A new dawn

A recent survey by The Royal Institution of Chartered Surveyors (RICS) saw commercial property sales showing a strong first quarter in the UK, with their surveyors reporting the best figures since 2007. This was supported by the IPD figures in the tables supplied, which showed growth in 2010.

However, it is fairly evident to see that these figures mask the dynamics which underpin our fragile recovery. Reflecting back on my O level maths lessons I remember my teacher stressing the arithmetic mean was not always the best way to express an average, and the current market clearly illustrates this, as property within the M25, and tight pockets in and around the West End and the City, distort the picture nationally.

Prime estate
Describing the commercial property market as a ‘market’, whether in the UK, or across continental Europe is misleading, as there are only two markets: London Prime and everything else. This is true across the EU, with the only variable being just how much ‘prime’ there is in each country’s capital city.

Of greater concern is where the market may be going. In the latest Hatfield Philips European CMBS insight (research, April 2011), the major lenders: banks, fund managers, VC providers and other key industry experts predicted that, for many European markets, commercial prices have not bottomed out. Full details are on the website but, looking at a few markets, 45 percent believed the UK had further to fall. Germany was much better at just 33 percent, whereas both Spain and Ireland were closer to 90 percent.

This poses a problem as traditional lenders are currently only interested in funding for prime properties, which leaves much of the £600bn of property loans that need to find a home in the next two years out in the cold.

In reality, the picture is not as clear cut, as you have two types of borrower – the one that found its funding through the CMBS (commercial mortgage-backed securities) route and those that used a balance sheet lender.

The CMBS market, while much smaller, does afford a snapshot of the whole of the market and is also in the position of being publicly scrutinised. The woes of the balance sheet lender can, at least momentarily, be hidden from sight – a strategy aptly termed delay and pray. Indeed, in a perverse turn of events, capital allocation rules mean it may be cheaper for Banks to hold these problematic loans on their balance sheets rather than enforce or sell them on at a discount. Having these loans ‘out of sight and out of mind’ is actually no bad thing as public disclosure could very literally lead to a calamitous event, possibly worse than the residential meltdown.

Funding flatline
There are a number of reasons why funding does not exist. Probably the largest is the impact of Basel, which means that even lenders with a strong balance sheet have to be more cautious about where they lend. Next in line is where the former lenders don’t exist anymore. Other issues include the sheer size of some of the loans, which any single lender would almost certainly baulk at today.

Most of the above will be very familiar; what’s important is to establish how we are going to extricate ourselves. First of all, I would like to dismiss any belief that sovereign funds are going to come to our rescue. Even before the events of recent months in the Middle East, the appetite for lending of the sovereign funds was restricted to very specific and extremely high profile developments, such as the Shard in London.

So, where is the funding for the business park outside of Glasgow or the distribution centre on the M1 going to come from? Traditional lenders will have to play their part, but only for a minority of loans; unless government pressure dictates otherwise.

The single largest source is likely to be insurance and pension funds, which have significant capital, but have traditionally not invested extensively in CRE. While investment from these institutional investors is good for CRE liquidity, there should also be caution as there is a danger of history repeating itself. Specifically, the capital rules which these institutional investors work with are completely different and thus they can treat the debt differently to traditional lenders. The same words of caution should be applied to the retail property funds, whose ability to attract cash in a rising market was on occasions greater than the ability to make prudent property purchases.

We are also likely to see venture capitalists cherry picking some assets, a good example being Cerberus Capital Managers picking up Maxim just outside of Glasgow, Europe’s biggest speculative office development and the UK’s largest enterprise zone – the Tritax EZ Eurocentral Unit Trust. Cerebus reportedly picked up the £95m loan at a deeply discounted £30m.

Finally, while there is currently no CMBS in the market, it will return some time in the next few years. Our research indicates that the majority of respondents foresee some return for CMBS in 2012 (43 percent) and a further 28 percent expect a return in 2013. Furthermore, many senior and junior noteholders are still active and would be more active if a way were found to allow them to exit positions in what should be a public and liquid market.

Changing lanes
However, in order for the industry to move forward, there will also need to be some significant changes in the way that all the parties involved operate.

Starting with the borrowers, many will need to be ‘re-educated’. For most borrowers, the processing environment is substantially different today than at inception of the loan. The extent of the information for new borrowing, refinancing or extending the loan will, mostly, be in excess of that produced to secure the loan in the first place; our research showed that 80 percent of respondents thought that borrowers would need ‘credible business plans’. The European Commission is also looking at increasing the amount of information that even balance sheet lenders have to collect on loans.

Borrowers will also need to be flexible when refinancing. Our research highlighted that almost 70 percent of respondents thought it was important or very important that borrowers surrender equity at re-financing. And, 75 percent thought it was important or very important that the borrower was willing to restructure the loan.

Lenders will also need to change their practices for managing loans. For loans in default, lenders are often faced with costly and drawn-out enforcement and, unless they are outsourcing to a servicer, our experience shows that modifications, extensions and refinancing all take time, creativity and possibly a depth of experience that some lenders wouldn’t have been expected to have historically.

Rating agencies will also need to change the way they operate. Last year the IMF’s half-yearly Financial Stability Report called for transparent methods and no conflicts of interest. The current model, where rating agencies are financed by firms that arrange and sell debt to investors, has been widely criticised. Many overseas investors, particularly from the US, now have regulated ratings out of their own process. Additionally, if organisations can enter a market without ratings and it makes no difference to how the market perceives them, it begs the question do ratings even matter?

In summary, the CRE industry is facing some fairly fundamental changes and integral will be borrowers and lenders’ willingness to push forward some fairly radical changes and adapt to the new commercial environment.

Stewart Hotston is a director at Hatfield Philips