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© Business Money Ltd 2008 |
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With only marginal evidence for rental growth, why are such unprecedented prices being paid for commercial property across the country? Generally, such sharp yields should correlate with anticipation of something happening in the market in the future, ie. as the result of clear evidence of rental growth. However, over the last three years the only sector that has really experienced rental growth to any major degree is retail. The key question to ask in such a climate is: “Why are people prepared to pay such inflated prices?” Is this simply fuelled by the low interest rates that we have been enjoying or is an external catalyst driving the market? It is clear that investment fundamentals are not being adhered to; the standard practice of sticking to a certain rate of return is being discarded by many property investors. Over the last 18 months the market has become increasingly heated, and returns have fallen to historically low levels. For example, in the current market, even retail investments are generating yields as low as 4-4.5 %, which, with 5-year SWAP rates currently at 5.18% (as at 9 May 2006) renders a negative differential. It is never quite this simplistic but the market appears to have been turned on its head; historically a 2% “buffer” has been seen as a reasonable risk premium for property which may imply that property yields may become increasingly susceptible to interest rate rises in the future. The only manner in which investments of this kind can prove robust is if investors themselves contribute significant equity. However, levels of equity demanded have reduced with banks currently jumping over themselves to lend money. Thanks to the state of the economy, with calm rates of inflation and a historically low interest rate, the banks are able to provide incredibly competitive borrowing rates. As a result, the market is cash heavy, encouraging companies to invest in properties or portfolios with low yields if only to avoid becoming too cash rich. Robin Pritchard, head of our asset-based lending team, has recently worked on a portfolio valuation for a major retail client. He found that many of the properties involved were on prime sites and excellent locations where the institutions, investors and pension funds can accommodate very low yields, whilst driving the price of all similar properties up. Out of the three main sectors in commercial property, office, industrial and retail, retail has been the best performing over the last three years. However, office and industrial markets are actually currently increasing in terms of gross returns because we are starting to see rental growth. In fact, offices are suddenly back in vogue, especially in the City and the West End. Whereas a couple of years ago people avoided the City because of lack of occupier demand, there is now a shortage of prime Grade A space. In response to this, we are now seeing the return of speculative development. Speculative development is inherently reliant on the banking sector. That banks are now willing to lend on speculative development is a noteworthy progression. In comparison to their confidence in speculative lending in the residential market, banks have always been slightly wary of speculative commercial development and consequently the commercial market is still much more restricted than residential. The commercial market has not picked up sufficiently to indicate a reliable rise in demand, there are very active pockets in the City, but overall improvement has been slow and rental growth has not augmented dramatically. Therefore, it is notable that three years ago there may have been one or two banks who were specialists in speculative development and prepared to take a risk on it, but the majority were very apprehensive, whereas in the current climate the number of banks prepared to invest on speculative developments is rising steadily. Interestingly, of the few speculative developments that emerged two or three years ago that were viewed as high risk, a number could become a great success. For example, the Wil Alsop-designed Palestra on Blackfriars Road, London SE1, is nearing completion having commenced on a speculative basis in 2003. Two floors in the 290,000 sq ft scheme have now been let to The London Development Agency. The scheme was carried out by Blackfriars Investments and Royal London Asset Management. Another good example of a successful speculative scheme out of London, which we recently valued, is the development by Oracle, on Jubilee Street in Brighton, which commenced approximately two years ago. The 54,000 sq ft retail and office development is nearly fully let with tenants including Tesco and Carluccio’s. Ironically, three years on, we are suddenly seeing a flux of planning applications being submitted for development in the City, and eventually there is going to be a potential glut of new schemes. In another two years, it will become clearer which banks have made timely loans and which have perhaps left it too late. When a market moves as fast as the commercial property market can, planning delays can be a major threat to returns. The planning system currently causes a number of frustrations to developers, namely the high workload of planners in the city. Getting planning right is of course essential to the sustainability of any development project. However, when a development waits several years for consent, the market moves on and speculative investments