BNP Paribas analysts are worried about the health of the UK’s commercial real estate sector. In a note released on Friday, they warned that a “combination of rising vacancy rates, falling rentals and extraordinarily difficult financing conditions will almost certainly drive UK CRE losses higher.”
Analysts Vivek Tawadey and Olivia Frieser contend that CRE is the “next leg of the credit story” in both the US and the UK, which they believe could see a major CMBS default.
From the note (any emphasis FT Alphaville’s):
Bonds backing CRE assets of a UK property investor (Simon Halabi) are likely to default on £1.15bn of debt. In this particular case, the values of the nine “prime” London office buildings (included the offices of JPM, the UK headquarters of Aviva, the Naval and Military Club amongst others) that were securitised have fallen from £1.8bn in November 2006 to £929mn as of 8 June, a reduction of almost 50%. This is leading to a breach of its loan to value covenant under the credit agreement that must be rectified within 10 days, else it would lead to an event of default. Equity injections (or other measures to deleverage) could help, but given the environment, one has to question whether this is possible.
Still, they also contend that while the big picture remains negative, the pace of bad news coming out of the sector has declined:
A combination of falling rentals and rising vacancy rates continues to weigh on credit quality. According to the May- 09 RICS survey, UK CRE activity continued to decline in Q1/09 after a record fall in Q4/08. According to IFD, UK commercial properties values have been declining fast with peak to current declines of around 45%, with major declines noted in all major segments – retail, offices and industrials. The good news is that the pace of deterioration moderated across the three sectors (office, retail and industrial) particularly industrial, though retail remained weak. Although the number of enquiries to occupy space continued to decline, the pace of decline moderated, from an all time low. The confidence in the outlook for rents fell to the lowest level in the survey’s history.
With the following caveat:
At the same time the amount of available floor space for occupation increased at the fastest pace since 1999 in all regions with the exception of London (Chart 2) and thevalues of inducements rose at its fastest pace since the survey’s history in 1999. Collectively this implies that an upward correction in prices in the foreseeable future is unlikely.
Tawadey and Frieser also point to the refinancing risk ahead:
Around £43bn (or 19%) of all CRE loans comes due for repayment in 2009. A further 14% matures per year annually in 2010 and 2011 (Chart 3) or in excess of £100bn over the next 3 years, implying very significant refinancing risk inevitably leading to higher defaults.
As for the notion that loan-to-value ratios on commercial real estate have been generally restrained compared to those seen in the residential market, they point out that the average LTV is “close to 80 per cent, and rising and with further declines in CRE prices, equity could be completely wiped out.”
They also note that RBS and Lloyds Banking Group are the most exposed of the UK banks to CRE, with an exposure of £97bn each at year-end 2008, most of which at par on their books:
Needless to say that we are expecting provisions and impairments to rise significantly in this segment over the coming year or more.
For RBS, the UK represents around 58 per cent of its CRE exposure, Ireland 12 per cent, the US 8 per cent, Spain 3 per cent and Germany 6 per cent, with the rest of Western Europe making up the remainder, according to BNP Paribas.
Other RBS tidbits from the note:
- Of the total exposure, 73 per cent is investment and 24 per cent (i.e. £23bn) is development, which is riskier
- Less than 2 per cent of the CRE exposure is speculative lending
- The average LTV was 84% at end 2008, but this ratio will have come up with falling prices. However, this exposure will be captured within the Asset Protection Scheme.
As most of the exposure to CRE is in the lending book, it has not been written down much, and provisions as of end 2008 were minimal. The CMBS exposure has had some write-downs, but this is only a fraction of the total CRE exposure. Therefore, the bulk of the losses and provisions have yet to come. RBS did not detail provisions for CRE in its latest interim trading update, so more information on this will come in H1 reporting in July.
On Lloyds, Tawadey and Frieser note:
. . . the UK CRE originated by Lloyds represents £23.3bn (24% of total CRE exposure), UK CRE exposure originated by HBOS £44.7bn (46%) and CRE exposure originated by HBOS Overseas £29.4bn (30%).
Significant impairments on these banks’ CRE books should be expected when they report first-half earnings in August, according to BNP Paribas. And on a more macro (and anti-green shoots) note, our emphasis:
. . . it is becoming increasingly evident that the problems in the CRE space are not only confined to the US, but also spreading fast across the UK and other Anglo-Saxon markets. The Eurozone CRE market remains slightly more opaque given the significant variations in the dynamics of individual markets. However, it is not immune, especially given our view of a prolonged recession there. The fact that only 10% of CRE loans are securitised in Europe (US: 30%), also underscores that more of these loans are held on bank books, leading to potential write-downs down the line.
Related links:
Fitch study points to high UK CMBS risk – FT (July 2008)
The commercial real estate risk list – FT Alphaville (November 2008)