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Property's bargain hunters

Created:

22 May 2009

Written by:

Claer Barrett

It is either the best or the worst time in history to be a commercial property investor. Since the property market toppled off its debt-inflated pedestal in the summer of 2007, the value of shops, offices and industrial estates has crashed by 40 per cent or more. Fast forward two years, and a distinct investment spectrum has emerged. At one extreme, there is the misery of distressed property owners whose debts are now worth more than the assets they are secured on. But at the other end of the scale, debt-free opportunist investors are busy raising funds to profit from the market's pain.

Call them opportunity funds, recovery funds or even vultures, barely a day has passed in the last fortnight without a new investment vehicle being launched by a property tycoon seeking to exploit the "repricing" in the markets.

The biggest buzz surrounds Nick Leslau's surprise return to the quoted sector with the launch of Aim-traded opportunity fund Max Property, which is expected to raise £200m on admission this month. The second listed recovery play to come to the market since our Tip of the Year London & Stamford, which is headed by veteran property investors Raymond Mould and Patrick Vaughan, market watchers believe it is unlikely to be the last of its kind.

The prospect of having £200m to spend in the current market causes Mr Leslau to liken himself to a kid in a sweet shop. "Of course, I want to get the best sweets as the best possible price," he says. Finding the money to buy them with is the first step, and Max has already received a £35m commitment from US hedge fund manager Och-Ziff Capital. "It is very hard to raise private money today; you could spend a year trying and still not do it," Mr Leslau adds. The fund has no official target rate of return, although Mr Leslau says deals must show an initial return of 25-30 per cent to even be considered.

Max's celebrity appeal is further enhanced by the poaching of Helical Bar's Mike Brown as chief executive. Of course, Helical completed an opportunist fund raising of its own back in January, raising £28m to target distressed property acquisitions via an oversubscribed share placing. And news has broken this week that listed property companies Great Portland Estates and Shaftesbury are considering launching rights issues explicitly to target bargain properties.

Not to be outdone, other big names in the private property sector are setting out their recovery stall. This week, former Segro chairman Paul Orchard-Lisle announced he plans to raise £200m for three separate UK opportunity funds managed by his private vehicle, Apache Capital, and its partners. With a minimum investment of £250,000 these closed-ended funds are within the reach of private investors, and will target commercial, residential and infrastructure assets.

Last week F&C Reit's Leo Noe announced that he is seeking to raise £300m from institutional investors for the Devonshire fund, aimed at snapping up UK property bargains. And private investors are the target of smaller funds set up by the likes of Hunter Property, Eaton Investments and Pinder Fry & Benjamin to name but a few.

FOREVER IN YOUR DEBT

With a "40 per cent off" sticker effectively slapped on every property in the country, it's easy to see the investment rationale at work here. But buying into the anticipated recovery is complicated by one small problem - the lack of bank debt.

The extent of the banking industry's exposure to commercial property sector is now calculated at a whopping £225bn, according to the influential De Montfort University survey of the UK real estate banking sector, published last week. To put this figure into context, a decade ago, bank lending to commercial property was a mere £50bn.

Now consider the following: the average commercial property loan-to-value ratio is 80 per cent, and commercial property assets are on course to halve in value. It is therefore not surprising that De Montfort calculates that £15bn worth of loans have already breached lending covenants, and a further £6bn are in default. More worryingly, loans worth £43bn are due for repayment or refinancing this year. Concerned by their exposure, banks seem unwilling to lend more money into property, which raises the prospect of a rash of defaults across the sector.

Or does it? Before the vultures get too excited about picking apart indebted property carcasses, it is worth considering the greatest unknown in the whole recovery story - the attitude of the banks.

In the property crash of the early 1990s, the banks were not afraid of pulling the plug on indebted property companies, calling in loans, and taking properties onto their own balance sheets in lieu of debts. Vast profits were made by the entrepreneurs who participated in the "work out" of such assets, which reinflated in value when the market came back, but the same pattern has not emerged thus far into the current crunch.

This time around, pushing property onto their own balance sheets looks to be a disastrous strategy for our weakened and bailed out banking sector. With so little activity in the property investment markets (itself caused by a lack of bank debt) a hefty "distress discount" would apply to any sales, crystallising the banks' losses and making a bad situation worse.

Tellingly, bankers who responded to the De Montfort survey confirm that as long as the interest is being paid on a loan in breach of covenants, banks are generally happy to keep up the pretence of a performing loan, squeezing out higher fees and interest rates in compensation, and where possible, demanding that further equity is injected.

This sustained squeeze, as opposed to sudden strangulation, is of little benefit to the vultures waiting patiently on the sidelines.