are put at higher risk as the development may miss the optimal window for returns. The fact that banks are now opening themselves up to such risks as speculative development, which takes us back to the boom of the late 80s, shows us quite how aggressive the lending market is at the moment. Banks vowed after the last crash that they would never go back into speculative development, but now we have a new generation of individuals who are keen to exploit the current market. Banks are currently highly competitive because there are too many banks chasing too few deals. Over the last six to nine month period, 11 new banking teams have been set up across the City to deal purely with property lending. These new teams have come to the market in competition to existing teams. The result of this dramatic increase in competition is that greater risks are being taken on loan to value (LTV). LTVs have historically been about 70% on clean investments, but in the current climate are rising to 80, 85, 90%, and we have even seen cases where the LTV has been raised even higher! As the banks put more and more money into the property market, buyers are committing less equity, and consequently the banks are now much more susceptible to any change in the market. In the event of a sudden economic change of fortune the banks could be left exposed to falling prices and left with properties that are worth less than the value they have in their books. Competition in the banking market is driven in part by the fact that loyalty of investors and purchasers has greatly diminished – the majority of investors will now shop around. In addition to competition within the traditional banking market, there is now serious competition from other sectors in the banking world, for example: asset-based lenders. Our own ABL team has found that ABLs offer an alternative, more flexible method of banking to the traditional banking method, because they use the whole parcel of the companies assets to leverage funding. Consequently, more people are moving from the one dimensional security to an all-asset-based lending capability, in order to position themselves astutely in today’s much more competitive market place. The ABL market is in a period of expansion and the conventional clearing banks have had to sharpen their pencils to compete with ABLs. The recent growth in the securitisation market is also an indication of how competitive the banking market is currently. The European Securitisation Forum released statistics on the 13 March 2006 which claimed that in Europe the fourth quarter issuance volume of 2005 established a new record of €135.7bn, led by the mortgage-related and collateralised debt obligation (CDO) sectors. ESF also predicts that securitised issuance is likely to increase by approximately 15% in 2006, with most of the increase expected to come from the commercial mortgage-backed securities (CMBS) and CDO sectors. Moreover, securitisation also acts as an important driver for the commercial property market, creating space in loan books for new ventures. Investing in the UK property market is difficult at the moment, with too many people chasing too few products. Consequently, investors have been turning their heads towards the European property market, Germany in particular. The banks are following and investing heavily in European property, however it remains to be seen whether the banks and investors are experienced enough in this market, or indeed whether they have entered it early enough. The impact in the surge of money pouring into Europe has seen yields sharpen dramatically. For example, a retail unit let to Dixons would have sold for 7.5% a year ago, and will now achieve between 5.5 to 6%. A more home-grown solution to the overheated investment market in the UK is to look at alternative uses of an existing building. We are increasingly carrying out a number of valuations where we have been asked to provide figures on the special assumption that consent is granted for an alternative use as well as existing use. Investors are often paying over and above the existing use values by reflecting “hope value”. Are banks basing their lending criteria on these higher values? Again, as is the case with speculative development, investors are taking these risks because of stagnation in the clean investment market, and because of the increasingly competitive borrowing rates offered by lending institutions. Banks are driving all three sections of the UK commercial property market: the investment market; the development market; and UK ventures into Europe. The majority of items discussed in this article are of the open treaty market, but banks can be seen to be driving prices in the auction market as well. The auction market has become increasingly active, again because buyers know that they can get such competitive borrowing rates form the banks and therefore place higher bids. Rising LTVs are increasing the spending power of investors across the board and we have again moved towards speculative development. However, the SWAP rate has jumped dramatically over the last month and this has already had an impact on several deals which we have valued. It will be interesting to see what will happen over the next few months and the effect that SWAP rates have on the market. All we need is a shift in the market and the end result could be dramatic. The question we should now be asking is are banks reflecting such potential risk in their lending criteria?
Chris Hornung, head of valuation services,
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