UK secondary commercial property values have at least a further 20% to fall in value in the next two to three years, forecasts Deutsche Bank, with the reduction of bank lending for distressed property to just a trickle effectively suppressing any meaningful recovery.
This further secondary capital depreciation exacerbates the already pronounced polarisation in property markets, with prime values continuing to rise over the same period, Deutsche Bank wrote in a research paper published last Thursday.
Deutsche Bank’s research team wrote that as banks have reduced the supply of new loans secured on secondary properties to just a trickle, the long-argued de-coupling of yields between prime and secondary commercial property in the UK is set to become even more pronounced.
This further deepening polarisation of good and secondary values will be triggered by the on-going dearth of debt for financing secondary property transactions – due to what Deutsche Bank terms “the vagaries of the property lending cycle”.
These dynamics have established a correlation between pricing of prime to secondary and availability of debt to the commercial property market, argued Deutsche Bank’s analysts team.
Running contrary to the positive commentary from other research houses, including DTZ which have argued that investors will this year begin to materially move up the risk-curve, Deutsche Bank argues investing into secondary markets is premature.
“We think that it is too early and expect prime to continue to outperform secondary over the next two years,” co-wrote Martin Allen, research analyst at Deutsche Bank, alongside Jason Napier, Markus Scheufler and David Lock, in a paper published on Thursday.
“Depending on which historical cycle one refers to and what one assumes happens to prime yields, our analysis suggests that secondary property prices could fall by at least an additional 10% to 40% by 2015/16.
“Our best guess implies the risk of at least a further 20% fall in the value of UK secondary quality commercial property, before considering any additional downside risks from rising vacancy rates or falling rents.”
This deepening polarisation runs parallel to the investment market itself, argued Deutsche Bank. The UK’s very largest property companies, and fund managers with prime portfolios, are not only impervious to the predicted continued capital depreciation among secondary assets, but could also be among the best-placed to capitalise once the price-adjustment has run its course.
Banks to write off an estimated 5% of CRE loans in 2013
Lloyds Banking Group (LBG) and Royal Bank of Scotland are most exposed to a significant fall in UK secondary property prices.
For banks, Morgan Stanley expects collateral values for commercial real estate (CRE) loans to decline in 2013 and 2014 at about the same rate as they did in 2012.
Allen wrote: “Losses to date [by banks] have been very significant – more than 25% of loans in LBG’s UK CRE work-out group compared with early 1990s losses of 17% and 20% for RBS and Barclays – and our 2013 and 2014 estimates assume another 5% of loans will be written off.”
Although there is “a decent chance [that] losses are higher in a weaker asset environment”, Deutsche Bank does not expect a threat to capital adequacy requirements under Basel III.
A Financial Services Authority study indicated that around a third of British CRE loans by value have been subject to extensions, to stave-off a vicious ircle of fire sales depressing values with the market overrun with stock.
But Deutsche Bank’s Allen said empirical evidence in recent years provides contrasting evidence of the effectiveness of the “extend and pretend” strategy from the years immediately after global financial crisis.
Allen wrote: “While forbearance on loans secured on prime property has been vindicated by the recovery in market prices, forbearance on loans secured on secondary property has so far not. Yields are high and rising.
"And the lack of credit availability and concerns about a structural reduction in demand for some commercial property may restrict any recovery in secondary property prices.”
In its recent Financial Stability Report, the Bank of England said that bank forbearance on loans secured on secondary quality commercial property in the UK has not yet been vindicated and expressed concern that a lack of availability of credit for such assets may have negative implications for future pricing.
Alternative debt fund sources no panacea
The incremental pools of capital which are being raised throughout the European market are almost exclusively focusing on refinancing where the problems are least, cherry-picking attractive good secondary and prime deals and attractive risk-adjusted margins rather than gilt markets.
Allen wrote: “The volumes of new property lending that they are advancing remains very modest compared to the existing stock of property debt, and most of these new lenders seem as keen as the banks to concentrate their lending on higher quality property.
“Ironically it is banks' reluctance to extend new loans secured on secondary quality property that is undermining the value of secondary quality property and hence the security for their own property loans, just as during the credit boom it was banks' eagerness to extend new loans secured on secondary quality property that boosted the value of secondary quality property and hence the security for their own property loans.
