To kick off the new year, Real Estate Capital and Barclays Real Estate hosted a round table with some of UK property’s leading investors. The discussion ranged across asset pricing, development risk, residential build-to-let, finance and buying debt. The verdict? There are opportunities out there but the panel remain cautious and recovery will be slow.
Top investors gather to look at the opportunities ahead
Chris Grigg: Prime property is in decent shape, driven by its safe-haven status and low interest rates. If you are not in that category it is going to be tough this year. There’s going to be less finance around, because there will be a lot of concern about occupiers and the state of the economy. The speed of the polarisation process has probably been accelerated by the general feeling that the economy here and around the world has weakened.
Jamie Ritblat: You have a set of investors driven by fear and greed, buying Bond Street shops at 2.5% and supermarkets at 4%. They are all about capital preservation. The fundamentals of a Bond Street shop at 2.5% don’t really stack up in real estate terms.
On the flip side, you have the other type of buyers – the institutions, some of the REITs who are probably going to be less fussed about the capital values but want income. That will be their analysis this year and next: how secure is the 8%, the 7%, the 10%?
Nick Leslau: There’s a discrepancy between prime, which is overpriced, and the second-ary market, which is so unloved. There is some very good secondary real estate. The dysfunction in the market will make secondary incredibly exciting, with the one proviso that the owners of this real estate have to let it go. Out of dysfunction comes great opportunity.
Brendan Jarvis, Barclays: A lot of the pur-chases of the real prime, super-prime have been from cash. The way I see things shap-ing up is that as the unloved non-core stuff becomes cheaper and cheaper, and people who know how to manage these assets are prepared to roll up their sleeves, surely that’s where the activity will be. So provided the banks like Barclays are prepared to sup-port those good clients, those good spon-sors, we’ll see unloved secondary fighting back over time.
David Atkins: There will be a much lower volume of deals this year than in the last 12 months. I don’t think any of us are in a hurry to put money out, because pricing has not got to the point where we feel it is the right level for the risk you’re taking, for the costs of capital you’re taking on. So no one is going to be in a hurry, and they will be increasingly selective about what they do.
CG: Propcos like us will be looking more at those assets where we think there will be an opportunity to turn them into prime assets. Whether that happens or not is very hard to call. It’s unclear whether there are that many distressed sellers. Remarkably, given the amount of investment needed to turn these assets into high-quality assets, the numbers still don’t add up on a lot of the deals we look at.
NL: That’s the arbitrage – a big empty building that you could buy at less than replacement cost or capex costs. If it’s empty, it has no interest for sovereign wealth funds at all. If it’s let, suddenly it’s worth 4.5% and you wouldn’t buy it. Big REITs are in the best position to take advantage of this. That opportunity will be out there for the big players.
JR: That was the argument behind us buying Minerva, buying Walbrook – a brand-new City building, below replacement cost and we have no building risk. We’ve got let-ting risk, but that is what we are supposed to be competent at. Finding more opportu-nities like that is the challenge. Unless you get a very distressed wrapper, it’s very hard to get at those things.
DA: Our thoughts first and foremost are: “What can we invest in our own business?” There’s plenty to be done, and our portfolio is no different to any other large prime portfolio. With shopping-centre extensions, for example, you own the land already and you can easily make double-digit returns at a much lower risk. You’ve proven the loca-tion, you understand demand and all the rest of it. These are developments in most people’s eyes.
NL: There is still demand out there, there are still people starting new businesses. People are being made redundant, but the world keeps turning. The further away from London you get, the less people give a damn about the eurozone. Some intel-lectual energy will go into new retail stores, some will go into industrial units and we’re starting the cycle again. But it’s going to be long, drawn-out affair.
DA: Retail is the most dynamic industry there is; new formats come along. I think many high streets will re-invent them-selves, but the price point – the rent – has to change. With a secondary shopping cen-tre you may not find anyone at any price, because frankly life has moved on and its role in the retail hierarchy, in a local or regional sense, has changed. You won’t get any retailer looking for space in it. That’s where the risks are quite different for retail.
Summing up 2012
- There will be fewer deals in 2012 because pricing is not at the right level for the level of risk and cost of capital.
- The market will continue to polarise between sought-after prime and unloved secondary property.
