Questions over how UK government stake in banks will affect large property loans

A steep decline in UK property values is raising worries for the government and its 40% stake in HBOS and Lloyds TSB, two of Britain's biggest lenders to property developers.

It is estimated that the state-controlled beast created from their merger will hold 26% of all outstanding UK commercial property loans and the Bank of England has raised the probability of loan defaults in this sector.

On top of this £100 billion of property loans are due for refinancing by the end of 2010 and civil servants are less likely to agree to roll over loans than bonus-driven chief executives.

In its most recent Financial Stability Report, the Bank of England said that the 16% drop in commercial property prices seen since last June has raised risk of losses. The rapid property correction had led to a number of loan-to-value covenant breaches but it was yet to see an increase in loan default rates.

According to a survey by compiled by the Bank of England and De Montfort University, if the commercial property loan default rate hit a baseline estimate of 1.5%, the UK's main property lenders could face a total implied write-off of £800 million, or 3% of pretax profits.

If the default rate climbed to 10%, the implied write-off increases to £5.1 billion or 19% of pretax profits, although BoE said such an increase was unlikely.

'Falls in property values erode the equity buffer with which borrowers can withstand financial shocks, implying higher losses on commercial property loans in the event of default,' the report said.

Commercial property lending now accounts for 38% of the stock of major UK banks' lending to UK private non-financial corporations, double what it was in 1998, the report showed.

The consensus among managers in the sector is that total returns from UK commercial property will remain negative until at least 2010.

'Lenders' risk aversion is still rising. There's a risk of further retrenchement among property developers. We think its going to be fairly challenging for property over the course of the next year,' said David Skinner, head of property research at Aviva Investors Real Estate.

It is not yet clear if the banks will move quickly to restore lending in this sector. 'For the last 12 months getting a loan over £50 million has been hard work because it needs more than one bank,' said Robin Goodchild, international director of European strategy at real estate specialists LaSalle Investment Management.