Economic Outlook

The outlook for commercial property

Key points
The western European commercial property sector enjoyed boom conditions for much of the first seven years of the last decade, with cheap and easily accessible funding providing the basis for a surge in investment. Investors were attracted by strong returns, with occupier demand underpinned by a period of robust economic growth. However, the crash from 2007 was dramatic. Several important sources of funding collapsed in a short space of time which, combined with a dramatic loss of investor confidence, caused a drop in capital values of 45% in the UK. The descent into recession also caused occupier demand to contract, driving up vacancy rates and forcing down rents. Since mid-2009 capital values have recovered strongly. But this appears to have little to do with fundamentals, with the weak economic backdrop meaning that occupier demand has continued to contract. The upturn has been driven by sentiment, with investors calling the bottom of the market and seeing buying opportunities. Further support has come from quantitative easing, which has significantly improved liquidity and, in the UK, from the weak pound which combined with the massive declines in capital values has made the UK market considerably more attractive to foreign investors. However, the outlook for occupier demand is subdued, with a slow recovery in the real economy in prospect. This makes it likely that vacancy rates will continue to rise and rents fall through this year and into 2011, potentially undermining investor confidence. The end of quantitative easing likely to come at the beginning of next month will bring about shifts in investor portfolios. It is likely to push up government bond yields, reducing the relative attractiveness of commercial property yields. The behaviour of the banking sector will also be a key factor. 160bn of loans to the commercial property sector must be refinanced in the next four years, but some are now in negative equity while others have breached loan-to-value covenants. Given balance sheet pressures, banks are unlikely to refinance these loans and the default rate will rise. Not only will further write offs impair the banks ability to lend, but there is also a risk that the market will become flooded with property for sale, which would push down capital values and could potentially trigger a vicious circle of falling capital values, rising loan-to-value ratios and increasing defaults. Though there is some potential upside to values from supply shortages arising from the dearth of development over the past two years the bigger risks are all on the downside and with the fundamentals remaining unsupportive it is difficult to see how the recent bounce can be sustained.

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Economic Outlook

Introduction
The commercial property market was one of the areas to suffer most from the onset of global recession in the first half of 2008 with capital values and leasing activity falling sharply. However, as the economic outlook stabilised in mid-2009, so did real estate indicators and the past six months has seen a strong recovery across many western European markets. However, given the weak economic backdrop and the need to refinance a large proportion of existing loans over the next few years, significant question marks remain over the sustainability of the upturn. In this special report we look at the causes of the commercial property crash and assess the outlook for the sector over the next couple of years.

The commercial property crash was devastating

The western European commercial property sector enjoyed boom conditions for much of the first seven years of the last decade, with the only blip coming in the period following the dot.com crash. Excess saving in Asia, supplemented latterly by a considerable build up of funds by oil producers due to soaring oil prices was channelled back through the banking system of western countries. This enabled the banks to lend more, and at lower interest rates, than would otherwise be the case. The resulting very high level of liquidity provided the basis for a surge in investment in commercial property. In December 2000 the sector accounted for 20% of the outstanding stock of lending to UK non-financial corporations, but by March 2009 this had doubled to 40%. All market segments posted strong growth in rents in the period with prime offices being the star performer, underpinned by demand for office space generated by the robust output and employment growth of the financial and business services sector. But secondary property also did well, the narrowing of the yield spread resulting from a decline in risk premia as investors became conditioned to the notion that the prevailing conditions of cheap and readily available money and firm occupier demand would be permanent fixtures. However, the crash from 2007 was dramatic. Confidence began to falter in the early part of 2007 as capital growth weakened and investors appetite for risk began to wane, ending the long period of yield compression. But this process was accelerated by the onset of the first wave of the credit crunch, which first caused inflows in property funds to rapidly dry up and then increasingly bore down on occupier demand through the effect on the real economy. Over the first half of the last decade, the sector built up a reliance on funding from the commercial mortgagebacked securities (CMBS) market, but this market almost completely collapsed in 2007. Banks also reacted to the credit market turmoil by reassessing their loan books, seeking to reduce risk and the high degree of leverage by tightening lending criteria and becoming more selective about the loans they made. The Bank of Englands Credit Conditions Survey reported a severe and prolonged tightening of credit availability to the commercial property sector, with the cut backs far more aggressive than for other forms of corporate borrowing or household lending. Syndicated lending, whereby a group of banks or other lenders jointly provide funds to a single borrower, had been an important source of funding particularly for large scale projects but this too became significantly more difficult to access. The Bank of England, using data from Dealogic, calculated that in the period since July 2007 the average monthly amount of gross syndicated lending to UK businesses has been 60% lower than in the preceding two years.