- Secondary property will provide great opportunities, provided the owners will let it go.
- Investors are split between those who are looking to preserve capital and those who seek income.
- REITs will be investing in their existing portfolios and looking for properties they can turn into high-quality assets.
- Development will take place, but on a more cautious basis.
- Retail is dynamic – the high street will reinvent itself but some secondary shopping centres are doomed to fail.
- There will come an inflexion point when office tenants who need to move will take a decision.
- New space will get the tenants; secondary offices will struggle.
- Central London tenants are more flexible on location – some will go to fringe areas with good communications and local infrastructure.
- Well-located areas like Stratford will work for residential, but residential rentals require scale to deliver adequate returns.
- The availability rather than the pricing of debt is the major issue; the use of bonds will grow and vendors will have to provide stapled finance.
NL: The problem in retail is the perma-nent voids. If you have 20% voids in a poor shopping centre, you will never see rental growth. You can’t chop the units off – they are genuinely embedded voids. Yet inves-tors have been spending a lot of money on secondary retail.
JR: And prices are beginning to drift, quite materially.
DA: I have walked around some secondary centres and you get void, void, temporary let, temporary let, proper letting, mobile phone, mobile phone, temporary let, void. That is not sustainable. At the moment there is some demand and you can patch it up with temporary lettings but when that void market becomes so big and secondary centre is competing with secondary centre, you get to the point, which you see in the USA, where you effectively have a centre that fails. I’m not so negative on high-street retail, because the lack of common owner-ship means ultimately an owner will take a decision on a unit that will only affect that unit – if it means letting it to a startup retail business for £5,000 a year, well, that is bet-ter than nothing. It finds its level.
NL: Single ownership does allow you the flexibility to move the high street up or down, left or right, which you can’t do in a shopping mall. The problem is that the UK has 20m sq ft of consented open A1 space with the supermarkets. And they will build those. That is one of the single biggest determinants of what will happen to our high streets.
CG: If you look at the numbers, supermar-kets have been the clear winners. As super-markets have moved into non-food they’ve squeezed a lot of other retailers in a way that hasn’t happened before. But equally, supermarkets are where people want to shop. That’s why it’s hard to know where to go with the social issues, which are big.
JR: The next stage might well be where it becomes more troublesome for supermar-kets to go out of town because the plan-ning regime tries to force them back in. They might be the buyers of some of these secondary shopping centres. It could be very cheap for them to walk in and buy, Nunea-ton for example, at 10%, occupy part of it and control their entire environment. That may be a very efficient way for them to oper-ate. If I were a supermarket, that’s where I would be going because I’d get bricks and mortar for free.
NL: The market is constipated because Lloyds and RBS have not just let go. When we raised Max, I thought there would be huge amounts of real estate coming on the market. And for five months, four months, there was lots; we were all buying around that time, before the REIT rights issues in early 2009. But then that window closed. And since then the banks have been sitting around discussing what they are going to do.
DA: Largely they have gone for the low-hanging fruit, the stuff that can be sold quite easily, the good stuff. The problem now is that what they’ve got doesn’t look quite as compelling.
JR: And swaps are a problem. Hopefully in the next couple of years some of those swaps will burn off. It gets a bit better. But the mark to market on swaps is horrendous.
CG: But the value of the asset is going to burn quicker than the swap.
NL: The average unexpired lease term in IPD is 5.6 years. And we know that IPD is institutional stock. So on secondary, tertiary stock it is probably more like two, say, three years. In which case you have two years to burn off, no one investing any capital, no incentivised management, so your asset value is falling while your swaps are burning out. I am staggered that banks are not forced to publish what their swap exposures are.
DA: I think the banks have actually done a pretty good job of deleveraging. One of the UK high-street clearers I know has sold £2bn in the last 12 months and the average lot size is £7m. So they did the big stuff early but they spent months and months selling shops in places like Halifax.
DEVELOPMENT AND LETTING RISK: Moving toward an inflexion point
DA: Most of us here have some involvement with development and will develop. But the way you go to the market with those schemes will be on a more prudent basis. People will be thinking more about prelettings, what type of financing, what type of partner they have. We have land in the City of London. On the one hand you can say rents are relatively low compared with historic averages, there’s very little supply coming forward, but ultimately you are making a £300m-£400m bet. That’s one hell of a bet.
