Walking around London's financial district is like touring a construction site. Giant cranes dot the skyline around St. Paul's Cathedral as workers busy themselves putting up the latest additions to Britain's long-running boom in commercial property.
But cracks are starting to appear in the edifice. The fallout from the U.S. subprime crisis has slowed demand for office space -- particularly from the financial services sector -- at a time when more mega-skyscrapers are in the works than ever before. According to real estate tracker Investment Property Databank (IPD), after surging 17% in 2006, British commercial property prices fell 12% in the last half of 2007. Analysts are now predicting a further 15% drop by the middle of this year.
Writedowns Likely to Accelerate
That's bad news for property companies like British Land (BLND.L) and Hammerson (HMSO.L). Perhaps even more worrisome, many major European banks, such as Britain's HBOS (HBOS.L) and Germany's Deutsche Bank (NYSE:DB - News), have lent billions of dollars to developers during the boom, which now could be at risk of default as projects lose value.
Estimates vary about how much is at stake, but Morgan Stanley (NYSE:MS - News) reckons as much as $212 billion in outstanding commercial real estate loans worldwide -- including assets left on banks' books and other securitized financial instruments -- could be vulnerable. How much of that might be written off depends on the property market's performance over the next 18 months, say the bank's economists. They argue that the probability of writedowns has increased since the third quarter of 2007 because investors are now shying away from complex, property-related financial products, such as securitized loans.
"There's no doubt that billions of dollars are at risk," says Ian Harnett, European strategy director at the London consultancy Absolute Strategy Research. "The whole sector has really fallen off a cliff."
Plummeting Property Values
Market fundamentals have indeed changed quite dramatically for commercial property. One indicator is the so-called "average prime yield," which has risen during the past year -- a sign of cooling demand and weakening returns on property investments. Data from realtor CB Richard Ellis (NYSE:CBG - News) show the underlying price of real estate assets in Britain has declined relative to rents, causing the yield to rise. It climbed 50 basis points, to 5.7%, in the fourth quarter of 2007 -- some 90 points higher than during the same period in 2006..
Downward trends look likely to continue this year, and not just in Britain, which remains Europe's largest and most dynamic commercial property market. Strains are showing up as well on the Continent, especially in Germany and Spain, where overbuilding and subprime losses are taking a toll. Since December, for instance, Spanish property firm Inmobiliaria Colonial (MOCE.F) has been forced to sell more than $450 million of its commercial portfolio to ease its rising debt obligations, which stood at $13.1 billion as of September, 2007. Given the spreading woes, real estate firm Jones Lang LaSalle (NYSE:JLL - News) predicts the value of property transactions across Europe will decline 20% this year, to $260 billion, from 2007 levels.
Central Banks Sound the Alarm
The potential implications for the financial sector already have caught the attention of central bankers. In the wake of massive writedowns from the subprime crisis, the last thing banks need now is further losses tied to commercial property. In its October, 2007, financial stability report, the Bank of England highlighted the problem, saying the risk of defaults could put extra strain on the already stretched financial system.
Similarly, a European Central Bank (ECB) report in December, 2007, cautioned against the rise of commercial, mortgage-backed securities, which sprang up as banks repackaged assets to be sold to third parties, a process similar to the securitization of U.S. subprime loans. And just as the subprime market implosion left banks unsure of who owed what to whom, the ECB worries that defaults in securitized loans resulting from a weakened commercial property market would "make it difficult for investors to understand the risks involved."
Is this Chapter Two of the subprime mess? Yes and no. The downward trend is unmistakable, but the losses are likely to be on a much smaller scale because commercial property lending is a safer and more stable business than writing home mortgages for people with bad credit histories. Kelvin Davidson, property economist at London-based consultants Capital Economics, notes that developers protect themselves better than they used to in the 1990s (when overbuilding promoted a brief collapse in the British commercial real estate market) by signing long-term leases and hitting higher occupancy targets before breaking ground on new projects.
What banks are most exposed to the downturn? According to estimates from the Bank of England, there were $369 billion in outstanding commercial real estate loans at the end of the third quarter of 2007 in Britain, which is Europe's largest market. Research from brokerage Dresdner Kleinwort (NYSE:AZ - News) shows HBOS and the Royal Bank of Scotland (RBS.L) are the most exposed, with $86.3 billion and $103.3 billion worth of loans, respectively. Analysts disagree on how much could be lost, although conservative estimates predict 5% of assets might be wiped out.
"Banks that have gone after the sector aggressively will have to face defaults from developers if there's a downturn," says banking analyst Alex Potter at stockbroker Collins Stewart (CLST.L) in London. "It might not be a vast amount, but it could come back to bite banks where it hurts when they're already suffering."
More Bargains for Sovereign Funds
That's tough news, but for other investors, particularly for cash-rich sovereign wealth funds, the possibility of banks selling off distressed assets to cover debts could provide an ideal investment opportunity. Without needing to raise financing in the contracting debt markets, these government-backed investors could snap up bargains only to resell them when the cyclical commercial property market once again turns bullish.
"They don't have to take leverage, so won't be too affected by the change in credit conditions," says Tony Horrell, head of European capital markets at Jones Lang Lasalle (NYSE:JLL - News) in London. Indeed, he argues that the change in ownership from cash-strapped developers to cash-rich funds could help stave off bank writedowns at a time when sentiment has turned negative.
The move is already under way. On Jan. 9, GIC Real Estate, an investment fund owned by the Singapore government, paid $266 million for a 3% stake in British Land, the shares of which have fallen 41% since the beginning of 2007.
Whether sovereign wealth funds will once again bail out banks still remains to be seen. But with billions of dollars invested and property values set to sag in 2008, banks are set for a bruising year that will only compound their current economic woes.