The great weakness of commercial property is that it depends on the level of domestic business activity; empty offices, as in Manhattan, mean cheap rents. On the other hand, the harvested value of a field of barley will always be based on its world market value; if the pound falls against the dollar, the value of a field of barley, or a field capable of growing barley, will rise. In effect commercial buildings gain their value from the domestic economy, residential property from the level of domestic wages, and farm land from the world price of farm products.
This excerpt from an interesting leader which appeared in The Times on May 20 1975 is well worth keeping in mind. It sets out basic truths which affect the value of agricultural land, commercial property and houses alike. Certain other factors, however, may also influence values.
Farmers in the USA have now come face to face with the harsh facts of over production in the world, leading to a fall in food prices. At home, even with the protective cloak of the Common Agricultural Policy around them, British farmers are finding the going harder as their incomes fall. More frightening is the collapse in land values which, as in the US, are bound to make the bankers look at the capital cover for their loans. Lower farm incomes also provide less cover for payments of interest and leave smaller residual margins for rent. Agricultural rents by law can move either up or down, so there can be no contractual floor of the type which often protects commercial property.
No wonder the agricultural land market is in the doldrums. The EEC urban population pays an enormous price to support the minority agricultural population. They dislike seeing their money subsidising sales of food to foreigners at prices well below what they have to pay. The CAP is under constant pressure to reduce its cost burden and it is reasonable to expect that this will gradually happen. Eventually, stability will be reached, but it will take time and patience.
Farmland is unlikely to recover its attraction for the institutional investor until the uncertainty over future rental levels has been removed or the yields available make adequate compensation for the risks and uncertainty.
The value of commercial property is dependent on the prosperity and ability of the owner-occupiers or tenants to meet the total cost of occupation. Put another way, it is the ability to pass on the costs to the consumer which perhaps really matters.
The present high level of consumer spending is being sustained by earnings rising much faster than inflation, but it is also being boosted by the growing burden of personal indebtedness, both short- and long-term. Thus, household debt has risen from 40% to 70% of disposable income in the last seven years.
Spend, spend, spend
Consumers are being encouraged to spend by credit facilities being made more readily available. Retailers are issuing their own charge cards, which on average probably give a month’s credit free of cost. Credit cards are more widely used and for smaller purchases — even though the interest rates can be expensive.
It is now becoming apparent that many increases in home loans destined for dwelling improvements are being diverted in whole or in part to household additions in the form of cars, furniture and other consumer durables. Loans based on a higher percentage of value and a higher multiple of income are being offered by the increased number of home lenders, some of whom are new to the UK market.
A limit on personal borrowings will one day be reached and this, coupled with any successful attempt by government and CBI to bully employers into granting smaller pay rises, will rebound on the growth of retail trade. Growth in sales volumes can be delayed by price reductions but eventually profit margins are squeezed, leading to an inability to pay higher rents and even pressure for lower ones on new leases. An interesting example is that in the first six months of 1986 electrical goods sales rose in volume by 17%, but prices fell substantially.
Any drop in personal savings would counter this movement but lenders, including the Government, continue to tempt the personal sector with high interest rates and “special offers”. The sustained current boom in retail sales has surprised most forecasters and any slowdown will quickly react on the expectations of retail rental growth. This will automatically put upward pressure on the lowest yields at which the best retail investments are being traded.
The spending power per household varies widely across the whole country. One of a number of key factors in determining rent levels, accordingly, must be the ratio of spending power to total floorspace in any one locality, just as sales per sq ft are a yardstick for rents per sq ft for an individual unit.
Stockbrokers’ forecasts are generally predicting that company profits will rise by about 15% in 1987, a little lower than this year. Increases of that order indicate in broad terms that commerce can afford current rental levels and indeed be able to pay increases where the supply/demand balance is sufficiently tight to force up values.
The ability to pay interest charges on borrowings, whether long term or short as for credit sales, depends on the continuance at the same level of earnings of companies and individuals. Both the lender and the borrower need to be fully aware of this fundamental point. It is more important than the capital value of the asset or goodwill upon which it may be secured. At the end of the day, capital values of assets and goodwill depend on their earning power.
