Tuesday, 27 May 2008

The other real estate crash

Over the last decade or so, the UK has enjoyed not one but two property bubbles. While residential property prices received all the attention, commercial prices have also shot into the stratosphere.

Both markets are in deep trouble. While denial remains pervasive in the residential sector, the commercial property suffers from very little irrationality. Prices are down massively, perhaps 15-20 percent from the peak.

As prices have tanked, investors and banks are desperately trying searching for the fire exit. As investor confidence collapsed last summer, net flows into property funds suddenly went negative. As banks woken up and realized that they are deeply implicated in a crashing market, they have belatedly increased interest rates and cut their maximum loan-to-value ratios. In short,panic has gripped the market.

This sudden change in sentiment may have arrived too late for UK banks, who continue to be heavily exposed to commercial property. According to the Bank of England, commercial property lending accounts for 38 percent of UK bank lending to private non financial companies. Back in 1998, this figure was just 19 percent. Last year, banks were holding around ₤247 billion of loans issued against commercial property. That is around 17 percent of GDP - so we are talking big numbers here.

This debt number hides a more interesting figure. Last year, banks saw a 16 percent jump in this kind of debt on their balance sheets. The reason? The securitization market broke down, forcing many banks to hold onto loans that they would have preferred to bundle up and sell to other investors. Instead, this debt sits like a rancid Kebab on bank balance sheets, preventing a recovery in commercial property lending.

Looking forward, the situation is bleak; prices are dropping, credit has dried up, and defaults are expected to rise. So far, the market hasn't seen a significant rise in bad loans. Defaults rates are currently less than one percent. However, it is still early days. If a recession takes hold, that rate will begin to rise, and then banks will really begin to sweat.

9 comments:

aSteve said...

Commercial property is very odd... I can't help but to think that the speculators are just as irrational as the residential speculators. I suspect that commercial property speculators are even more aggressive because:

a) They likely have far greater access to affordability data for their tenants.
b) It is easier to sleep after having exploited a company than an individual.
c) Companies likely find it even more difficult to move than individuals... especially those of an industrial nature.

My anecdotal experience is that operational businesses have, for the past few years, existed in cramped accommodation while substantial premises sit empty or seriously under-utilised.

Josh said...

I wonder whether the commercial real estate crash will affect the residential market.

Mark Wadsworth said...

But what's the explanation for retail outflows having dried up (we appear to have reached no net inflows or outflows)? Is this simply because REITs aren't paying out any more (a lot of them refuse to redeem shares at the moment), or has confidence returned? I suspect the former, but hey...

Russell said...

I was wondering the same - why the graph levels off.

I can only think it's because they aggressively marked down the values of most of the funds. From a personal perspective a fund I own was marked down 20% at the end of last year. The typical retail response to a drop like that is to wait until the high water mark is achieved again, even if that takes 10 years+.

Wesker said...

Mark, Russell - answer - investors aren't putting any money in, but cant get any money out.

Vodka drinker said...

Commercial crash on the high street, residential crash in the backstreets. One complements the other.

Lurker said...

asteve - I was thinking a similar thing on the way to work today: commercial property seems to be falling at a much faster rate than residential at the moment. Is this because there is not so much emotional attachment - it's just a business rather than a home..?

DCM said...

I reckon commercial property was just as overpriced as housing. It is just that commercial landlords are more hardnosed. Commercial property is down around 20 percent in about 8 months. It is just moving faster than housing, but heading to the same place.

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