Spanish Real Estate Crisis: A Perspective from the Inside

José María Sanchez de la Peña was a man with a problem when he came to address our Lunch on 15th March 2012. It was a lovely early Spring day, with Hyde Park looking full of promise, but his message did not match this backdrop – by some distance. Apart from a few favoured locations in Madrid and Barcelona, all parts of the Spanish market are in retreat. Despite falling by around 30%, housing is still not affordable, and, with a weakening economy, demand from business occupiers remains feeble. Banks have become effective owners of large swathes of property, but have really not yet ‘bitten the bullet’ of changed circumstances. There are many examples of their selling buildings with 100% mortgages; the triumph of hope over reality! With very few exceptions, whilst land might have a price attached to it, it has no value. In response to a question, to emphasise the darkness of his message, José María doubted whether this represented a good ‘buying’ opportunity.

To make his message bleaker, the prospects for recovery seemed remote. He saw values falling for a further 12 or 18 months. Beyond that, the future was not really in Spanish control. If the Euro and Europe could be stabilised, then a base from which growth could start would be found, but bringing about that (relatively) happy state was not in Spain’s gift; the big issues lay elsewhere. Whilst José María emphasised that he did not want to make political points, the recent change of Government had, perhaps, removed one of the sources of trouble, but it was far from clear that the new lot could find the way out.

This description of such a dark picture left your scribe wondering how Spanish Society was coping with it; José María drew attention to the foundation of National Socialism in Germany in dire economic circumstances. However, there are two counteracting forces. First, there is a very extensive ‘black economy’ – ‘black’ in the sense of being below the radar of official statistics rather than illegal. The second is the strength of the ‘family’ in Spanish tradition; most people live in a supportive social context that mitigates, and spreads out misfortune.

I found José María’s words academically interesting (an insight into how it feels when economic distress reaches a tipping point), but socially deeply disturbing. I felt there to be a degree of desperation in that there seems to be no view of an exit from the present turmoil. The message was a gloomy one, and your Scribe may have over-emphasised its blackness; José María was clear that there are opportunities; you just need clear eyes and brain to judge them. However, in response to another question, he did not seem to think that there was a deal to be done in that Spain has a million houses to spare and Britain has a million people wanting homes.

Michael Mallinson

Stagflation becomes stagnation; buy property not peanuts in 2012

Overview

Our speaker at the lunch on 19th January was Prof. Angus McIntosh, Economic & Sustainable Property Consultant with Real Estate Forecasting Ltd and Oxford Brookes University. Prof. McIntosh gave us a passionate and persuasive case that prime UK commercial property investment will have the best decade in real terms of performance (apart from the 1990s) since the 1960s. Total returns will out-perform inflation. To find out why and how please read on below.

Members and guests were persuaded so during the Q&A session most discussion focused on where value could be found in the markets both sector and location. The risks inherent in an uncoordinated green agenda were also explored fully.

Economy

As inflation slows down from over 4.5% to 2.2%, and economic growth falls from 0.9% to only 0.4% pa or less in 2012, stagflation (higher inflation but lower growth) has receded. Economic stagnation is with us, but this is not as bad for property investment as conventional wisdom dictates.

Even if the Euro currency does not collapse in 2012 (this is still less likely – Germany has far less to lose by holding it together) UK economic growth will be close to a double dip recession. At present all the Euro policies are wrong; extreme austerity (as imposes on Greece & others) never worked in South America in the 1960s, nor in Russia in the 1990s, nor even in Germany in the 1920s. You would think Europe knows the consequences can be disastrous.

Quantitative easing, a low bank rate and a low value of £Sterling will assist the UK economy.

Commercial Property Rents

London office rents remain the only star in a stormy sky; across much of the UK office rents will fall further.

The credit crunch has now become a consumer crunch; down-town retailing will collapse still further. All out-of-town retail property will out-perform in-town property rents. Even the London Olympic Games will not change consumer sentiment; London is already performing better. The rest of the UK will remain a tough environment for many retailers.

