UK commercial property: The banking sector albatross

LONDON (Reuters) - Europe's banks are ready to pull the plug on faltering UK commercial mortgages to limit losses on a 225 billion pound loan book in a bid to prevent a dramatic next turn of the banking crisis.

More than 10 billion pounds of commercial mortgages have so far breached their terms, a recent study shows, and banks are running out of patience with problem borrowers.

"Compared to a couple of months ago, there are clear signs the banks are becoming more organised as to how they approach their commercial property exposures," said Mark Creamer at real estate consultants CB Richard Ellis (CBG.N).

"Instead of working on no-hope situations, banks will get rid of those and move onto properties where they have a real prospect of getting their money back," Creamer said.

In 2009 alone, 43 billion pounds of property loans mature, according to the De Montfort University study, posing a much larger risk than commercial mortgage-backed securities CMBS.L, which have largely been sold on.

Lenders have long turned a blind eye to borrowers in breach of covenants -- when the value of a property drops too low relative to the size of the loan -- as long as they met interest demands by collecting rents.

But they are now abandoning this softly-softly approach as the British economy worsens, planning foreclosures on a scale not yet seen in this cycle.

Industrial landlord Brixton (BXTN.L) and FTSE 100 heavyweight Land Securities (LAND.L) are two of many UK landlords sweating over possible loan-to-value covenant breaches.

"At the moment, banks are big hostages to fortune," said Solly Benaim, head of real estate and construction at restructuring firm BDO Stoy Hayward.

"It is unrealistic for some of them to hope that this laissez-faire approach will carry them safely through the downturn, a certain number of repossessions need to happen to truly rehabilitate the market," he said.

Banks including Lloyds Banking Group (LLOY.L) unit Bank of Scotland, HSBC (HSBA.L), Commerzbank (CBKG.DE) unit Eurohypo and Royal Bank of Scotland (RBS.L) lent vast amounts to the British property sector during the boom years.

While some of this was parcelled out to bondholders via commercial mortgage backed securities CMBS.L, much of it remains on their balance sheets.

GRIM OUTLOOK

Average UK commercial property values have tanked 43 percent since peaking in June 2007 and the worst may not be over. Rents are in freefall, compromising cash flows and putting landlords' ability to pay interest on their debts in jeopardy.

First-quarter data from business rescue specialist Begbies Traynor showed an 87 percent year-on-year increase in the number of UK companies with critical financial problems.

"Commercial property will be a huge burden on the UK banking sector. Unless there is a bottoming-out of banks' exposure to sector, no-one will start lending again," said Gareth Davies, a restructuring expert at Close Brothers.

Until now, banks have only repossessed as a last resort because they feared they would be unable to sell assets in the debt-starved investment market.

But a flurry of fund launches and opportunistic rights issues has ratcheted up competition among buyers in the sector, stoking hopes for less costly exits.

They have already hired hundreds of workout specialists, many of which used to originate loans.

Leading property lenders HSBC, Lloyds Banking Group and Royal Bank of Scotland declined to comment on their strategies.

A wave of repossessions is likely to begin once banks know what they can offload into the UK Asset Insurance Scheme, details of which are due to be announced in July, said David Swan, managing director of real estate advisor WW Advisors.

"Banks know they cannot possibly hope to re-emerge from the most intense UK commercial property downturn in generations without any blood-letting in their loan portfolios," he said.

A key economist at the Federal Reserve on Friday expressed confidence that U.S. banks can survive similar default pressures on their $1.3 trillion (804 billion pounds) commercial mortgage and bank portfolio loan book.

Banks maintained some CMBS debt on their balance sheets, though Barclays Capital estimates that it totals less than 10 billion euros (8.7 billion pounds) across Europe, a fraction of the amount of their non-securitised property lending.

And only 12 billion pounds of CMBS secured by UK properties will mature before the end of 2011, giving time for values to recover, according to data from ratings agency Standard & Poors.

Still, investors in CMBS -- largely pension funds and insurers -- face years of uncertainty over their commercial property exposures. The market is dominated by intercreditor fights and complex funding structures that have never been tested," Close Brothers' Davies said.