Return to fundamentals

It’s not surprising that borrowing money is difficult at the moment. Real estate is a risky proposition. If you have an asset then finding tenants at suitable rents is difficult. Keeping them there is a challenge. Hoping they wont go bust is a genuine worry and as for building speculatively? Now isn’t the right time. Yet there must be some money out there somewhere. Isn’t there?

The 1990s saw the beginning of a property boom led by investors with little or no money of their own. They used clever financing to secure massive exposure to the market. For many investors it was a good wheeze. For a few it was incredibly lucrative and for a few? It was their downfall.

During the 1990s I was working for DTZ advising private individuals and German open-ended property funds on their investment acquisitions in the UK. For the first time we saw investors buy a property and then borrow all the money to do so. Looking back it was amazing that investors were allowed to get away with it. These private individuals were, in effect, gambling on yield shift and market movement to buy into a market that they perceived was cheap. And it was. They made the right call and years down the line they were able to refinance or sell assets taking a bundle of equity with them. Several factors played into their hands. The economy was recovering which led to rent inflation, interest rates which had been high began to fall consistently, finance became more available and yield compression added fuel to the flames. For these private investors the market was sweet and many of them did incredibly well.

At the same time, German open-ended funds were buying into the UK market. Long leases, five yearly upward only rent reviews and a favourable pound all encouraged this wave of investment activity. Yet these funds were very cautious. Not only did they take few risks with the assets they bought but also they were also incredibly conservative with the finance they put in place. Rarely did they borrow more than 50 percent of an asset’s value. Perhaps if we had looked at their approach when they stopped buying, we might have learnt a thing or two. For they were crowded out of the market towards the end of the 1990s and first half of the noughties by funds and individuals using high leverage to increase their return on equity.

First hand, I saw this while at Morgan Stanley. We were at the vanguard of securing finance through the debt capital markets in the form of securitised loans. To be fair, we were incredibly careful about structuring the instruments and highlighting risks involved for investors. Contrary to popular belief, it was not the instrument that caused the financial crash. Yet it was the abuse of this form of structuring that contributed.

Financial institutions began to buy market share. They forgot about the underlying asset and what the inherent risks are in real estate. Loan books were built to be sold on to investors. Many of whom took little or no time to actually investigate what they were buying. In particular, high street banks, flush with cash on their balance sheets began to mix lending with investment in a way that was not only toxic but also highly flammable. We all know what happened in 2007 and what that has done to our lending markets.

So it really is back to property fundamentals. If you are buying an asset that is single let, you had better have a plan to keep the tenant happy. Especially if the lease is coming to an end. There is a lot of space out there and that’s why location is so important. Multi-let buildings can of course offset some of that risk, because they have a reduced risk profile.

Through skilful asset management you can continue to grow rents, offset vacancies and grow the asset’s value. New doesn’t necessarily mean best.

Except you have to be aware of location. Core West End is always likely to be highly prized both as a location for tenants and as an investment location. Yet try to borrow on these assets and you could find that the low yield and high prices make this a better proposition for wealthy individuals or sovereign wealth funds. Elsewhere in London, of course, the City and Canary Wharf are the two main office markets. Rents have held up reasonably well. Yet there is a huge chasm between grade A space and the rest. Finance is available but rather like the housing market – you’d better have a big deposit available.

Ironically at the very time when development is best, financing is hardly available. It strikes me as utterly dumb. Banks have little or no idea on how to play the financial aspect of property and the property cycle. Many of them pile in too late and break the rules because they think they don’t apply to them. Yet at the very time they should be building up an investment portfolio in property debt, they don’t seem to want to touch it with a barge pole. In my view, if you are a property lender, now is the time to get in.

The investors and developers who are active are the smart players in town. They have weathered the storm and they are the likely investors who will spot the right opportunities. Having said that if you want to perform speculative development and you are looking for a bank to do it? You might as well go and shout with the wind rushing into your face. No one will hear you. No one wants to hear you. That means it’s cash-rich funds and sovereign wealth funds that will have the pick of the opportunities that exist.

And then to other market sectors. Shopping centres continue to attract interest from real estate investors. It’s obvious. A range of high quality tenants. Diversified risk, real asset management possibilities, inherent shortage of supply, alternative forms of revenue and no sign that shopping and leisure, even in these constrained times, will be adversely affected. Banks and institutions seem a little keener to lend on this sector but again prices are sharp and you had better have some money in the bank to put a big chunk of the equity in place.
Even though interest rates are low at the moment, what we have seen is continued economic turbulence. The Bank of England rate may be at 0.5 percent yet in the real world it’s closer to five percent. And that’s not very healthy when rents are at best rising in line with inflation and at worse stagnant.

This means the property model has changed. For the first time in a generation debt is something you use with care and not to leverage return. The numbers simply don’t add up. Ultimately the banks that are lending you money are back to their core business. Lending. Not investing. They don’t want to buy market share. They are not looking to buy into the upside but simply to protect themselves against the downside. I think they have retracted their horns too far but it won’t be for a good few years until the market becomes more normalised and they realise that property really is a good prospect and a business area to expand.

So where does that leave the investor? Somewhere between a rock and a hard place. There are plenty of deals out there but making the numbers add up and sourcing the equity is tough – particularly when performance is unlikely to be spectacular over the three to five year investment window.

So property fundamentals come back into play. Good assets, with management and development angles, location and quality of offer are all essential ingredients. If I were you? Sovereign wealth funds and institutions are the big new players. Forget the traditional lending banks for now. They have wounds to lick and governments to please. And that’s never a good combination when talking about property investment.