Industrial rents will mark time; what you see is what you get, for at least three years – despite the on-going explosion of on-line retailing, which is further undermining down-town retailing.

Residential Property

House prices, apart from Central London (where funny money from around the world is "parking funds" in the market) will stagnate for at least five years.

Residential investments to lease, especially in South East England, will produce returns (mostly income) of three times the rate of inflation, at +7% over the next 5 years.

The Green Agenda

The "Greenest Government Ever" has lost its way; short-term political expediency from 11 Downing Street will eventually cost the UK far more than, for instance, the financial legacy debacle of defunct PFI projects dreamt up over 10 years ago.

The legal farce the Government created, by dramatically lowering the feed-in-tariff for homes making photo-voltaic energy, two weeks before the consultation period ended, is symptomatic of the mess.

Climate change is a reality – however caused. Over the medium term oil, food and all commodity prices will rise faster then general inflation, caused by crop failures (sure as peanuts in 2011) and the Asian economic boom. The UK needs to both save energy and make far more green energy to protect its future.

The Green Deal (enshrined in the Energy Act 2011 allowing energy companies to retro-fit buildings) is unworkable and very expensive to operate. It is lacking due-diligence and enforceability. It is a sop to voters, and unlikely to work in the commercial property market.

Energy Performance Certificates are an un-regulated unenforceable expensive farce; 4 un-regulated assessors could legitimately produce 4 different certificates. The BPF and many others have campaigned for compulsory Display Energy Certificates on all commercial buildings. This would wake up the property market to their energy profligacy, and accelerate the UK’s declared commitment to meeting lower energy emission targets much sooner.

However, the taxation on energy (the largest in the world) via the Carbon Reduction Commitment will make the negative impact of climate change even worse. It is a regressive tax and does not address the need for a progressive tax based on both the whole-life carbon emissions of buildings and its market value. As proposed lower valued buildings will proportionally pay far more CRC tax than valuable investments.

For investors, the main worry is that the cost of the Green Agenda (Building Regulations are becoming ever more expensive) is eroding asset values dramatically. There will be winners and some dramatic losers.

Retrofitting or rebuilding buildings, which are, say 20 or 30 years old, is becoming increasingly expensive. For example, any office with less than 5 years lease un-expired, in a market where the PRIME rent is less than £20 per sq ft, sits on a negative land value!

Investment

Property not peanuts; world peanut prices have exploded by between 60% and 100% in 2011. Go short in peanuts in 2012, but long on well-let commercial property.

With average investment income yields at 6% pa, and with general inflation expected to be below 2.5% for the next 5 years, a real return of over 3% looks very attractive. Buy whilst stocks last!

Commercial property investment will have the best decade in real terms of performance (apart from the 1990s) since the 1960s. Total returns will out-perform inflation.

It is hard to see gilts repeating the performance of the 1990s, with yields starting from such low levels. Yields would have to fall even further to even achieve a 2.5% real return. More likely gilts will struggle to achieve a positive real return at all, leaving property looking like a valuable asset class in a diversified portfolio.

These are conditions are not normally thought to favour property returns, but low inflation has typically been good for real property returns, as inflation is not fully passed on into rents, and therefore nominal returns remain relatively high.

But be beware; for older stock, in poor locations, investment asset depreciation (especially for non-green buildings) is widespread.

UK -- The Big Chill

At the final lunch of 2011 we were treated to an insightful, if at times dispassionate, talk on the economic prospects for the UK by one of the foremost economic commentators of our times: Bronwyn Curtis, OBE - Head of HSBC Global Research.

Earlier in 2011 Bronwyn had spoken about the prospects of "a lost decade" which the eminent Martin Wolfe of the FT also has used in his economic commentaries.

The UK already has had 12 quarters of recession along with anaemic growth leading to the economy "bumping along the bottom". The last 7 recessions experienced by the USA had all been 5 quarters. With very low growth, GDP is still 4% below the 2007 peak in the UK, slightly ahead of the USA which is 5% below their peak and Europe at 6.2% below its peak. The recession developed as a result of debt in the private sector which now has moved to being a public sector debt problem.

