercial real estate loans. However, the larger banks are most likely to react differently to the situation. They will continue to make capital available to the commercial real estate but since the changes to capital requirement and the risk weighting of real estate will have negative impact on their profitability and return on capital, they will be forced to lend to the sector at higher cost. This will be the case to retain profitability and the desire level of return on capital. As result, real estate borrowing cost especially for commercial properties will go up.
The financial regulatory changes introduced by Basel iii accord will not however affect the entire real estate in a negative way. In some cases, it will affect the real estate in a positive way. For instance, under the new capital requirement, Basel III requires banks to allocate a risk weight of 50 percent for multifamily property loan and 100 percent for non- high volatility commercial real estate loan (HVCRE) and non-multifamily loan (Bank of international Settlement, 2017). These therefore means that banks will not need to hold more capital on these real estate assets as compared to HVCRE loan and as such, the multifamily assets will remain attractive. As results, banks are mostly likely to reallocate capital to toward the multifamily sector and this will benefit homeowners by increasing liquidity and lowering the cost of capital. However, despite the financial regulation changes having positive impacts on multifamily property loan, the redirection of capital to the multifamily sectors is most likely to reduce the capital available to other property types (Rubin et al 2013).
3.3 The impact of financial regulation changes on real estate return on investment
The financial regulation changes as introduced largely by Basel III accord will also affect the real estate’s return on investment. As explained earlier, these financial regulation changes is likely to lead to high borrowing cost and high loan rate especially for the commercial real estate (CRE). Banks that will chose to continue financing the commercial real estate’s assets/loans would increase their lending cost to retain profitability. In addition, the borrowing cost will increase due to higher mortgage servicer fee resulting from less favorable capital treatment. In general, term, the debts given to commercial real estate will become more expensive than it is today (Rubin et al 2013; Hoesli, Milcheva, & Moss, 2017). Expensive debts will have a direct impact on the real estate return on investment. Expensive debts will lead to reduction in return on investment. However, as noted by, Rubin et al (2013) depending on the supply and demand for space in the real estate market, property owner may or may not be able to pass the higher financing cost to the tenants by increasing rent. In real estate market where, the supply will be low and the demand for space is higher, then property owners will be able to pass the high financing cost to the tenants by increasing rents. In such case, the return on investment on the property may not be negatively affected by financial regulation Changes. However, in real estate market where the supply of space will be higher and the demand of the same will be low, the property owners will not be able to pass the high financing cost to the tenants via rent increase. Such markets will be negatively affected by the financial regulation changes, as the return on investment on the real estate property will be reduced and minimal, as the property owner will be forced to absorb the high cost of financing the property.
Conclusion
As it has been properly explained in this paper, the adoption of Basel III accord has led to financial regulatory Changes. Some of the financial regulatory Changes related to capital requirement, liquidity requirement and leveraging requirement. In summary, the financial regulatory changes include an increase in capital requirement. Banks are now required to hold 8 percent capital of their risk-weighted asset. About liquidity, banks are now required to hold adequate high quality liquid assets to cover banks’ cash outflow for at least 30 days in a high stress scenario. Furthermore, the banks are now required to maintain a leveraging ratio of 3 percent. These financial regulatory Changes as introduced by Basel III will have both positive and negative impact on the real estate. On the positive side, the risks assessment of certain real estate property such as multifamily loans has been revised downward to 50 percent. These type of real estate assets will remain profitable and will have high return on capital for the banks. As result, banks will reallocate more liquidity to them and lower the cost of borrowing. on the negative side, under the new changes, the risks assessment of some real estate assets types include high volatility commercial real estate (HVCRE) loans and project loans has been revised upward to 150% for HVCRE and up to 250% percent for project loan. As results of these revised risks assessments, banks will be required to carry additional capital once they have such type of real estate in their balance sheet. This will make reduces banks return on their capital and negatively affect their profitability. As a result, Small banks are most likely to avoid all commercial real estate assets/loans hence reducing the liquidity available to the real estate. The larger banks may continue to make capital available to the real estate, but will increase the cost of borrowing. Therefore, in the end, the commercial real estate sector is likely to experience low liquidity and higher cost of borrowing. This will in turn lead to reduced return on investment in most of the commercial real estate property unless the owners are able to pass the high financing cost to the tenants by increasing rent. Despite, the financial regulation changes having both positive and negative impacts on real estate, the negative impacts outweighs the positives as they have far-reaching consequences on the real estate sector than the positive one.