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UK: Credit availability to commercial property

% balance ti ghtening (-)/loosening (+) credit 10 0

UK: Syndicated gross lending to UK firms

bn 60 50

-10 -20 -30 30 -40 -50 -60 -70 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2007

Source : Bank of England
*The sing le d ata points repr ese nt 3 mo nth forecasts, while th e columns represent actual data

40

20 10

Q1 Q2 Q3 Q4 Q1 2009 2010

0 2003 2004 2005 2006 2007 2008 2009

Source : Dealogic / Bank of England

2008

The loss of confidence in the sector also triggered a major reappraisal of risk by investors. There was a collapse in the level of funds invested in pooled commercial property funds, with the Association of Real Estate Funds reporting that a net inflow of 1.1bn in the first quarter of 2007 had turned into a net outflow of 1.2bn by the end of that year. The net effect was a collapse in property investment transactions, followed by a sharp decline in capital values, with IPD reporting a decline of nearly 45% in UK commercial property values between June 2007 and July 2009. The impact on occupier demand was also severe, though this took much longer to feed through. In 2007 most of the major economies of western Europe continued to post strong growth in both GDP and employment and it was not until 2008 that the recession started to bite. However, once it hit the impact was devastating and all market segments were hit hard with sharp declines in the key drivers of occupier demand, manufacturing output, retail sales and financial & business services employment. With occupier demand weakening and new space continuing to come on stream the impact on rents was devastating, particularly in office markets. All of western Europes largest office markets endured double digit declines in prime rents and, having enjoyed the strongest gains in the early part of the decade, the London market led the downturn and fell furthest with rents down more than 30%.

but 2009H2 has seen an equally dramatic turnaround

However, the fortunes of the market turned dramatically from the middle of last year, with investment funds flowing back into the sector. Though this did coincide with the stabilisation in world economic conditions, the recovery in property investment has been robust even in countries such as the UK where the economic upturn has lagged. CB Richard Ellis reported that turnover in the EMEA investment market rose by 40% in 2009Q3, despite the summer usually being a quiet time for the European market, with the UK and Germany both posting growth of more than 50%. Meanwhile IPD estimates that UK commercial property values have risen by 5.4% since August 2009.

The bounce appears to have little to do with market fundamentals

Welcome though the bounce in activity is, its sustainability is far from certain with little sign of a pickup in market fundamentals. There were further upward movements in vacancy rates and downward shifts in rents throughout last year, reflecting the fact that the economic recovery was still very much in its infancy. However, anecdotally there is some evidence from property agents that the tenants market of 2008, where landlords were forced into offering generous incentive packages and periods of rent-free letting to encourage take up, has given way to greater balance.

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Economic Outlook
The upturn looks to have been partly driven by sentiment, with investors deciding that the bottom of the market had been reached and that the massive decline in prices over the past couple of years meant that the market offered buying opportunities. As such, there is evidence of yield compression in some markets where investors have become more confident about the strength of future returns. However, in most European markets this has been concentrated mainly in the prime segment, with agents reporting little interest in secondary property. It is likely that investors are being attracted to the greater liquidity that they believe the prime sector offers them. However, it raises concerns about how much room exists before prime properties begin to look overvalued once more. The ultra-loose monetary policy being pursued around the world has undoubtedly provided strong support to property investment. Having reduced interest rates as far as they could, central banks adopted quantitative easing as a key policy tool. New base money was created and central banks used this money to buy assets from the private sector. In the UK this has mainly involved buying gilts, with the new base money flowing into the private sector and allowing these sellers to buy other assets. Since quantitative easing began there have been sharp increases in a number of asset classes, including commercial property, residential property and equities. The scheme has also boosted bank liquidity and started a slow thaw in credit conditions. In the UK the sector has been further boosted by the persistent weakness of sterling. Since mid-2007 the pound has lost around 25% of its value on a trade-weighted basis and this, combined with the deep declines in property prices, has greatly enhanced the competitiveness of the UK and the London office market, in particular. Figures from DTZ suggest that 81% of the $4.3bn invested in the Central London property market in the first three quarters of last year came from abroad, compared with an average of 44% over the rest of the decade. These funds appear to be coming from a wide range of areas, from Middle Eastern investors to German property funds and North American private equity and property companies.