Our speaker took us through a wide range of negative economic indicators for the developed world, including the more recent downgrades of anticipated growth from 2.3% pa to 1.4% pa. In contrast, growth forecasts for the emerging markets had slipped from 6.2% pa to 5.9% pa.

Why are these indicators so awful? This is a combination of: policy makers having to issue cheap paper whilst remaining highly leveraged; oil prices staying up as a result of emerging market growth leading to even greater tax on consumers and the fact that 50-60% of the UK’s and USA’s economies being consumer driven with 9-10% being unemployed. The UK can expect a further loss of 300,000-700,000 jobs in the public sector which will have been cut by 16% in real terms by 2016.

The conclusion Bronwyn offered us fitted the billing. We in the UK should grow old gracefully and accept we will be worse off, or, emigrate. Brett, like the speaker, an Australian ex pat, asked should we move to their home country. The response was we should learn Mandarin.

As some pulled their Christmas crackers during a lively Q&A on the prospects and implications of Europe consolidating or breaking up in part or whole (very hard to do and massively disruptive) others could not get in a festive mood. Given there appears to be a 50/50 prospect of 17 European countries having their credit ratings reduced within 90 days, 2012 is likely to offer little cheer. It was encouraging to hear our Spanish colleagues stressing the importance of strong links and economic ties with the UK for their country.

London Chapter treasurer John Dallimore, who persuaded Bronwyn to speak, made the observation in his opening remarks that perhaps the talk was 2 or 3 days early. How observant given the Cameron veto over the following weekend. We now wonder what will unfold in UK and Europe in the next 90 days and decade beyond. Where is growth to be found beyond China and the emerging markets? Answers, thoughts and observations welcome . . .

Mark Loveday
December 2011

What’s in the Future for our Nation’s High Streets?

We would all have been aware that there is a problem with extensive, sometimes almost overwhelming, shop vacancies in virtually every town in the Country, and with well-known trading names disappearing at an accelerated pace. At our lunch on 27th October we were fortunate to have Andy Godfrey, Public Policy Director, Alliance Boots, to give us his analysis, an analysis from probably the most-represented retailer on the High Street.

Whilst the proximate cause may often lie in the current depressing economic climate, Andy made clear to us that the roots of change go much deeper: the rise of supermarkets, out-of-town retailing and mail and internet shopping being the prime movers. These forces have been at play for two or three decades already and will not go away, with the impact of the internet in particular likely to grow considerably. Internet driven sales have increased from 5% to 9% in the last 10 years and some predict a doubling again within a decade. It is also the case that the very largest top 30 centres have prospered at the expense of the rest of the High Street locations.

Against this rather dark background, Andy suggested that people are rather fond of their local High Street; this was manifested in some local responses during the recent riots. Perhaps they fulfil a social as well as a commercial role. If that is right, there is a need to rethink the detail of that role, and not just in terms of retailing. Hopefully the emerging Report by Mary Portas will address the right issues. The re-thinking needs to take account of changing demographics, in particular more older people (your Scribe regularly shuffles round Woking looking for the spectacle shop) and, sadly, more have-nots. We should build on two factors: first, whilst many goods can be commoditised, and thus sold indirectly, and many, particularly fashion, rely extensive comparison, there remains a huge range of goods that people wish to ‘touch and feel’ before they commit themselves. Secondly, the concept of a ‘shopping experience’ is socially well-established, and that experience does not just include the purchase of goods. In Andy’s view the recipe for success, when times improve, will depend upon an emphasis on advice and service, providing room for individualism in the products and services offered, offering convenience of access and a safe and welcoming environment, and, above all, the fostering of the sense of ‘community’ that the best High Streets provide; these will be the crucial factors in encouraging footfall.

However, a successful High Street in 2020 will be very different from today’s offering and there are great difficulties in getting from here to there. Not the least of these is fragmented ownership. Realistically, this will only be overcome if Local Authorities take a leading role in ‘championing’ the high street, presumably justified by social importance. It will also require changes in Central Government Policies, laws and Regulations.

