Double trouble

As the credit crunch continues to paralyse the financial markets, is the Square Mile about to turn pear-shaped? Banks in the City of London have not only reduced lending to property, but are not keen on occupying more than they have to, shelving expansion plans and potentially slashing tens of thousands of jobs.

Yet in a hangover from the days of cheap finance, a total of 5.5m sq ft of speculative uncommitted office space will reach completion in the City over the next two years. With precious little active demand, this oversupply will be exacerbated by job losses and the ‘grey space’ occupiers return to the market for sublease.

Calculating these varying ‘shades of grey’ is a gruesome guessing game. The Centre for Economics and Business Research forecasts 10,000 City job losses this quarter.

‘Applying a rough rule of thumb of 150 sq ft per person, this means another 1.5m sq ft of grey space will have to be accounted for,’ says Lehman Brothers real estate analyst Mike Prew. ‘That’s the equivalent of three empty Gherkin buildings – to add to the 11 empty Gherkins coming from uncommitted construction.’

However, JP Morgan has estimated up to 40,000 City jobs will be lost by 2009 – using Prew’s rubric, a staggering 12 empty Gherkins, or 23 when combined with speculative space. Moody’s has downgraded the City’s office market to ‘code red’, predicting ‘imminent stress’, not just for property values but office rents too.

Since last autumn, property values have been in freefall because of the financial system’s inability to fund debt-backed purchases. A ‘short, sharp shock’ of 15% -25% has been wiped off the value of standing investments, and the Bank of England estimates Britain’s banks stand to lose £5bn from their commercial property investments.

Now, as waning occupational demand and oversupply come to bear, analysts expect a ‘double dip’ in values caused by falling rents. Some even predict a ‘triple dip’ by the end of 2008 if the UK economy slides into recession. Lehman’s Prew expects City rents to drop by 15% over 2008/09 – and he is not alone. In a note entitled ‘Keep the tin hats on,’ HSBC real estate analyst John Fraser-Andrews predicts a 9% fall in City rents this year, followed by further 5% falls in 2009 and 2010.

This correlates with Morgan Stanley analyst Martin Allen, who says he anticipates a 23% ‘peak to trough’ fall in City rents.

CB Richard Ellis believes City rents have already fallen by 10% from their peak last year. Deputy chairman Stephen Hubbard says prime space commands £57/sq ft including incentives, down from £65/sq ft in 2007.

Hubbard fears City rents will fall by a further 10% this year and then stagnate for a further two years as oversupply is gradually reduced, returning to growth only by the end of 2010. No prizes for guessing that quoted property companies with exposure to office development in the Square Mile have seen their share prices sink through the floor. Over the past 12 months, British Land has lost 44% of its value, Hammerson 38%, and Land Securities 23%. However, the biggest casualty is Minerva, which has shed 77% – until takeover talks began.

Dicing with debt

The City may bear the scars of the market’s worst excesses for years to come, but the whole property industry is set to suffer from a national unwillingness to finance new development. Lending to commercial property has prospered in line with the commercial mortgage-backed securities (CMBS) market – the financial ‘slicing and dicing’ of debt, which is sold off in smaller packages to multiple creditors (see graphs).

Jones Lang LaSalle data show that in 2006, there were €75bn of CBMS transactions across Europe, €20bn from the UK. This growth correlates with the huge rise in lending to commercial property, which hit a peak of £200bn in the UK last year. But in autumn 2007, the CMBS market stopped dead.

‘Banks had syndicated loans in this way to recycle cash on their balance sheets, but the current liquidity crisis means they are unwilling to borrow from each other,’ explains Barry Osilaja, director at Jones Lang LaSalle Corporate Finance.

‘Relationship lending’ is the acceptable term for banking paranoia.

Speculative development and job losses in the City of London could lead to the equivalent of 23 empty ‘Gherkins’

‘What little cash the banks have, they reserve for their best clients,’ says Osilaja. Set against a backdrop of huge losses, writedowns and rights issues, when the banks have recovered sufficiently to lend to property again, the cost of debt will soar and loan-to-value rates will fall.

‘Faced with having to inject more equity into deals, office developers are more likely to line up a prelet before schemes proceed.

‘Larger deals are already much more difficult to do,’ Osilaja adds. ‘Most banks will only allow a maximum of £35m to £40m for each transaction. Bigger lot sizes demand a “club deal”, which means deals are more cumbersome and take longer.’

The constriction of debt finance could be good news for the City, as the supply pipeline from 2010 onwards has been virtually turned off.

Vultures circle

Meanwhile, back in 2008, quarter one statistics show the impact on the UK’s office investment market has been nothing short of catastrophic.

‘Total UK investment turnover was £6.4bn in the first quarter of 2008, compared with £16bn in the first quarter of 2006 and £14bn in the first quarter of 2007,’ reports Julian Stocks, Jones Lang LaSalle’s head of capital markets.

‘Encouragingly, the first-quarter figures are slightly up on the last quarter of 2007, which totalled £6.1bn.’

Stocks estimates that the UK will end the year on £20bn – compared with £50bn last year – largely driven by sovereign wealth funds and growing numbers of so-called vulture funds, whose strategy is to snap up distressed assets on the cheap.

‘All investment categories in London are holding up more strongly than shopping centres or national offices at present,’ Stocks says, noting that Middle Eastern investors have been particularly active.

‘There is significant firepower sitting on the sidelines, and London is still seen as a safe haven for investors. Opportunity funds worth more than £2.5bn have already been raised just for the UK.’

But the scarcity of debt finance to augment this equity may yet clip the vultures’ wings.

Another trend is office investment in riskier locations overseas. A year ago, 8% yields on office schemes in Turkey might have looked attractive. Given that UK yields are now 6%-7% on a risk-adjusted basis, investors could beat a retreat to home soil.

Finally, let us not forget the serviced office sector. True, economic uncertainty means that flexibility is at the forefront of occupiers’ minds right now. But with conventional landlords liable to offer bigger incentives on ever-shorter leases, the gap is closing. In a deflationary rent environment, operating margins for the likes of Regus and MWB will come under pressure.

Add the chequered outlook for regional offices, and it seems that no corner of the UK’s office market can be considered ‘recession proof’.