CG: What people don’t take the trouble to understand is that if you minimise building risk, then the key risk to development is the letting risk. If you look at the letting risk in our entire office portfolio and add in our developments, our letting risk in the next few years remains less than IPD’s. Our maturities will let at or above today’s rent. The rest probably won’t let over the next six to 12 months, and I’m cool with that.
DA: The short-term risk is indecision. You have a number of tenants who need to do something but are inert. It is a question of when they go from fear to: “I’m running a business, I have to get on and make a decision.” Rents in the City don’t look very demanding – it’s neither here nor there for most of those occupiers in terms of their businesses. There will be an inflexion point. At some point those decisions will be taken, and people will move to new buildings. They tend not to stay and refurbish, because it is expensive, disruptive. And the cost of running an obsolescent building is much higher than a brand-new one, if you’re looking at 25 years. And once one goes, we’ll see a series of them.
NL: New space will get the tenants. Does it matter if you are budgeting £60 per square foot rent and you get £55 or £50? As long as you get a tenant, the rent will look after itself. So long as people are building great buildings, they will let them. The shortages are unbelievable – look at the statistics, there is nothing being built. The biggest issue is in secondhand space: institutions own 1980s buildings that are probably valued at 8% with three years left on the lease. Those are hard to let.
DA: They’ll have to wait for someone to buy them to redevelop, and a lot of the time it is really challenging to do that.
NL: A lot of people who own buildings in the City will be looking at potential residential schemes.
DA: The City will have to adapt its planning policy. North of the City in Shoreditch, where we have a goods yard and sites on the edge, it’s becoming fashion, catering and tech. You have occupiers who can’t expand in Soho saying, “We’ll move over there.”
JR: You have to make the environment nice enough. Stratford is another case in point. I think it will fly, it has such fantastic infrastructure.
DA: Firms are thinking much more about what’s good for their people. Those are certainly all the conversations we’ve had around the Shoreditch area. They say, “Convince us in terms of the environment.” Staff retention is everything. Stratford ticks the boxes in many, many ways; I just think commercially it will take a while.
RESIDENTIAL: Making the rental story work
JR: We bought Elephant & Castle – it’s like Stratford, a residential story about Londoners who can no longer afford to live in the middle. These are the new Fulhams. As long as you are absolutely on top of or very adjacent to zone 1, with very high levels of communication, these are places where our kids will live in the future, at rates of £500-£600 a square foot. It’s the same story as the Olympic Village in Stratford, in terms of both rental and sales. I think Elephant will be terrific. If you went back 80 years, it was in the heart of London. It was a very lively place.
The returns on residential rental only really work when the capital values are at a certain level. At £1,500 per sq ft it doesn’t really fly, so you have to be in there at £400-£600, and you have capital value growth embedded. At Elephant & Castle we paid a low price per square foot for the site and quickly implemented the consent, so we can build to suit. With those numbers, the rental story works very well. That’s the challenge, finding the sites cheaply enough. It’s not for the fainthearted.
Plus, the ability to drive decent net returns is much greater out of a Stratford or an Elephant & Castle, where you have concentrated ownership, rather than owning 1,000 apartments spread over London. You have to get the business model right and run it like Broadgate or a big estate. But the only way to do that is to have big quantities of residential in one space and control the environment. You can manage it efficiently; you have the possibility of generating enough net rent to justify pushing it out as a REIT. I can see that happening in five to 10 years.
Stratford is a bit unusual, because although we launched it last month, we have to wait for the Olympics to finish and for the government to refit it. We don’t get it until 2014. Then like a shopping centre, you have to get stabilised cash flow, and that’s probably 24-36 months after you let it, to prove the model.
CG: I think one of the gaps was created by the size of the assets. They are on such a small scale and each of those properties needs fixing – the shop in Halifax or wher-ever. It is very difficult to generate enough total return, in pounds, shillings and pence, to extend to all the work that is required to do that on a big scale.
DA: Not many people are set up to go into secondary markets. It’s hard to see how you would attract enough capital, enough lend-ing, to go after that very small asset.
CG: You have to bulk it up. If you don’t aggregate, it won’t happen.
