Lo and behold — the commercial real estate market crash in nuanced detail.
FT Alphaville journeyed to the offices of CB Richard Ellis, the CRE specialist and special servicer to the CMBS stars, on your behalf, and returned with the below — a series of charts (we know you love those right?) and the thoughts of executive director Robin Hubbard.
To start, here’s a reminder of just how far we’ve come on the CRE front:
Not very, then. While property valuations have improved, the outlook isn’t exactly encouraging.
That chart, however, conceals a great amount of variation between so-called ‘prime’ properties — like central London office buildings let on good covenants — and ‘secondary’ properties like, say, a shop let to a struggling retailer on an almost-vacant Bolton high street.
Here’s a chart of the differential between prime and secondary UK CRE properties in recent years:
Why the (increasing) difference?
Hubbard thinks prime property values have been pushed up by certain investors, perhaps under pressure to do something other than sit on cash, who are keen to buy the best sites at attractive yields (by historic standards).
Moreover, he contends the UK is also one of the few markets where foreign buyers have confidence that it has ‘bottomed’ and where their currencies buy a lot more bricks and mortar than they used to. However, they are understandably unwilling to take on the risks associated with buying assets of ‘secondary’ quality.
But the other, perhaps more important, issue is financing — at the moment, banks are very reluctant to extend loans for secondary properties. It is also worth noting the graphs above reflect good ‘secondary’, not mediocre or poor quality secondary.
Here’s Hubbard:
“Prime assets are tightening in a yield sense because of the level of demand and the fact that prime is the only thing you can get financing for at the moment. But yields on secondary properties may continue to widen out and there’s a lot of potential supply. The key question for the overall CRE market, then, will be whether demand for prime assets will spill over into secondary assets to stop yields in the latter widening further.”
Hubbard thinks there’s a high risk that demand for prime assets will not spill over into secondary assets, for reasons which the below charts should make fairly clear. A lot of UK bank lending, he contends, was against secondary, and even tertiary, properties — and for these properties things are likely to get worse before they get better.
For banks that is very bad news. As Hubbard explains:
- Prime assets don’t generate sufficient IRRs for a lot of new equity but….
- New equity doesn’t want, nor can it finance, non-prime assets
- Non-prime assets will struggle badly until the economy fully recovers
- At some point lenders will have to suffer pain on fire sales of non-prime assets
- The potential flood of non-prime assets will cause a downward value spiral
And while the prime end of the market continues to roar ahead with property sales going to best bids, Hubbard says the interesting area of the market will be the ‘battleground’ represented by those mediocre secondary assets:
“As landlords struggle to service their debts, lenders will have tricky decisions to make. Do they wait it out hoping values will rise, or do they enforce their security and sell? If they sell in bulk then this could cause a downward spiral in values as well as creating large write-offs. Naturally the answer lies somewhere in between as opportunistic buyers negotiate with banks over prices they are prepared to pay, versus the size of the losses the banks are willing to suffer.The state of the occupational market will determine both the confidence of the buyers and the extent to which valuations could rise and inherently reduce the banks’ potential losses. It’s back to the fundamentals of real estate again and demand from the real economy. The Christmas trading period could be more important for real estate owners and lenders than ever before as an indicator as to how this plays out.”Related links:
Looking at European retail rentals – FT Alphaville
“Losses on UK commercial real estate could equal subprime” – FT Alphaville