Equity has made a comeback in the property sector, with investors feeling more confident and a great deal of money looking for a home. However, the latest Emerging Trends in Real Estate Europe report, published by the Urban Land Institute and PricewaterhouseCoopers, also warns that banks “hold the key” to the market’s 2010 prospects and debt is still substantially undersupplied.
The previous report, published early in 2009 but collated in the difficult time after the collapse of Lehman Brothers, rightly predicted that debt markets would re-open last year. But the respondent who suggested then that it would be 2010 “before lending returns to anything like normal” does not look likely to get his wish.
Banks still control “both sides of the real estate equation”, the latest report says. They are restricting property supply through “their extend and pretend strategy” of allowing borrowers to roll over debt rather than repay it by selling assets at lower prices. This in turn affects their ability to lend on new deals, but they are reluctant to finance deals other than those for prime property anyway.
“Banks haven’t taken the action some thought they would,” says John Forbes, real estate leader at PwC. “The report’s opening headline last year was: ‘The going gets tough’, but it hasn’t been as tough as some thought; the occupiers side is tough, but not as grim as some expected, and banks haven’t had to take the action some expected.” Forbes says tenants’ fortunes will determine what happens next.
“When loan performance ceases to be a loan-to-value issue and borrowers default on interest payments, there is a new level of impairment for the banks,” Forbes says. “Even if there are some positive economic signs, you have a time lag; landlords may find they’ve been getting closer and closer to the edge in the past 18 months. But it won’t be wholesale carnage; its will work out over years, not months. We won’t see fire sales.”
The study says banks ‘extend and pretend’ strategy has worked “as an emergency patch”. Recent rises in values, particularly in the UK, mean that “a lot of real estate debt may be salvageable, given time and a fair wind”. However, the report adds: “Everyone – banks, investors, developers and brokers – is understandably apprehensive” in the face of €781bn of commercial property loans on eurozone banks’ balance sheets, plus some £250bn held by UK banks. There is also €95bn of CMBS outstanding. Of these loans, about half of the UK debt will mature over the next four years and €65bn of the CMBS. There are no estimates for the rest of Europe.
Tight borrowing terms
The effect is that terms are still very tight for new lending or refinancing, and are expected to stay that way: loan-to-value ratios are low and underwriting is strict (see fig 2). “One needs to be prepared to pay the full set of fees,” said one respondent, while lenders are focused on income. While banks’ margins in the UK and most Western markets seem to have settled at 200 to 250 basis points, in Russia they have doubled to 600bps. It is not so much the cost of borrowing that bothers Western investors, but the fact that “loan-to-value ratios, other covenants, and getting less recourse are more critical”. Respondents believe new lenders will step in to fill the credit gap and that “insurance companies, mezzanine lenders and other players will be active”.
Different players are targeting different parts of the capital stack, but all have been frustrated by the lack of deals and hope this logjam will start to break up in 2010. Investors are also very focused on income, which has driven large capital flows from institutional and retail investors back into property since the second half of last year. “They see property as offering the potential upsides of income protection, should inflation take off, and the prospect of longer-term capital gains if and when property values recover,” the report notes, For those with a global strategy who are looking to rebalance their portfolios, the target is Asia (see fig 3), which has weathered the financial crisis much better than either Europe or the US, and is “regarded as the engine of global growth” the study says. But last year, “buyers stayed at home”, the report says.
Total direct investment in European property nearly halved to €69bn (see fig 4), while cross-border spending totalled €33.4bn, compared with more than €150bn each year in 2006 and 2007. Leveraged buyers were “vaporised”, while those that did invest “played safe, focusing on big, liquid, ‘priced-to-buy’ markets”. One respondent added: “The UK is top of everybody’s list. France and Germany will surprise on the upside.”
The UK attracted 43% of cross-border capital invested in Europe in 2009 (see fig. 5), with euro and dollar-denominated buyers attracted by cheap sterling and cheap prices. “It’s buy one, get three free,” the report says.
Will transaction levels rise in 2010 and will there be a broader-based pick up? So far, would-be buyers have had to work very hard to spend their money. Forbes cautions: “A large volume of relatively low-risk capital and low-risk debt is chasing a fairly narrow band of prime assets in some German cities, Paris and London, so a bubble is developing and prices have risen quite sharply in those markets. But secondary prices are still falling, masking a more complicated picture.”
What to expect in 2010
Property skills are back in demand.
REITs are recovering because investors like their liquidity, transparency, corporate governance and ability to create value in a ‘leverage-lite’ world.
Investors remain positive about the asset class. “They scent recovery, seek income and fear inflation,” the report says.
But investors are still fixated on prime and core-plus stock, partly due to the attraction of long-term returns and partly because debt is not available for any remotely risky deal.
The focus is on core assets, city-centre offices and good retail, but not leisure, which depends on discretionary spending.
Leverage is likely to remain lower for niche property sectors, especially ones with less secure income, like hotels
Private equity fund managers are still being culled and new capital doled out sparingly.
Simple, easy-to-understand debt structures are likely to arise, backed by strong credits. Pfandbrief and covered bonds will gain traction as a funding mechanism.
Any global expansion will head east to Asia.
Interest rates will stay low this year as governments and central banks try not to tighten monetary and fiscal policy too quickly and to support fragile economic recoveries.