The vision offered by Andy met, I think, very wide acceptance. The questions really reflected the willingness, and ability, of all the parties concerned to overcome the barriers to delivery of the vision. Andy was quite upbeat about this, not least because there is an underlying commercial logic; not all will succeed, but that logic should give a fair wind. It was that that encouraged your Scribe: we had a hard-headed, but soft-spoken and entertaining, businessman espousing the vision, not a politician or academic.

Michael Mallinson

NAMA – part of the solution, not part of the problem

How do you bail banks out the hole into which one subset of the ‘Masters of the Universe’ had driven them? The Irish Government, faced with a bigger problem as a percentage of GDP than most, chose, rather than a bank-by-bank resolution, to place a large proportion of the problem property loans into a specially formed Agency, NAMA, tasked with managing the resolution of the loans in an orderly manner over 10 years. At our lunch on 15th September 2011 we were fortunate to have Ronnie Hanna (Head of Credit and Risk for the National Asset Management Agency) to tell us how this project was working out.

The size of the task is prodigious, £72 bn of loans, 60% of which concerned Irish property and 32% in the UK, including Northern Ireland, with the balance in USA and Europe. Ronnie made clear to us that the fundamental principle for NAMA was orderly disposal or working out, with no fire sale element. In principle, the scheme is neither a bail-out of borrowers, who will be expected to repay the loan eventually, nor is it a bail-out of the banks as they will hold the losses on ultimate wind-up. This principle is key to the relationship between NAMA and all the parties involved; whilst, in reality, it will not be wholly achievable, the discipline it brings is crucial to the project.

The majority of loans have remained in the legal ownership of the lending bank, but, for each loan, the bank is required to prepare a realistic ‘business plan’ under the eagle eye of NAMA. Once the plan is agreed, NAMA is able to issue a ‘letter of support’ which will help the bank in dealings with third parties. If additional funding is required to oil the resolution, and it cannot be raised elsewhere despite the ‘letter of support, then, provided that it is in line with the business plan, NAMA is able to provide it, on commercial terms. It is a feature of the scheme that the banks, who do much of the work, are left with some of the upside if things go well; whilst, to some, this seems like rewarding failure, Ronnie argued that it is pragmatic to give the banks some incentive.

In some of the questions that followed Ronnie’s talk, there was an undertow of criticism that NAMA was sometimes getting in the way, perhaps an inevitable danger for an intermediary interjected into a previous commercial relationship. Ronnie was vigorous in his defence. Often complaints amount to a criticism of a price being demanded by NAMA, but investors must realise that they are not picking over a corpse; his task is to secure optimum resolution, and his needs will often quite properly not match the particular wishes of some purchaser; so be it! He was confident that the ‘assets’ confided to his care would, in due course, almost all find proper resolution, perhaps sometimes following co-operation with other agencies of government; there may be a small residue of land that will have to revert to, or remain as agricultural land, but that will be trivial when compared with the starting position.

Ronnie was very firm that NAMA was proving to be part of an innovative solution to what had seemed, at the outset, to be an unbearable problem. Your Scribe has always had the prejudice that the Irish were a bit tricky, particularly in loose play around the back of the scrum. Ronnie convinced him that, here, they had found an interesting way of getting the ball away in more profound circumstances.

Michael Mallinson

Do Greener Buildings Really Mean More Value?

Whilst your Scribe can safely be thought to be ‘out of touch’ in most things, he senses a continuing scepticism amongst many, perhaps most building owners about the ‘green’ agenda; it is widely seen as just one more impediment for landlords. At our Lunch on 19th May 2011, George Fowkes, Co-Founder of Low Carbon Workplace, sought to convince an audience that was by no means as sceptical as I have suggested that greenness can be seen in a positive light.

The Government has set ambitious carbon targets: an 80% cut in emissions by 2050. There is no doubt that property, contributing 20% to current emissions, is seen as a soft, as well as a necessary target. Perhaps justifying a negative perspective, potential taxes are in place to bully, and ‘Display Energy Certificates’ will be seen as a tool to shame. However, the real driver for change will lie in energy-pricing and the anxiety of occupiers, who ultimately meet energy charges, to minimise a growing threat to their bottom line.

