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Posts Tagged ‘Commercial Real Estate’

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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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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