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Archive for the ‘Commercial Property’ Category

Lehman Brothers

I‘m not going to write much about Lehman’s demise because there will be thousands of column inches out there (most ignoring the equally important news of the BoA purchase of Merrill Lynch and the problems at AIG). Lehman’s British companies have mostly been put into administration. All I want to note is that in a live interview with the Administrators (PwC) it was stated that some of the best assets left in the UK companies were real estate assets, held in special purpose companies and joint ventures. This shows that – despite the current hand wringing about property markets and reference to ‘toxic’ real estate involvements in the Media – owning real estate assets is safer than lending on them. This is a point I will return to in a future post.

HBOS

Amongst the carnage on the Stock Exchanges around the world yesterday, HBOS shares took a huge battering again in the UK. Quite why still baffles me, although this article suggests that one reason is that the bank is ‘ so exposed to the mortgage market and falling house prices ‘.

In the current climate, the relevance of falling house prices in relation to HBOS is not that important – the ability of mortgagees to meet their payments is the critical issue. Over the life of a mortgage, a house value can fall below the amount of the mortgage (known as ‘negative equity’) and rise well above it. It has happened to me. This is not a cause for concern so long as the borrower can make payments. Therefore, interest rates and the job market should have a greater impact on HBOS’s position, rather than the state of the housing market. When panic spreads throught markets, logic and common sense seem to go out of the window.

The same applies to commercial property loans, but since they are for a much shorter period, the state of values and the market is relatively more important than for residential mortgages. Nevertheless, so long as a borrower can meet their income payments, only a foolish or desperate bank will force the sale of properties in a weakening market. It will only make things worse – for them and everyone else.

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One way of spotting a serious recession in the commercial property market is the inevitable whining and moaning by retailers about the rental obligations of their premises. It’s happening again, with a concerted effort by the British Retail Consortium to change the way retailers pay rent.

I recollect back in the mid-’70s sitting in a packed hall at the R.I.C.S. to hear a presentation from retailers asking for rental holidays and/or reductions in order to be able to survive a tough recession. There was a suggestion from a surveyor working for landlords that retailers who could no longer afford rents on prime locations should move to cheaper, less well located premises – a suggestion that produced incredulity from retailers who clearly felt that signing a 25 or 35 year lease (there were still 35 year leases with 7-yearly rent reviews in those days) gave them a ‘ right of residence ‘ and if they could no longer afford to pay the rent, the landlord had to make concessions to permit them to stay in their premises.

Discontent was raised again at the next recession, particularly about upwards-only rent reviews, which was also an issue in the early ’90s recession. Then, the B.R.C. had their greatest success. Again they complained: this time about residual liabilities after retailers have assigned their leases to other retailers. At the time many smaller retailers were going out of business and landlords were reverting to demanding rent from the original signatory to the lease. Retail chains who had moved premises as they had expanded and/or abandoned the High Street suddenly faced rent demands for premises they used to occupy, as well those they currently occupied.

The Government succumbed to the political pressure and changed Landlord and Tenant Law to suit the tenants. Public sympathy was very much on the retailers’ side, partially because of Press support, who failed to educate the public about the other side of the debate. What outsiders fail to appreciate is that retailers have a number of options if they want to leave their premises: they can offer to surrender their lease to the landlord (which can produce costs for the retailer), sub-let or assign their lease to another retailer. Usually, the incoming retailer will pay a premium (a capital payment) for the lease, which can be quite substantial. It is often expressed as for fixtures and fittings (for tax reasons), but few retailers make use of the previous occupants fixtures and fittings. It’s a payment for the difference between the market rent and the (lower) rent payable under the lease. It’s borne out of the anachronism of having rent reviewed to market levels at long intervals. In effect, it’s part of the landlord’s equity.

The change in the law made a colleague of mine at the bank at which I worked apoplectic. He was in charging of Leasing Finance (not real estate, but plant, equipment, car fleets etc). He saw it as a fundamental change in contract law (which it was), as it permitted one party to a contract to walk away from their obligations under the contract. No doubt he was concerned about it gradually infecting other areas of contract law, but, as he said: “Why should property (real estate) be an exception ?”.