Whilst BREEAM assessments and debates about ‘embodied carbon’ address important issues, George expressed the view that these are unlikely to be real drivers of value in the market place. He suggested four headings that might be:

1. Access to public transport. If Government continues to squeeze the cost of motoring, which it is likely to do to the bounds of political possibility, less dependence upon it will be attractive to occupiers in attracting staff and customers.

2. Buildings that offer ‘smart passive systems’ – not too much glass, high ceilings, open spaces etc. These will offer tangible advantage to occupiers.

3. Efficient active systems, particularly good zonal controls so that energy use matches closely actual building use, mitigating waste. (Your scribe has just bought a kettle that boasts its ability to boil ‘only the amount of water you need’ – but he still overfills it!)

4. Landlord engagement with occupiers. For example contractual parameters for energy use, with costs and benefits being shared. The equipment of buildings with extensive metering and monitoring systems will be a selling point of value.

Rather than an incidental, George sees energy use and cost as becoming an active, and perhaps disputatious, component of the landlord/tenant relationship. If this is correct, landlords need to develop strong ‘test as you go’ methods, not only in developing and refurbishing buildings, but in their continuing running.

One questioner raised the implicit conflict between building conservation and listing, and energy efficiency. It was George’s view that the latter is now the louder voice, and English Heritage will have bend to meet that reality. Another questioner, whilst accepting George’s argument in high cost/high demand London, wondered whether the value issue will prove so real in the provinces. George refuted this view, arguing that growing energy costs will prove painful wherever they are incurred.

In some cases, reducing energy consumption may have quite high initial costs, but George left us with the view that most buildings present opportunities for short payback with basic and simple stuff - a positive message to end a lucid and entertaining presentation.

Michael Mallinson

State of the Property Finance Market and Alternative Sources

When addressing our Lunch on 17th March 2011, Wilson Lee, Managing Partner of First Growth Real Estate Capital LLP, was confronting a topic of close interest to all his audience – how and when will the capital markets return to normal?

He started his talk with a resumé of how we got into this pickle in the first place. It might be summarised as a thorough exercise of what I paraphrase as 'due indigence': people failed to think through the inherent risks of domino effects in the structures that were being created, and didn’t build the contracts properly. When the music stopped, financial institutions across the Western World found themselves short of several chairs.

The political and fiscal responses, and uncertainties about what those responses might be, led, perhaps inevitably, to a capital market distorted in many respects. Banks are still in a state of flux. Whilst many US Banks have 'marked to market', that process is, in Wilson’s view, by no means complete in Europe; this implies more pain to come, and more reluctance to lend. In Europe, around £260bn of bonds fall due in 2011/12. Whilst some of these may be extended, there will be a very substantial pool to be re-financed in what will be a highly unfavourable climate. Wilson’s worry is that, as and when interest rates start to rise, lender tolerance will recede. This will lead to increasing defaults, cranking up the pain to the Banks. There are signs of this already as applications to the ECB for emergency loans have exploded.

Against this torrid background, investors crave liquidity and security; if both are not available, prices take a big hit. In property terms, we have moved from a position of the spread between prime and secondary property being too narrow during the bubble years to being too wide today; as an aside, Wilson thought that this might indicate some opportunities.

It was a testament to Wilson’s delivery skills and the value of what he was saying that, up to this point, there had been no suicides amongst members or guests. How will it all be resolved? Wilson was clear that there are more failures to come before the system is purged. There is, however, no shortage of capital in the world – witness, for example, Sovereign Wealth Funds. There is fear, and there is a mismatch between investors’ expectations and the returns that are actually likely to be available to them. Fear should recede if governments take steps to encourage wealth creation, both at the macro-economic level and in local initiatives. Wilson was also optimistic, I think(!), that Institutions will identify the opportunities open to them whilst the Banks occupy the Recovery Ward. In case that made us happy, however, Wilson suggested that we were not yet half way through the trough, if the previous upsets for capitalism were anything to go by.

Michael Mallinson, Scribe