The year ahead is set to go down in commercial property history as one of the worst on record. Property values have already plummeted 25 per cent since their 2007 peak, and industry body the RICS forecasts a further 25 per cent fall over 2009-10. If true, this implies. Given the highly leveraged state of most property companies, debt is the key issue going forwards.
"The worst-case scenario is if we were to end up in a deflationary environment," says Harm Meijer, real estate analyst at JP Morgan. "This would cause an increase in the real cost of debt, which would be devastating to the sector, and prompt us to knock down our target prices for all UK Reits by 20 per cent."
However, deflation is not the only worry ahead. If values fall as much as the RICS predicts – and given the recession, defaults, voids and falling rents there is every chance they could – huge numbers of property firms, including listed companies, will default on their banking covenants.
Should a breach occur, the lesser of two evils would be banks hiking up rates and fees, rather than calling in their loans and foreclosing on property assets. There is growing evidence of both approaches in today's market, although listed property companies are surprised not to have had more phone calls from banks desperate to offload assets. "There is a huge amount of distressed property which simply hasn't appeared on the market yet," comments one chief exec.
Analysts believe that given the extent of likely defaults, to help manage assets, rather than have them clutter up their own balance sheets as they did in the 1990s. This could produce valuable fee income, at a time where cashflow is under extreme pressure.
A lack of bank debt combined with nervousness about falling values means investment volumes remain low, and only prime property is expected to bring buyers out of the woodwork. British Land hopes to sell a 50 per cent stake in its flagship Meadowhall shopping centre to Middle Eastern investors, and Land Securities is offering a share in its Bullring shopping centre, illustrating that even the biggest Reits need to create liquidity.
Secondary and tertiary values clearly have further to fall than prime, and falling values on the continent are playing catch up with the UK, which could prove costly for Hammerson and SEGRO which have European exposure.
Going forward, tenant defaults will impact negatively on rents, which the RICS forecasts are set for a 10 per cent decline in 2009. The scrapping of empty rates relief adds a nasty sting to any voids, proving the adage "the most beautiful property is a let property".
As our graph shows, the CIPS/Markit commercial construction activity index hit a new record low in November, showing developers are resigned to double-digit rental falls, and are shelving new projects.
However, a whiff of opportunity is starting to emerge from development sites, which are being sold for a fraction of 2007 valuations due to the preciousness of property company cash, and the time-lag before any income can be recouped.
One such bargain is Kaupthing's sale of the former Middlesex Hospital site in London's West End. Bids in order of £40m are anticipated - a hefty drop from the £175m it commanded in better times.