“Given the excessive nature of the recent property lending bubble and the corresponding severity of the downturn in the availability of credit to UK commercial property we think that it is reasonable to expect the ratio of prime to secondary yields to fall to at least as low as the lowest point reached during the last nearly 40 years.”
Prime bubble on the horizon in the UK
Continued capital inflows from overseas investors chasing trophy central London real estate, together with robust rental incomes and a competitive pool of prospective senior and mezzanine lenders for blue-chip leveraged investors could cause a pricing bubble in the UK prime property market.
Deutsche Bank is among the research teams which subscribe to this, writing: “While we expect yields on secondary quality property to widen considerably further, we are by contrast bullish on prime property yields."
The research paper continued: “While our stated forecasts assume only a relatively modest narrowing of prime UK commercial property yields, our 'gut' feel is that, just as we experienced a bubble in the pricing of secondary quality property in the credit boom, so now we might well experience a bubble in the pricing of prime property, and so our best guess is that prime yields could fall to record lows.
“Putting this all together, our analysis suggests that the values of secondary quality UK commercial property could fall by a further 10 to 40% before prices clear. Our central scenario is a further circa 20% fall, assuming the prime/secondary ratio hits the 1981 low and assuming prime yields fall to historical lows.”
Downside risk of 20% secondary value fall turns spotlight back on Lloyds and RBS
Deutsche Bank explained that there is an absence of critical information to model the downside impact of a 20% fall in secondary CRE capital values on banks’ loan books.
To do so, would require knowledge of the latest breakdown of UK commercial property loans by LTV ratios based on written down values, not gross values.
“In the absence of this information,” wrote Allen, “we think that it is not possible to arrive at a sensible estimate of the potential downside risk of a 20% fall in secondary UK commercial property values to the current, written-down holding values of UK commercial property loans in bank balance sheets.”
However, useful analysis is possible. Lloyds and RBS will significantly be the most impacted by further deterioration in UK secondary commercial real estate values.
“We don’t know the total non-performing (NPL) book for CRE at LBG or provisions taken overall. We do know, though, that charges taken against the work-out book in UK corporate – the Business Support Unit – come to 25% of existing loans which is high by historic standards.
“RBS’s disclosure is much better, showing provisions to loans of 7% across UK CRE book and 12% across all CRE. Provisions to loans in the non-core UK CRE book are about half that of LBG, at 13%.
“This is, however, driven by RBS’s book reporting half the rate of impaired loans of LBG i.e. NPL provision coverage is the same for both banks at 36% to 37%. So, RBS’s UK noncore book is either twice the quality of LBG’s or sustained elevated loan losses in this book should be expected. We think the latter and have included significant charges in our estimates for 2013 and 2014.”
Further CRE investment bank research
Last November, CoStar News wrote a two-part summary of Morgan Stanley’s latest Blue Paper research, entitled Banks Deleveraging and Real Estate.
In the first part, Morgan Stanley calculated that deleveraging banks with exposure to Europe’s €2.45trn of outstanding CRE debt have already deleveraged as much as €138bn in the last 18 months to last October, equating to 23% of the total €600bn planned over the next three to five years.
The second report covered Morgan Stanley’s estimates that Europe’s structural re-ordering of the CRE markets could see up to €168bn in assets coming to market over the next four to five years from German open-ended funds (GOEFs), unlisted funds and government property portfolio sell-offs.
Alongside this potential near €170bn in European commercial real estate sell-off by current direct property owners, is an aggregate estimated firepower of circa €130bn, from private equity real estate funds, listed property companies and sovereign wealth funds.
In addition, up to €200bn in additional capital could become available to replace reduced funding from traditional debt and equity capital providers, from insurance companies, bond markets, debt funds and pension funds.
In a more bullish outlook to Deutsche Bank’s, JPMorgan published predictions at the end of last year arguing that the likely prime bubble to emerge in some Western European markets this year could see some investors investing up the risk-curve.
Finally, last September, JPMorgan, in a comprehensive analysis of European CRE markets, argued that as much as €413bn worth of commercial real estate is expected to come to market in the coming five-year cycle.
This significantly larger estimate than Morgan Stanley' takes into account a combination of European bank deleveraging, government property sell-offs, CMBS and German open-ended fund unwindings as well as cyclical listed property company disposals.