My reaction was at the lack of quid pro quo for landlords. The most obvious change would have been to stop tenants being able to charge premiums for assigning their leases, or at the very least force them to share a major part of the payment with the landlord.

Now, I have no problem with changes to real estate leasing, so long as it is fair and the benefits are shared between landlord and tenant. Retail tenants complain about their lot in the middle of a recession not just because they are suffering, but because there will be little focus on how much retailers benefit from their lease arrangements in boom times and also because their bargaining strength is at its greatest in a recession.

The B.R.C. wants rental payments to be switched from quarterly in advance to monthly. Apart from the increased administration costs of doing that for both parties, I have no problem with the change, so long as there is a change that benefits landlords, such as annual rent reviews or sharing of assignment premiums.

We’ll watch what happens. In the meantime, I mentioned this to a friend who has been in property management for over 40 years. Her response ? “Does this mean I’ll be sending the bailiffs in monthly now, instead of quarterly ?”.

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HIATUS

Apologies for the hiatus in posts. This was due to what might be termed a family tragedy. A number of posts will follow soon.

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Estimates of job cuts in the City are increasing week by week (and have now started). This is no surprise. Financial institutions have always viewed staff as a liquid commodity and as the easiest overhead to cut when the going gets tough.

This article points out one implication for the commercial property market: that of empty office space. However, whether this will lead directly to a ‘ plunge in property rents ‘ is rather uncertain. That depends if the job losses are as a result of company failures (which would lead to empty non-revenue producing space that landlords would be keen to re-let as soon as possible) and on the strategies of surviving organisations.

They will (in most cases) still be left with the obligation to pay rent, whether they occupy the office space or not. Space rationalisation can sometimes be an expensive proposition, so if the organisations expect an improvement in market conditions that may lead to them hiring new staff within a year or so, some will judge it prudent not to seek to sub-let the space. There are undoubted efficiencies from contiguous occupation and breaking up such hard-fought for continuity can cause problems in the future. Sub-letting a couple of empty floors in a building you occupy may mean that future expansion will have to take place in separate buildings, reversing a trend that financial institutions in the City have been striving for a long time: to get everyone under the same roof.

Of course, there could be a flurry of mergers and takeovers that might lead to whole buildings being put up for let. However, in the current climate of fear, uncertainty and lack of available credit, I would be surprised to see this happen.

So I would not expect a ‘ plunge in rents ‘, but anticipate a decline. The impact of City job losses on the commercial property market concerns me for other reasons altogether.

In the early ’90s, initially the attitude of many banks’ towards troubled loans was generally supportive. In particular, one of the High Street banks was notable for this. However, it suddenly changed its policy. Receivers and liquidators were appointed to take control of many of their customers. Another bout of doubt hit the commercial property market, values fell further as some of the appointees sought to sell assets quickly and other banks found it convenient to follow suit.

I thought I knew why this had happened and had an informal meeting with some of the bank’s lending team, which confirmed my worst suspicions: they were overwhelmed with work. Troubled loans take more time administrating than putting on new business (contrary to general belief in the lending world). This, coupled with the fact that banks earn far less from restructuring loans than granting new ones, made the choice inevitable – appoint a receiver to do the work, whose costs are proportionately borne more by the borrower’s unsecured creditors.

The obvious suggestion was to take on more staff – there were plenty of suitable staff available following cuts elsewhere and it could be done on short-term contracts – but this was deemed unacceptable ‘ for security reasons ‘. Cynics might say such an approach would show few benefits for banks and neither they nor their shareholders care about that much about lending losses in the longer term.

Another aspect of concern is job cuts in lending teams, which can see troubled loan portfolios handed over to a ‘ debt recovery ‘ team who have little to gain from supporting customers in difficulties. In fact, in the last recession, we were disappointed to have representatives of a High Street bank’s debt recovery team attend a meeting of various borrowers for a troubled company. Not surprisingly, they led the demands for liquidators to be appointed and when there was clear disquiet at this approach in the room, their senior representative – and I’ve always admired his frankness – said “What else do you expect us to do ? Why should we risk our jobs by voting to support the company for another year or two, only to have it then fold with bigger losses ?”.