The recovery in occupier demand is likely to be slow

Given that much of the recent activity has been founded on improving sentiment and speculative investment, it is imperative that the fundamentals underpinning occupier demand pick up soon to sustain investor confidence. Towards the end of 2009 vacancy rates were still climbing in most markets and segments, as the wider economy began its recovery, and they may still have further to climb in the short term. The economic recovery is still very much in its infancy and in a fragile state. Credit conditions remain very tight, while consumers and businesses are in the midst of a process of deleveraging which has some way yet to go. With governments also being forced to make retrenchment plans of their own, all signs point to a very slow recovery in western Europe, with economies taking up to two years to get back towards trend growth rates. As a result, the recovery in occupier demand is likely to be subdued in each of the major market segments. Office rents are closely correlated with office-based employment (employment in financial services, business services and public administration) and the plunge in office rents last year reflects a sharp contraction in office employment in all of the major western European office markets, with the losses being particularly severe in the more internationally exposed cities such as London and Amsterdam. In the short term prospects are relatively bleak, with most cities likely to experience further job losses in financial and business services as the sector adjusts to the postEurope: Office-based employment
%/year
3 2 1 0 -1 -2 -3 -4 -5

2009

2010

2011

fu rt

Source : Oxford Economics

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credit crunch world. London, in particular, faces significant challenges with the threat of further regulation continuing to loom large and a series of tax increases due to be implemented over the next year. These factors have the potential to damage the international competitiveness of the capital and to draw business towards other financial centres, not just in the US and western Europe but also in the developing world. But while these might be issues at the margin, we expect Londons natural advantages such as timezone, language and skills base to prevail, enabling it to retain its position as a key global financial centre. However, while in most markets employment in financial and business services should gradually recover from next year, there is likely to be a significant drag from public sector employment as governments retrench. In the UK, public spending is due to be cut sharply from 2011 which will inevitably lead to a significant reduction in headcount. Indeed, the ramifications could be more serious for London as the pursuit of efficiency savings is likely to lead to further decentralization. Indeed, with other governments also facing spiralling budget deficits, pressure to reduce employment in public administration is likely to be a theme across a range of office markets. Therefore, while occupier demand is likely to bottom out this year, the subsequent recovery is likely to be slow in many of the larger western European office markets. The damage to retail rents thus far has been much less severe, but here too occupier demand is likely to be subdued going forwards. Many European countries have endured steep increases in unemployment and in the more heavily indebted economies such as the UK, Spain and Netherlands consumers have been deleveraging at a rapid pace. Though interest rates are likely to remain low for some time to come, restrictive credit conditions and fragile confidence will subdue the consumer recovery.
Europe: Retail sales
%/year
6 4 2 0 -2 -4 -6

2009

2010

2011

fu rt

More upbeat is the outlook for the industrial segment, with a firm bounce in world trade underpinning a strong Source : Oxford Economics recovery in manufacturing output in a number of countries in the second half of 2009. This should be sustained over the next couple of years, as global demand continues to recover, though members of the Eurozone will be hampered somewhat by a strong euro.
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and the QE prop will soon be taken away

In the UK, in particular, one of the key props of the recent revivial is soon to be taken away. The strengthening recovery makes it likely that the Bank of England will call an end to its policy of Quantitative Easing when the current tranche of asset purchases has been completed at the end of January. With the Bank no longer buying assets from the private sector it seems likely that investors will return to holding a greater proportion of their assets in gilts, suggesting that the strong inflows into commercial property will fade, though given the lack of precedent the degree to which this will happen is uncertain. The impact on gilt yields will also be important. The 36 THE OUTLOOK FOR COMMERCIAL PROPERTY JANUARY 2010
UK: Gilt yields
% 6.00 5.50 5.00 4.50 4.00 3.50 3.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source : Oxford Economics/Haver Analytics

