Special feature: Unsafe as houses

Which way will commercial property go now that we’re in the eye of the credit
crunch storm? The fact is, nobody knows, or, to be more accurate, everybody
thinks they know, but can’t really be sure.

What is certain is that last August, property deals collapsed, but values had
quietly started falling before that. Between late 2006 and late 2007, the value
of commercial property transactions fell by a staggering 95%.

Bruce Dear, head of the real estate investors group at law firm Eversheds,
says, “Those who have been surfing the rising price wave are falling off their
surf board pretty hard.” “This is the quickest and deepest property ­correction
in living memory.” Sentiment drove the nose-dive, says Barry Gilbertson, a
partner at PricewaterhouseCoopers and a former president of the Royal
Institution of Chartered Surveyors (RICS), who adds that more than £10bn in
major ­property deals were put on ice last summer when the credit crunch hit the
news. “Confidence in the market was completely zapped. Buyers ­wonder why they
should buy today when the price might be cheaper tomorrow.”

But who knows what will happen tomorrow? And how this could affect occupiers
of all types of commercial property? Last year, property pundits predicted that
the “green shoots of recovery” might be poking through in the market by the
first or second quarter of this year. At present, there is little sign of that,
although some sources report that smaller deals are on the rebound.

PwC’s Gilbertson polled market sentiment at a recent property banking dinner
and found hope for a recovery pushed back to early 2009. But he admits there
wasn’t much science behind that view. “You might describe it as an emotional
reaction because 2009 will be a new year. Even so, the eight were very
experienced at lending money in the property market.”

Oliver Gilmartin, senior economist for RICS, notes that yields on commercial
property are a function of the real interest rate, rental expectations and the
risk premium that investors attach to the commercial property asset class over
and above the risk-free rate of return.

Risk premiums
Gilmartin points to Bank of England research that ­suggests a key factor driving
commercial property yields south since 2006 has been the risk premium factor.
“We expect the price that people are willing to pay for commercial property to
remain under pressure in an environment where there is ongoing concern about the
health of the financial services market,” he says.

Traditionally, property deals have been funded by as much as 90% debt and 10%
equity. Gilmartin points out that, at the top end of the market, banks have
securitised debt on larger deals. But in a fear-driven climate in which
investors are nervous about anything to do with securitisation, the banks have
lost that option, for now. “When the debt was securitised, the risk to the banks
was minimal – they were literally distributing the risk out. Now that the
securitisation market has dried up, that approach has come unstuck,” says
Gilmartin. “As a result, the risk factor on debt from commercial property deals
is higher.” If, indeed, the banks have the cash to lend at all.

One impact of the credit crunch is that loan-to-value ratios have fallen.
Take, for example, an investor that might have previously borrowed 80% of the
value of a new development and made up the remaining 20% with their own cash. If
the loan-to-value ratio falls to 70%, the investor has then to find 30% of the
investment value – half as much again – elsewhere.

“Where this equation gets tricky is when the bank, on reviewing the
facilities extended to its customer, decides to change the loan-to-value ratio
during the life of a loan. The customer may then be under an obligation to find
an additional 50% of its original equity stake,” says PwC’s Gilbertson.

James Beckham, a partner at property services firm King Sturge, agrees that
the debt market for commercial property has not recovered, but believes there is
a silver lining. “Speculative development won’t happen without a pre-let in
place or will be deferred until the outlook becomes more settled,” he says. That
may, indeed, be a silver lining for investors in existing properties who see
their yields under pressure from a range of other factors, including a downturn
in the economy.

Occupiers can also take advantage of this rare occasion when some landlords
are on the back foot. Some occupiers are already talking tough in negotiations
over rent reviews and related ­matters. But persuading landlords to hold rents
in a periodic review or even negotiate a ‘golden hello’ to persuade a new tenant
to occupy an unused property are so unusual that some FDs may not realise this
is the time to strike such deals.

“The balance of negotiating power has swung in favour of the tenants because
of the change in the economic climate, particularly over the last year – the
result of an over-supply of properties and market pressure on landlords
exacerbated by the sub-prime crisis,” says Stanley Beckett, head of property at
law firm Magrath & Co.

When it comes to taking on landlords in this climate, flexibility is the key
word, advises Beckett. “Other than for properties requiring high capital
investments, the cost of which may need to be spread on the balance sheet over
five to seven years, it is now expected that tenants will get break clauses
exercisable after three to five years or linked into the first rent review. It
is not unusual in start-up office space for there to be a rolling break after,
say, 12 months.

“Rent-free periods of 12 months or more are not unusual, taking into account
the need to let and property condition, and this is sometimes aligned with
financial incentives from landlords such as reverse premiums, where properties
are dilapidated. And schedules of condition limiting tenants’ repairing li
abilities are becoming more common,” he says.

Yet, when it comes to negotiating over property, it’s the details that count.
The commercial ­property market may look bleak, but there are wide differences
in sentiment between the three main sectors – offices, retail and
industrial/warehousing – and again within those sectors.

Research published by King Sturge suggests demand for office property in
London’s West End will be stronger than in the City this year. Beckham notes
that never before has there been such a wide rental difference for prime
property between the City (£64sq/ft) and the West End (£112.50sq/ft). He expects
prime rental growth in the West End to rise by 4% this year – against little
overall rental growth in the City.

Outside London, the picture is no less mixed. There are plenty of areas where
office rentals are at a standstill. But there are also some hot-spots where
rents are predicted to rise – for example by 8% this year in Leeds, according to
Ian Pennington, development director at property group MEPC.

Retail in therapy
When it comes to retail, prospects look uncertain for investors, brighter for
tenants. On the face of it, retail property is booming with major new shopping
centres or parks coming on-stream this year in Liverpool, Bristol, London’s
Westfield, Belfast and High Wycombe. But, from an investors’ perspective, storm
clouds could be gathering.

Gilbertson reveals that, last year, PwC helped restructure seven major retail
chains with 2,000 stores between them. In those restructurings, 27% of the
stores were closed as part of the ­survival packages. He points out that if just
10% of the UK’s 1,100 retail chains with more than 20 outlets needed to
restructure in this way, a further 2,700 empty units would flood the ­market.

This could drive down valuations, though property commentators point out that
in retail, location is everything and that there still seems to be high demand
for prime locations – while secondary and tertiary locations are suffering the
most. A growing love affair between consumers and internet shopping further
exacerbates things. In the six weeks running up to last Christmas, UK household
spending on internet shopping totalled £14.5bn, double the previous year. If
that trend continues, more retailers will begin to feel the pinch, and we may
see a glut of retail spaces come on to the market.

But what’s bad news for retail could be good for the industrial and warehouse
sector. More internet shopping means more goods need to be stored and
distributed. The trend is towards big box warehouses (typically more than
100,000sq/ft) and away from smaller warehouse properties. King Sturge’s Beckham
points out that the return of empty rates liability on ­industrial property from
this April is going to make landlords even more nervous than usual about ending
up with empty space. From the tenants’ perspective that could be a useful
­negotiating lever when it comes to rents and other conditions of use.

RICS’s Gilmartin predicts that commercial property will have a “soft landing”
from the credit crunch. He may be right, but there will be plenty of companies
for whom it doesn’t feel that way.