by Peter Evans and Desmond Jarrett
Institutional investment in property has continued to decline in relative importance; in 1987 the real value of investment was a mere one quarter of that in 1980. In contrast, commercial and industrial construction output continues to increase dramatically, re-emphasising the point that property is inherently a cash-hungry sector not dependent on any one source of funds. With both the availability and the cost of finance fundamental to its prosperity the sources of funding, in the absence of strong institutional investment, have broadened. Developers, traders and investors seeking finance have been able to exploit a wider and increasingly sophisticated range of options in recent years.
A second article, in next week’s issue, will examine the future property investment intentions of the institutions.
Our latest analysis of “Money into property” has examined both the size and structure of these flows of finance, particularly in terms of bank lending and the corporate sector. Together these accounted for between £5bn and £6bn of new money in 1987, raised by property companies to fuel their extensive acquisitions and development programmes. Although there are signs of increased activity by the insurance companies and pension funds, it is unlikely that it will return to its pre-eminent position. Non-institutional finance will remain critical to the continuing health and expansion of the commercial property market.
The banks
The banking sector injected a further £4bn into commercial property last year and by the end of February loans outstanding exceeded £15bn. Over a 15-month period total property debt has risen by just over 60% compared with a 23% rise in overall commercial lending. This popularity of property among the banks means that it now accounts for around 8% of the banks’ total commercial debt. Although still significantly below the peak of around 12% recorded in 1974, the trend appears to remain upward.
Our survey of bankers’ lending policies last year (Estates Gazette vol 282 pp 524-528) highlighted their overwhelming preference for loans relating to schemes within central London. That attitude continues with the present rise in lending closely linked to the very large and expanding central London office development programme.
Undoubtedly the strong rental and capital performance of the property sector has encouraged new lending commitments; indeed, a study of new loans announced by banks over recent months demonstrates that there is a sizeable amount of funding which will boost the figures in the 1988 and even 1989 lending statistics. The official figures measure the flow of money as loans are drawn down rather than money committed to schemes and thus tend to paint a more historic picture of bank policies than appears to be the case. With major projects such as Spitalfields planned for the 1990s, but with finance already agreed, it is clear the banks are making long-range commitments.
The distribution of lending activity highlights the continuing influx of foreign banks into the UK property market. While the Americans have been key players since the early 1970s, it is only in the last three to six years that the European, Japanese and Australian banks have also created a sizeable presence in the market. Although there are examples of a number of banks significantly increasing the size of their loans, the major stimulus to property debt has been the growing number of banks lending rather than very substantial additional commitments by a limited number of existing players.
The much-vaunted arrival of the Japanese is beginning to show through in the figures, with their share of new lending to UK property companies running at around 10%. More particularly their interest in UK property is highlighted by their outstanding loans in overall terms having increased by around 17% over the last year or so, but their loans on property increased by 250%.
Other overseas banks are also enlarging their share of lending, although the Americans are lagging behind in the aggregate sector increase. This appears to reflect the switch by some of the more experienced ones in this group from lender to loan manager. Growing use of “lending syndicates” has given them the opportunity to co-ordinate the lending project and raise their loan-earning capacity by combining fees with margins income.
Few banks would discourage greater institutional involvement, and hence an expanded investment market, but their reaction to the entry of building societies as a new source of lending on commercial property is likely to be more muted. As a result of the Building Societies’ Act 1986, societies can lend up to 10% of their loan portfolio on non-residential opportunities. The Abbey National was the first major lender from this sector, with their £40m loan for the Bishopsbridge development in Paddington. Given the movement’s substantial resources, the entry of the societies into the commercial property debt market could significantly alter the balance of lending, although it is unlikely that significant in-roads will be made until the early 1990s.