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Forecast

Economic Outlook
asset purchases by the Bank significantly increased demand for gilts, driving up their price and pushing down yields. This has made commercial property relatively more attractive, despite property yields dropping sharply over the second half of last year. However, given that the Bank has purchased 23% of the total stock of gilts, its exit from the market is likely to cause a significant increase in yields. Indeed, persistently high fiscal deficits and the resulting high level of gilt issuance, plus a lack of investor confidence, is likely to drive up yields further as we move into next year. It is quite conceivable that gilt yields will rise back above commercial property yields over the coming year, which will significantly reduce the attractiveness of commercial property to investors. However, the other factor that propped up the UK market in 2009, namely the weak pound, is likely to continue to offer support for some time to come. Markets remain downbeat on UK economic prospects and, with the UK set for a slow recovery with subdued inflationary pressures, interest rates are likely to rise later and less aggressively than elsewhere, further weakening the currency. The UK and London, in particular, will remain an attractive market for foreign investors, although it is debtatable whether there is sufficient overseas demand to continue to support the market in the way it did in 2009.

while large-scale refinancing could cause further distress

Potentially the most significant threat facing the sector comes from the state of the banking sector. Banks remain highly vulnerable to property companies defaulting on their loans, with the combination of rising vacancy rates and falling rental values each of which are likely to persist for the coming year at least increasing the chances of default. Further issues arise from the sharp decline in capital values during the two-year slump, which mean that a number of commercial property loans are in negative equity or have breached loan-to-value covenants. Thus far banks have largely given more leeway than would otherwise have been the case, partly because they would prefer to avoid crystallising losses. However, the situation does leave a number of companies vulnerable and at the mercy of their bankers, particularly when the time comes to refinance. Banks are under pressure to recapitalise and clean up UK: Banks' maturing funding 2009-2014 their balance sheets. UK banks have an estimated billion 1,220bn of funding due to mature over the next five 600 years, of which 160bn are loans to the commercial 500 property sector, according to De Montfort University. A 400 significant proportion of commercial property loans are non-amortising, i.e. the principal is repayable on 300 maturity, and companies with loans that are in negative 200 equity or require a high loan-to-value ratio are unlikely 100 to be able to either repay the principle or convince the banks to roll over the debt. Some larger companies 0 Bonds RMBS Guaranteed SLS might be able to bridge the gap through an equity funding Source : Oxford Economics/Bank of England injection, but otherwise the banks are faced with foreclosing. Already UK banks have written off 10bn worth of commercial property loans, but estimates by Standard & Poors put potential write offs over the next two years in the range of 23-37bn. Write offs on this scale would wreak further significant damage on banks balance sheets and further impair their ability to lend, not just to the commercial property sector but across the economy as a whole. Thus far banks have held onto repossessed properties, seeking to avoid crystallising losses while also taking advantage of the recent rise in capital values. However, their capacity for continuing with this course of action is uncertain, particularly if default rates rise sharply. There is a risk that a large number of repossessed

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Economic Outlook
properties will become available, pushing down capital values and creating a vicious circle of falling capital values and rising defaults that could be difficult to arrest.

Though longer term supply constraints might help to support the market
However, in other ways the state of the banking sector might also act as a support to the market through the impact on development. While developments that were already in progress when the credit crunch hit have largely been unaffected, there has been a sharp slowdown in new development. Developers have found it much harder and more costly to access funding as banks reacted to a sharp increase in bad debt in the sector. They have been reluctant to expand their loan books and have applied far more stringent tests to determine the viability of a project. Investors too have displayed greater risk aversion given recent trends in occupier demand. Though there has been little impact on supply to date, while pre-credit crunch projects proceeded to completion, the legacy of a dearth of development is beginning to become apparent. Drivers Jonas estimate that this year the development of office space in the City of London will fall to its lowest level in 30 years, while other agents suggest there is little new floorspace in the pipeline for the next two years.

Conclusion
The commercial property market revival of the past six months appears to have been largely built upon sentiment and there are significant question marks over its sustainability. Occupier demand is likely to remain weak across all market segments, while the wider economy gradually recovers, which will translate into further increases in vacancy rates and declines in rental values. With the fundamentals remaining unsupportive it is difficult to see how the recent bounce can be sustained. The UK will continue to attract foreign buyers through the weak pound, while a dearth of new development will impose some upward pressure on values from supply shortages. But these effects are likely to be offset by the end of quantitative easing, which will stem the recent strong inflows of funds and reduce the relative attractiveness of property yields against those from gilts. The key to the outlook will be the behaviour of the banks. Thus far they have given companies a significant amount of leeway, but with a large amount of funding scheduled to be refinanced imminently, and a proportion of that in negative equity or requiring a high loan-to-value ratio, a rise in default rates seems certain, further damaging banks balance sheets and impairing their ability to lend. The most significant risks are all on the downside and, with the fundamentals remaining unsupportive, it is difficult to see how the recent bounce can be sustained.

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