Analysis: European property

Industry commentators have begun to worry that there could be problems bubbling under the surface of the European commercial property sector.

The Financial Times recently reported that the European property market is facing a “debt time-bomb” caused by leverage which is still to unwind. When the commercial mortgage backed securities (CMBS) in the market come up for refinancing, borrowers may find they cannot get banks to lend to them at previous rates, the argument goes.

As capital values fall, loan to value (LTV) rises, and borrowers find they have broken banks’ LTV covenants. Generally, borrowers can only refinance at up to 70% LTV, so when the time comes, not only are they in negative equity, but they cannot find another loan at a reasonable rate, and the existing lender may have the right to foreclose.

But property managers say the potential impact of this issue has been overstated by the press.

Alex Ross, the manager of the Premier Pan European Property fund, says the situation is worse in Britain than it is on the Continent.

“This property crash is different from every property crash in history. It was not caused by the same factors as the 90s crash when interest rates went to double digit levels for three years running and people couldn’t pay interest on their debts,” he says.

“In this market, debt servicing is actually very strong, and that is what lenders look for—can the borrower meet the interest cover?”

He says this situation is happening in Europe but not to the same extent as here. This is because property values did not reach the same lofty heights as the British property market, so they have not fallen as far on the way down.

Romney Fox, an investment manager on the Aberdeen Property Share fund, agrees that values not fallen as far in Europe, but he still prefers to invest in Britain because he says there is excessive leverage in the European market.

“European names have more financial leverage so they are not attractive to us. Property vehicles have used a lot of debt in their business models. When they come to renew it, who will lend it to them again?” he says.

But Ross points out that CMBS are a much smaller part of the European market than America or Britain. He estimates that CMBS in America total $1.2 trillion (£740 billion) and in Europe including Britain the figure is €130 billion (£118 billion), of which three-quarters is in Britain and Germany.

“Europe doesn’t have this massive over-leverage, which is one reason values haven’t fallen, while the US has a three- to five-year overhang of defunct credit. In the UK we are facing the same problem, but it will be easier to manage because the level is lower,” Ross says.

Jim Rehlaender, who runs the Schroder Global Property Securities fund, says he suspects the CMBS issue has been blown out of proportion. “This is a story the press has jumped on—we are trying to work out what the reality is,” he says.

He says the issue of refinancing will only be a disaster if the economy falls off a cliff. “If I am a banker and I know the market is bottoming, I will be more inclined to ‘pretend and extend’ [on loans] and hope that economic growth will come round at a time when maturities are coming up.”

Like Ross, Rehlaender sees bigger problems in America and Britain than in Europe. He points out that office vacancies in America are at about 20% to 25%, while in Paris this is closer to 6%. “The US, UK and Eastern Europe are the real markets we worry about,” he says. “If the global economy stays soft and doesn’t show much recovery, Europe won’t recover much, but it is hard for us to see where this big looming catastrophe will come from.”

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