Disturbing times indeed. Not surprisingly, I’m also concerned about the loss of skills and experience, having seen it happen before. However, I have to acknowledge this is essential for recovery and another boom: fresh meat without burns from the past is the staple diet of financial institutions when rehiring.

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One of the most critical components of a downturn in property values is a fall in liquidity. Bank lending has been the largest component in market liquidity for a long time in the UK, usually leading institutional investment and independent equity (frequently from overseas investors, but often with a component of bank loans involved). So a decision to ‘ turn off the tap ‘ by banks is a major factor in a market turndown, as well as an accelerator of a fall in values.

This may seem an obvious statement, but few appreciate all the reasons for this, particularly the banks themselves. Banks tend to see themselves as ‘ lenders to the property market ‘ rather than realising that they are an integral part of it. Their actions affect not only other players in the market, but often also harm themselves.

Before the creation of APB, I would regularly address meetings of creditor banks to point out that precipitous action in liquidating property companies would harm the market and cause presently secure loans to become risky. On one occasion, a colleague pressed me back in my seat as I rose to speak and announced “Can we take it as a given that Richard has made his ‘responsibility to the market ‘ speech ?”.

It was then that I decided I had to go ahead with the creation of APB – an idea that had been in my mind for years. If the message had become routine – and therefore in danger of being ignored – another way of making it had to be found. Whilst there were a number of reasons for starting the Association of Property Bankers, one of my intentions was to make the banks understand their involvement in property markets and therefore to consider carefully their actions when fuelling a boom and exacerbating a crash. It has to be said that I have failed, but I still live in hope.

So what is it about ‘ turning off the tap ‘ that causes problems ? Consider these reasons:-

  1. It makes new purchases difficult .

    The obvious one. It is what most people think of when one talks about liquidity and severely restricts what Economists call ‘ real demand ‘. Less credit available means less organisations able to buy property investments or owner-occupied property.

  2. Banks finance both supply and demand.

    The often forgotten one. Buildings are primarily a factor of production and have a secondary function as an investment product. Before banks face financing the purchase of them as an investment, they finance their construction and also lend to the companies that wish to occupy them. A halt to new building arising from a restriction of available finance may eventually help counterbalance a downturn in values, but any cut-back on general lending immediately affects the ability of occupiers to take new space and may even threaten their ability to pay for the space they already occupy. Tenants going out of business is not uncommon in a recession, affecting returns and undermining confidence in the commercial property sector.

  3. Borrowers are unable to refinance existing loans.

    The generally unappreciated one. Most commercial property loans are for 3 to 5 years and sometimes 7 years. When they reach maturity, the borrower can find the bank is unable/unwilling to renew the loan and alternative sources of finance are unavailable. This can force investors to sell at the weakest time in the market and perfectly stable property investment companies can become vulnerable. Furthermore, since past increased market activity produced a lot of new lending, loan maturities can come in large clusters, forcing a lot of property on a market at a time when there are few purchasers, tipping a falling market into periods of freefall.

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This blog was first conceived some time ago, long before the word ‘blog’ came into common usage. The first few posts had been mapped out, explaining why a commercial (and residential) property crash was inevitable and how it would manifest itself. The mechanics were to be explained and emphasis was to be placed on how unexpected it would be (a prerequisite of any rapid downturn).

It was going to anticipate the inevitable scoffing and complaints that would arise in reponse to such a prediction (as happened when I did make such forecasts on various Forums).

Given my background, the importance of the role of banks and finance in booms and crashes was to be explained, with particular emphasis on the inevitable ‘ turning off the tap ‘ of finance that would precipitate a more rapid fall in property values. I’m certain that I would never have thought of the term ‘ Credit Crunch ‘, I’m afraid.

NOW, IT’S TOO LATE !

Nevermind, in forthcoming posts I will cover much of this ground in rather more detail and – no doubt – have many more interesting things to say.

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