Commercial property: the worst could be yet to come
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Associate Editor
David Stevenson May 14, 2010
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You may well have missed it amid all the hubbub about the election and Europe's ongoing woes. But there's actually been some good news on the property front this week.
What's more, it was in Europe, too. The first quarter of 2010 saw cash pouring into German commercial property funds at its fastest since mid-2003. And that follows last week's solid British cash inflow figures. It seems UK investors are piling into commercial property as well.
So is the sector really bouncing back?
We're not so sure. We're still worried about the fallout from the last property boom. There could still be some real nasties out there, lurking on bank balance sheets, ready to pounce.
And that could mean prices are heading for another fall...
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Is it time to get into European commercial property?
The amount of money flowing into British commercial property funds fell between the last quarter of 2009 and the first quarter of 2010. But even so, flows remain higher than at any time over the past decade, according to the Association of Real Estate Funds (AREF). Money is piling into German commercial property too.
We've been wary about European commercial property prices for the past two years or more. That was a pretty good call – UK values plunged by 40% peak to trough – but recently prices have rebounded.
And more money flowing into funds gives fund managers extra buying muscle. So prices of properties could be pushed higher. Particularly as "in the core Western European markets, an acute shortage of supply is restricting activity", says James Purvis at Capital Economics. Further, in central London, there's even heady talk of rising rents, which tends to boost valuations.
So is it time to pile into European commercial property funds?
Actually, we'd still be wary.
"UK and German investors are the most active cross border players in Europe", says Purvis. So "if falling yields [i.e. rising prices] erode their 'bargain' appeal" – i.e. they can't find enough to buy at the right price in their own markets – they'll have a crack at the rest of the continent.
And if all that fresh cash gets spread around throughout Europe, it means that prices in any one country won't be driven higher by the weight of money. So we wouldn't bet on a sustained 'across-the-board' bounce in European commercial property unless the money keeps rolling in.
And this isn't looking as likely as it did a few months ago. Remember that those fund managers got their new money before the real trouble in Greece kicked in. Yes, there's now been a bailout. But this may well not be enough to get the 'euro show' back on the road: Why the bail-out rally might be short-lived.
The euro is doomed
Indeed, new MoneyWeek writer Simon Caufield goes further. "The horrible truth is that the euro is doomed", he says. "It simply cannot survive in its current form", he tells readers of his new True Value newsletter. That really would spook investors – why pour money into illiquid euro-denominated assets such as continental European property if the currency is vulnerable to fracturing?
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Meanwhile, here in Britain we have a new government that will have no choice about slashing its spending. That will mean higher taxes (VAT at 20% for starters, it seems) and fewer public sector jobs. In short, that will leave less money flowing around the economy. And the new team in Westminster could well be eyeing up surplus government assets to dump – including property.
Add this all up, and we're looking at a potential hammer blow to confidence. It's hardly likely to persuade investors to keep ploughing more of their money into buying buildings.
Another banking crisis is on the cards
But what's perhaps more important than all of this is the threat of another banking crisis. We've already seen how jittery investors are – the main reason the eurozone bailout was rushed through was because the interbank lending market had started to seize up again, as John Stepek explained last week: The Greek crisis is spreading to the banking sector.
Well banks have more than Greece to worry about. In the pre-2007 boom times, bankers were happy to hand out loans to almost anyone for almost anything. Including large chunks of cash for commercial property.
At the end of 2009, the total debt burden around the neck of the European commercial property sector came to almost €1 trillion. UK banks were owed 34% of this, with German lenders on the hook for 24%.
More than 20% (over €200bn) of the total borrowings were secured on low-quality assets at high loan-to-value ratios, say consultants CB Richard Ellis (CBRE). In short, dodgy debts on poor-grade properties.
This 20% is "most at risk of not being repaid", says Graham Ruddick in The Telegraph. "Also the debt is maturing at a rate of €155bn a year, meaning almost half will [need refinancing] by the end of 2012. Europe is facing a commercial property time bomb".
In the recent eurozone turmoil, rolling over debts won't have become any easier. But if borrowers can't do this or make their payments, they could be obliged to hand over the keys. And the pressure on banks might then mean more forced sales, according to CBRE. That would hit property values again, and potentially leave the banks looking at some chunky losses on their loan books. Although lenders will probably survive, they could sustain some heavy share price damage.
But the really serious situation lies over in the US. Ex-City banker Riccardo Marzi, who writes our Events Trader newsletter, has been tracking how this has been building up. He reckons that the stresses caused by America's commercial property problems could now put parts of the financial system under unbearable strain.
He's put together a special report detailing this growing problem and will be revealing a secret that could hit the markets as quickly and sharply as sub-prime debt did in 2008 – but more importantly, he's found a way for you to profit from it.
Meanwhile, we'd stay out of commercial property funds for now. There'll be better opportunities in the future.
Events trader is a regulated product issued by MoneyWeek Limited. Your capital is at risk when you invest in shares.
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