"Banks will only get nasty if the cashflow dries up, or there are tenant problems," reasons Chris Nicolle, head of Savills Capital Advisors, which advises on all aspects of real estate finance. "That is when they will take serious action, and I think we'll see more of that in the fourth quarter of this year. But will there be the deluge talked about? I don't think so."

Of course, there are always deals to be done in the property world, and the calibre of the management teams being amassed under the opportunity banner will undoubtedly result in some impressive transactions. However, there is a great deal of competition ahead for both equity and assets.

THE HUNT FOR EQUITY

Considering the scarcity - and the expense - of bank financing going forward, the opportunists are racing to raise as much equity as possible before the appetite for recovery wanes. A public listing is one route, but most of the private funds say they are targeting "institutional equity". But what does this actually mean?

A catch-all phrase, the UK pension funds can be effectively ruled out, as the slump in the equities market means their asset allocators are already fretting about being comparatively overweight in property. A better bet are foreign investors - be they sovereign wealth funds or US private equity funds - who can currently get "double the discount" as the result of the weakened pound.

Anecdotal reports suggest that there are already far more opportunity funds in the market than those willing to place equity. One advisor to a sovereign wealth fund confidentially reveals he has been deluged by presentations from 22 separate groups in the last fortnight, all punting UK recovery funds.

Middle Eastern investors have already shown an appetite for UK property in the downturn, with London & Stamford securing a joint venture wih Cavendish, an Abu Dhabi wealth fund, and Chris Bartram's Orchard Street special situations fund has already received a £100m injection from GIC, the Singaporean soverign wealth fund.

"We foresee quite a wave of Middle Eastern investment coming in," confirms Mr Nicolle. "Saudi and Qatar haven't exported a lot of capital compared to their neighbours, and realise that prime property has repriced. They like income, so any high income producing properties in the City of London and West End will appeal."

KISSING FROGS

Such trophy assets are hardly the preserve of every recovery player in town - the reality of distressed stock picking is a lot more like hard work. Frogmore has restructured its business from a property company to a property fund over the last few years. Its second fund, Frogmore Real Estate Partners, has now raised more than £200m of equity and had its first closing last July.

Thus far into the downturn, managing director Paul White and his team have looked at £31bn worth of property. They have bought one thing - a portfolio of freehold residential retirement parks for £17m - showing that good value is hard to find, even in today's bombed out market.

"Of the things we've looked at so far, about a third have been offices, a third mixed portfolios, and one third everything else," Mr White says. "Sometimes, sitting on your hands is the best strategy - you lose a lot less doing that."

When it comes to searching for the right deal, Mr White is only too aware that the asset value plunge witnessed in the property market is only one part of the problem. Tenant default is another big concern for recovery players.

"It isn't a pure numbers game anymore," he continues. "If you could see what a mess some financially driven deals have come to, namely half empty shopping centres with poor quality retailers, the risks have got to be reflected in the yield. Even if arithmetically it looks like a walk in the park, you've got to smell it, breathe it, touch it."

RENT IS SPENT

Property companies which have survived the brutal drop in asset value stand to be tested further by falling rental income, as tenants default and rising vacancy rates reverse the steep rental growth of the last decade.

"Very few banks will lend on shopping centres or industrial estates unless they are super prime as it's very difficult to know what the future rental income will be," says Devid Roberts, chief executive of private property company Edinburgh House, which is poised to re-enter the property market when the price is right.

"People say that in the boom, capital values got too high. But I would risk being controversial, and say that I actually think that rents have got too high," he argues. "If you look at the average retail rent in Germany, it's about half or a third of what it is in the UK. Part of the problem for the retail sector is that retailers agreed to rental levels in the good times which are now unsustainable."

For investors tempted to climb aboard the property recovery bandwagon, a further issue is how long it will be before the market comes back. Nearly all of the recovery vehicles mentioned in this article say they have an "investment window" of between five and seven years, which in past experience is how long it takes the property cycle to swing from one extreme to the other. This requires some stamina on behalf of the private investor. As anyone who had their fingers burned in the open-ended property funds debacle will testify, commercial property has proved itself a fearsomely illiquid investment. Furthermore, there is no guarantee that the record 15-year bull run we have witnessed in the commercial arena will not be followed by a longer-than-usual slump.

To counter this, many recovery plays are pushing the "asset management" angle, promising to maximise returns on their future acquisitions by winning improved planning consents, a change of use, or even re-letting to better tenants as the occupational market improves. Despite the impressive track records the management teams may bring to the table, there are no firm guarantees about levels of return, and close scrutiny should be paid to incentive structures.

The commercial property story is a compelling one, but investors should resist getting too carried away on the current tide of opportunity. For all the talk of recovery, it is worth remembering that the market has yet to hit bottom.

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