NL: At the very big level there seems to be a very healthy demand from private equity funds. Lone Star is a very interesting case. You wouldn’t have thought they were granular managers. Historically, debt buyers would buy the debt piece and sell it to the borrower for a 10% margin to get their IRRs. So on a leveraged basis they would get a huge IRR.
Today, the borrower can’t automatically go and borrow that money – it would be very difficult. And if the bank is selling to a private equity fund – presumably they’d had a crack at selling at a 30% discount to the borrower and the borrower couldn’t raise the money, so how is the fund meant to make money other than loan to own? So they are therefore taking the view that they are going to granularly manage that portfolio. And that’s an interesting challenge for them, because they’re not geared to do that. So while you can buy big – go into the market and buy one billion quid’s worth of loans – someone down the line is going to end up managing them. And it’s not a quick turn.
JR: The other thing about the big private equity funds is that they still seem to be pric-ing on the basis of the old model – that is, buying a loan and selling it on – as opposed to a loan-to-own strategy, where your price would be nowhere near what they actually appear to be paying. Where we will price bottom-up, they appear to price on the portfolio view.
FINANCE: Little liquidity but market will reinvent itself
NL: In the short term, the IPO market for REITs doesn’t exist. There is no interest in real estate at all in the equities market. But even if there were, you need an equity story “you should put your money in us because this is what our specialty is”. And they have to be very focused, very low-geared. Regarding debt, it’s the fuel that keeps the motor going and if you take debt out of the motor, it just grinds to a halt. That’s what’s happening. The liquidity is down to very little, except in those very prime areas.
CG: Banks’ finance is costing them more, so to make a proper margin, it goes into their pricing. The industry is going to have to get used to the fact that one of its good sources of debt finance is financing at a much higher margin.
NL: We can live with higher pricing – it’s the availability of debt that’s the major issue. The cost of debt doesn’t affect my decision. It goes into the pricing, into the model that we’re buying on. If as a bank, you can deliver certainty, you’ll have a lot of customers. But if your originators cannot give you any confidence on what credit is going to say, it is a waste of time. That is a fundamental problem today.
BJ: Selectively we are lending. We have to be choosy, because there are fewer banks in the market anyway, there’s less liquidity. I’ve been saying that for the last two years – we’ll choose on the basis of relationship and the quality of the transaction itself. It’s all about the borrower, it’s all about cash flow, and the tenants and the lease.
CG: You have to spread the risk on the debt as far as possible, so you want many sources. We’ve used the bond market over the years and that will continue. That area of financing will grow. Private placements are very popular, and insurance companies are now looking to lend.
NL: These guys have so much money they want to place, but they don’t have the management skills. Stapled debt has to feature as part of the future. We saw a deal where an institutional vendor wants to provide 70% financing at a 10% coupon. Someone’s going to come in and put a shedload of capex in, improve the asset and let it all up, so 70% LTV will come down to 50% in due course, and the institution gets 10% IRR.
JR: The other place you will get debt is some of the large private equity houses, people like KKR. They have billions under management in different funds – some are 20% funds, some are 10%, some are 4-5% core funds. They’ll definitely come in. Why shouldn’t they? They are effectively banks. The great opportunity is to be a bank. They can provide senior debt because they’ve got core funds that are happy to earn 5%.
CG: The other thing we will see is somebody like Vodafone, which is now involved in every stage of the lending process. Their borrowing rate is fundamentally below any of the banks – they’re providing vendor finance, customer finance, everything in their supply chain that needs a loan. Because they absolutely understand their own supply chain, they can price and finance sub-banks, and they think they are taking justifiable risk.
NL: The market will reinvent itself. Banks can be the intermediaries to furnish structured finance, because straight vanilla debt is never going to be a satisfactory contributor to a bank the size of Barclays. And you’re in an area that is going to become more and more competitive, because everybody wants that quality. That’s the difficulty, as a bank: you need to be more inventive and creative without necessarily going up the risk curve.
BJ: Real estate lending has regularly seen banks entering and exiting the market, not just through the economic cycle but every year. What the market needs is stability. We certainly view property as a robust and sustainable asset class with significant opportunities for growth. We intend to grow our book with experienced clients who want a broad banking relationship.