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 that 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 for refinancing 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 on the Continent.
“This property crash is different from every property crash in history,” he says. “It was not caused by the same factors as the 1990s crash, when interest rates went to double-digit levels for three years running and people could not pay interest on their debts.
“In this market, debt servicing is actually very strong, and that is what lenders look for – can the borrower meet the interest cover?”
However, Ross says British banks are more likely to exploit changing LTVs as a way to make more profit than to foreclose on a property. “Although technically a loan is worth more than the value of a building, and you are in breach of your covenant, typically banks won’t foreclose on that. Instead they’ll charge a whopping great margin.”
Ross says the reason this is not happening in Europe to the same extent as in Britain is that property values there did not reach the same lofty heights as the British property market, so they have not had so far to fall.
Romney Fox, an investment manager on the Aberdeen Property Share fund, agrees that values have 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 assets have fallen much less in value than the UK because they didn’t increase as much, and didn’t have the boom of 2002 to 2006.”
There is also a much smoother approach to valuations on the Continent, he adds.
Fox’s fund can invest in both Britain and the rest of Europe, but at present he has about two-thirds in Britain and is happy to maintain that position. “Despite a rally in the UK at the bottom, there are still better opportunities here, and we will see an improvement in values faster than on the Continent,” he says.
Another reason Fox prefers property in Britain is that it has comparatively less gearing than Europe. “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?”
Banks will generally not withdraw support from borrowers, Fox says, and will ignore the fact that the issue is more than the cost of the debt. However, LTV is a problem as values are falling, he adds.
But Ross points out that CMBS are a much smaller part of the European market than that of 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.
So with about €30 billion of commercial mortgage-backed securities in continental Europe excluding Britain and Germany, suddenly the problem seems to be on a much more manageable scale.
“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,” says Ross. “When CMBS loans come up for refinancing, senior bondholders will want out.
“In the UK we are facing the same problem, but it will be easier to manage because the level is lower. UK commercial property is in negative equity, which is unsustainable. Something’s got to happen – you want a maximum loan to value of 70% to 75%, and it is at 100% [on average] right now.
“Capital values across the whole UK commercial property market have fallen by 45% to 50%, so it is bordering on negative equity. But European property investors buy for income, not growth, so you don’t see volatility in capital values like you see in the UK.”
Ross says that an imbalance of buyers to sellers in Europe makes it difficult to find property to buy. “We now have a lot more buyers than sellers, which would have been unthinkable in March when the market was flooded as property assets were dumped. People don’t want to
sell and crystallise their losses at this stage of the cycle. This is pushing up capital values.”
Jim Rehlaender (pictured below), 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 points out that Reits and publicly traded companies that were not highly leveraged to begin with have been de-gearing, so he suspects the large numbers that are being bandied around are an aggregation of different types of loans.
Rehlaender says the problem 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 continental Europe. He points out that office vacancies in America are at about 20% to 25%, while in Paris the figure 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.”