The size and increasing rate of exposure to the property market by the banks has raised concern that so much short-term debt could destabilise the market. Comparisons with the early 1970s continue to be made, although clearly economic conditions are quite different. In addition, present banking procedures appear to be more disciplined with more careful assessment of the projects on which funding is committed. Nevertheless, because of the lag between changes in demand and the response on the supply side, the commercial property market has an inherently cyclical pattern. The benefits of spreading loan portfolios both by sector and geographically are self-apparent. The significant and continuing recovery of the provincial property markets provides an opportunity for a greater spread of lending. Potentially this is a method for reducing the competition and hence pressure on margins that the banks have been faced with as a result of having such similar preferences.
Corporate sector
A roller-coaster year on the stock market provided property companies with opportunities, assuming they were quick enough to respond to changing conditions. At the start of 1987 property share price performance was in the doldrums and the sector lagged behind the market generally. By mid-summer the strength of demand for property shares had pushed prices through the 15% discount to asset value barrier to a level reflecting a premium.
The opportunity to issue shares without diluting asset backing was seized by many. As a result a rush of new equity issues and sales of convertible stock extended up to October 19. The subsequent return to a discount rating to asset value allowed some of the companies who had raised surplus cash in the previous months to “buy in” their shares at prices 30% or more below the equity issued a few months earlier.
The amount of new equity injected into property companies during 1987 was in the order of £1.5bn to £2bn. In addition, the debenture issues in the early part of the year raised a further £400m. This money, combined with bank lending, produced a total inflow of around £5bn to £6bn, giving the corporate sector sufficient resources to expand its development programme. The larger capital base also enabled companies to retain completed developments rather than seek an elusive institutional investor.
With the level of share price discount to asset values reduced again in recent months, as a result of rising property values and CGT changes in the Budget, the possibility of further rights issues increases. However, given the weak demand conditions on the stock market generally and the low market turnover, the background is not encouraging. Companies face the risk of a flood of new stock eroding the rise in equity values.
The corporate sector’s strength is based on the recent upswing in rental and capital growth. Revaluation results, such as those of Land Securities with a 28% increase on the year to March, underline the rehabilitation of the sector to investors. Property failed to match the growth in equity values enjoyed during the long stock market bull-run and the sector relative declined from a peak of 160 in 1984 to less than 90 during 1987. The sustained growth of a service economy and the more recent resurgence of our manufacturing base has stimulated accommodation demand so that, late in the economic up-turn, property’s performance has lifted dramatically. The sector relative has again moved in favour of property companies.
Capital growth, coupled with the in-built reversionary potential of established investment portfolios, has enabled the large property investment companies to outperform the developer and trading operators. Those without a large secure base are, of course, more exposed to market cycles. The intense competition within the development sector remains, despite the sobriety inflicted by the stock market crash. There is a risk that the strong competition for development opportunities will squeeze the potential profitability of completed buildings, particularly in those areas where the supply/demand balance is changing. Such risk could translate into overt vulnerability.
However, the amount of new equity raised has ensured that the property sector’s balance sheets are in a strong position. The overlapping of heavy bank borrowing with a sizeable expansion of the capital base of property companies has ensured that gearing has not significantly increased. For example, according to Warburg Securities the ratio of debt to total assets of the largest 42 property companies was only 1% higher at the end of 1987 than a year earlier. These figures, however, underestimate the full exposure of companies to short-term debt because non-recourse or associated company debt is excluded from the consolidated accounts. Although changes to accounting procedures currently under discussion may bring this practice to an end, while it exists it is not possible to obtain a truly accurate picture of company debt. In the meantime it is a practice that makes many investors anxious, and gearing remains an emotive issue in the property industry.
Increasing use of equity financing and debenture issues has helped to reduce the lending risk of the property sector. Cost of financing is a fundamental part of the success of a property company and the efficient exploitation of new financing tools has played an important part in improving the profitability of the sector. Property companies’ search for alternative sources of funding was prompted by the substantial cutback in property investment from the early 1980s. The success of the corporate financiers of property companies in this task should mean that the likely re-entry to the market by institutional fund managers will be in the face of increased competition.