Interest rising

Commercial property values remain a third below their 2007 peak, despite growth of around eight percent since the start of 2010. As in the residential market, this reflects much stronger performances in London than across the rest of the country. Office space in the capital will always be in demand, owing to the concentration of businesses, both national and international, and London’s position as a financial centre. Overseas investors and real estate funds have been fuelling the rises, with many attempting to capitalise on sterling’s weakness and the hidden value in the market.

Many under-pressure UK businesses are not in a position to expand their premises – particularly outside of London – and, as the fallout from the Comprehensive Spending Review is felt across the country, there’s little chance of any further significant upswing in the market. Furthermore, values may be eroded when councils flood the commercial property market with empty office blocks as they prepare for the true depth of cuts announced in the spending review.
It is not clear whether commercial mortgage lending conditions are really easing. While overall lending has increased 19 percent from the same time last year, the National Association of Commercial Finance Brokers says that 35 percent of small and medium companies have had their mortgage applications rejected.

The Bank of England is currently doing the right thing in keeping interest rates at 0.5 percent. This can only help the market maintain its level and prevent pressure building on thousands of businesses already facing tough trading conditions. Any rise in the base rate would be taken as a green light by the banks to raise the rates on commercial property loans, at a time when banks have little incentive to lower rates in competition for business anyway.

Most commercial loans are linked to either LIBOR or base rate and negotiated on a case-by-case basis, so any increase in rates immediately has a negative impact on the financial position of businesses. Furthermore – and hidden from most people – is the burden raising interest rate places on other loan covenant breaches. For commercial property owners there is already a strain on the rental covenant (set as the interest payment as a proportion of rental income), due to void space and clients feeling financial pressure. An increase in interest rates will automatically result in some covenant breaches and the pain that that entails.

The commercial property market is already quiet and an increase in the base rate would serve to make it quieter. This will particularly hit the commercial borrowers who took out interest-only loans on a fixed term. They are already facing the challenge of a bullet payment or full repayment when loan to value percentages are looking steep. Any further deterioration in the market can only adversely affect the vast majority of these businesses.

With the economy so finely balanced at the moment, and with spending cuts about to hit home, this could delay or stop business growth altogether. Everyone is aware that raising interest costs hurts businesses and can lead to liquidations. However, the current challenge is evident in loan covenants where loan to value ratios are increasing well above those seen in the days of easy money. This is putting pressure on businesses to sell assets that they would want to retain traditionally. It is therefore essential that interest rates are held low to help support property values.

Commercial property prices in the country only increased by 0.2 percent in September, compared to annual growth of 14.2 percent, clearly indicating the slowdown in the market. There is still potential for a further correction in commercial property values, especially given that supply is increasing as government departments shrink and quangos disband. If this is the case, the most unfortunate businesses may be plunged into negative equity, with the respective liabilities outweighing the value of the property assets on their balance sheet. A rise in the base rate would have further implications for the interest paid on any credit extended to cover such damage.

The prevailing view in the market is that the base rate will remain low for a good while yet. However, inflationary pressures could increase hawkish sentiment in the MPC. CPI inflation now stands at 3.1 percent and has been above the government’s two percent target rate since December 2009, while RPI sits at 4.6 percent. Speculation has mounted in recent months that more quantitative easing is on the cards. That would stimulate the economy further and pile on the pressure to curb inflation.

However, there is still a great deal of uncertainty surrounding the direction of the Bank of England will take over interest rates. Economic growth is predicted to slow further in early 2011, as VAT increases to 20 percent and the impact of the government’s spending review is felt. These factors pose a deflationary risk which could outweigh concerns over slightly above-target inflation. As a consequence, the MPC is likely to adopt a wait-and-see approach before embarking on a course of action – in the form of a rates hike – which would add fuel to the flames.

Keeping interest rates on hold for the foreseeable future would be the best outcome for the commercial property market. Small businesses are already facing a struggle to securing commercial property mortgages and higher rates would make it even more difficult for companies to access finance, as well as heaping huge additional pressure on existing borrowers. An improvement in demand is vital in preventing commercial property values from plunging and for the overall health of the market. But the benefits of caution from the MPC are not limited to the commercial property market. At a time when the coalition government is banking on the private sector to drive economic growth, create jobs and to pick up the slack from the shrinking public sector, a low interest rate environment is an essential pre-requisite for any future success.