The keenness of lenders to lend may overtake a proper degree of prudence and loans may be advanced without sufficient regard to the continuing ability of the borrower to earn an income sufficient to meet the interest charges and all the other costs of operating a business or living. In many cases, the debt service includes capital repayments, so the borrowers’ surplus has to be at even higher levels in the absence of other free assets. The position in which the Shropshire farmer Alan Powell finds himself is a timely example for both borrowers and lenders to ponder.
Those borrowing on the strength of commercial property may find that the limit on the loan is determined as much by the capital cover required as the income cover demanded by interest over rents. In times when property yields are below interest rates this latter may be the governing factor. Loans on properties at fixed interest rates on this basis — and also the security of rents payable under medium- to long-term leases from substantial tenants — will produce few sleepless nights for either borrowers or lenders.
The far more dangerous field is that of loans granted for property developments which are either to be traded or held. Such loans, which are often at variable interest rates, usually allow the interest to be rolled up during the development period and the amount advanced depending on predictions of capital and rental values plus an ability to let and/or sell at a future date without undue delay.
Insufficient protection
Development profit margins have been squeezed by the competition between the traditional property entrepreneurs, the new generation of developers and the more recently arrived institutional funds. The profit margins too often allow insufficient shelter against the appearance of some adverse factor during development or on completion. The proportion of debt at variable interests should not be excessive. The companies who earlier this year raised debentures, many by the £ millions, must be pleased with themselves with the recent increase in interest rates.
The tenants’ market is likely to remain in place and the occupiers’ choice of space will be in most locations a wide one, both as to quality and price. The trader-developer is particularly vulnerable and needs other income resources in case unexpected cash-flow problems should arise. There can, of course, be equally pleasant surprises with prelets and competition between prospective tenants to push rents above original expectations.
Property as a commodity is “lumpy” and has a longer production time scale than most everyday consumables, so margins need to be high. Most manufacturing industry works on margins of 20%-25% and yet the property industry too often comes down below 20% — a far cry from the 1960s when 30% or more was the yardstick.
The generation of traders and the developers holding for the long term will remember how the events of the closing months of 1973 and the year of 1974 saw the collapse of profit margins, the disappearance of the expected surplus of income over interest charges and the decline in capital values. But now we have a new generation of borrowers and lenders who did not go through the forest fires of those times and who may find it a little difficult to perceive that high gearing is not always a one-way street to a fortune.
In bad times, it is very important to have a lender of substance and understanding who has seen such days. A difficulty may be that the new breed of loan officers, who are charged to build up a loan book, can be tempted to lend beyond the normal bounds of prudence. So borrowers find it easy to borrow and gain comfort from the fact that their financiers are so supportive. Shades of the attitude of the secondary banks of 1973 and 1974 are still around for those who look for them! And the idea that mortgages can be sold by lenders to others diminishes the value and comfort often derived from established relationships between borrowers and lenders.
So long as interest rates remain above the level of development returns those developing to hold are relying on the hope that the shortfall will be more than compensated by the rent increase at the first review. There is now evidence of commercial rental growth in varying degrees — albeit not very strong — but so long as the free market remains in place the underlying strength of that growth may remain patchy.
High gearing can be the road to a fortune but also to bankruptcy if expectancies do not mature. Is the recent rise in UK gilt rates the first sign of the amber light flashing? What is the rise in the price of gold saying? It was not for nothing that the Governor of The Bank of England recently commented somewhat critically on the growth in lending, and warned on the need for prudence by lenders and caution by borrowers.
As the general election looms, political uncertainty could lead to industry’s decision-makers deferring plans to expand or move. In such times the wise holder of property or trader holds his asset/debt ratio on a low-risk profile and keeps a weather eye open for the good opportunities, which are always around in any market. The shrewd investor will be allowing some cash to accumulate so as to be able to look around for some bargains.
