by Hugh Jenkins
Unlikely though it may seem to the average bystander, the process of restarting the property cycle has already begun. To the aficionados of property cycles the signs, albeit very tentative, are there to be seen. What is less clear is how long the process will take from “go” to a point when we are again in a very active and broad two-way market in both investments and development sites for all segments of the market; and, further, what the structure of the market and the yield matrix will be by the time we get to that point.
The renewal process starts when the market comes to a full stop, weak holders recognise their problem and prices fall to a point where a variety of bargain-hunters appears with cash to start a market-place. It is obvious that the current recovery in activity is weak and not widespread. However, there has to be a beginning and I for one am grateful for small mercies. What we look for is an increase in activity levels and for it to spread to all areas of the market. “When” is the $64,000 question. The best we can do is look back at past cycles for some inspiration.
One thing is clear, no two property cycles are quite the same, but they all have one thing in common. They were all ignited by “easy money” and ended when the money ran out.
1971-75 was led by the licensed short-term deposit-takers in the wake of the Barberboom and ended with the secondary banking crisis.
1978-83 was fuelled by the long-term investing institutions as they tried to escape excessive levels of inflation.
1985-91 was again led by short-term lenders, but this time the authorised banks.
While hangovers are never pleasant, at least in 1981 the assets ended up in the right place when the music stopped — in the hands of the long-term investing institutions, albeit that they had too much at the wrong price.
The other two cycles ended with banks facing two problems: the property ended up in the wrong place and with large losses likely to be crystallised on realisation. At least this time the banks are large, better placed to withstand shocks and therefore have more time to liquidate the security.
By far the biggest problem will be to get the assets into long-term homes and also to repair the damage to confidence caused by the memory and the effects of these cycles. This need not be a fatal problem for the property industry, but it does call for the readjustment of the policies and practices of all those involved, including the banks.
That a change has occurred in the confidence of some investors as a result of these cycles is obvious from the way in which their investment policies have altered.
At the outset of the vogue for property in the 1960s the fact that property prices might be volatile was never fully appreciated by many pension fund trustees. The advent of performance measurement in the 1970s forced this upon them, since properties have to be valued every year in order to calculate “total return” for a comparison against each of the other asset classes and also for relative performance purposes against other pension funds. They also came to realise that you cannot engage in tactical asset allocation so far as property is concerned, because it is not so liquid an asset as the other components in the pension fund, such as equities and fixed income securities.
Many smaller funds now appear to believe that they cannot accept volatility, illiquidity and returns which in the medium term appear to be less good than those from equities, particularly when coupled with intensive management, and now the recognition of depreciation and the need for heavy capital expenditures that go with it.
The very large pension funds have been somewhat more pragmatic, taking a strategic decision to continue to diversify at least part of their portfolios into property. However, even their property proportion has been halved since 1981 in order to produce flexibility and, more important, a total fund return that is seen in the lean years for property to be not too far distant from that of the median pension fund.
I am sure that many of you will have seen the chart (Fig 1) which shows the pension funds, like the Duke of York, marching up the hill until 1980, when annual investment peaked at £900m, and then down the hill again, to a point where, in 1990, there was net disinvestment of over £200m. The weighted average proportion of assets in property (Fig 2) has declined from around 23% in 1979 to an average of around 8% and the small funds from 10% to around 2%. The total median is around 4%.
A slightly different picture emerges for insurance companies, as can be seen from the asset shares of total investment holdings (Fig 3). While the average has slipped from around 22% in 1981, average investment in property is still around 14% of total portfolios. However, the upwards slope on the curve since 1985 is misleading, since it represents only the sharp upward movement in values in 1985-86 rather than a change in policy, because there are clear trends to suggest that net new investment is being reduced.
On the other hand, equities have seen a steady increase in investment to an average of around 40%, entirely as a result of their superior long-term performance.
The insurance industry at least recognises property as a core-asset class and certainly a better alternative than fixed-income securities, which have been dropping steadily since 1980. It is noteworthy that some of the insurance companies have been among those who have been “bottom fishing” and who have recently helped the rather tentative restart of the property market.
The pension funds from 1977 to 1986 produced almost 50% of net investment in property by the long-term investing institutions. When the market became liquid again, around 1985, they progressively reduced their proportions of net new money until they were net disinvestors in 1990. All this corresponded with the time when bank lending to property companies was set to soar.
In other words, as one long-term investor was getting out of the market, the short-term providers of funds were dramatically increasing their exposure when one of their avenues for permanent take-out was closing. In reality the position was being exacerbated, since the pension funds were selling assets to property companies which were then provided as security to the banks for further loans.
At the time it corresponded with a bull market in property shares, which enabled companies to come to the market with either new issues or rights issues to finance the equity for these purchases and their new development activities.
Bank lending on property (Fig 4) has now reached £37bn and is forecast to exceed £40bn shortly. It is interesting to look at the source of these funds and the changes that have taken place since 1976.
In this period, overseas banks took over a significant market share — more than 43% compared with around 22% in 1976. Nevertheless, the UK banks still hold 57% of the total, which approaches 10% of all loans outstanding, more than twice the size in 1984.
Since the banks are in the business of only providing short-to-medium-term finance, they obviously look to their customers to refinance a large part of these facilities with long-term investors. However, even in their heydays the most the funds ever committed in direct purchases and funding was in aggregate only some £2bn a year.
Clearly we have a log jam of major proportions, with a low and reducing appetite from the long-term investment institutions and indigestion among the banks. Undoubtedly, until the size of their property book is reduced in both relative and absolute terms, banks will be reluctant lenders to the sector. In itself this creates a vicious circle, particularly since overseas banks are in a similar position in their own countries. This time around, there is no easy or quick short-term fix.
Looking back on the development front, what emerges naturally mirrors the flow of funds — a huge spike in development in the period 1985-1990. It is interesting that the scale is both greater and contains numerous differences from the previous cycles.
Retail
Encouraged by the consumer boom of the period and some retailers’ quest for market share at almost any price the cycle produced some 55m sq ft in five years alone. However, 64% of this was in out-of-town shopping in one form or another.
Fig 5 shows the rapid emergence of out-of-town shopping, dominating completion of town centres. There is in addition still some 23m sq ft under construction of which some 10m is out of town. By any standard all-time records were being made for new retail development.
Offices
New records were also established in this sector, with annual additions to office stock peaking at an all time high of 35m sq ft (Fig 6).
The cycle was initially driven by central London, with developers responding to the onset of Big Bang and the need for dealing floors and hi-tech buildings.
In central London alone, including Docklands, some 27m sq ft is still under construction. The feature here was the emergence of business parks with about 16m sq ft completed (Fig 7).
Industrial
In the industrial sector additions to stock (Fig 8) peaked at around the 1980 level and well below the peak of the previous cycle. Currently there is some 23m sq ft of space under construction. While the sector quickly comes under attack in a recession, the oversupply would have been made even worse had it not been for the arrival of the B1 category. In a sense the problem has been transferred into another sector, which is not unwelcome news for the industrial market.
The pattern overall, then, is the now familiar one of past cycles of overborrowing by developers and considerable oversupply of space, particularly in central London offices, B1 and retailing. Also in every other category throughout most of the country, there is several years’ supply of space. An obvious casualty, until this overhang of vacancy can be cleared, will be rental growth, not to mention capital values.
It must be apparent from this, since the pattern clearly mirrors that of the 1979-83 boom and the years that followed, that the next development cycle will be deferred until around the middle of the decade. However, what is needed most in the meantime is the restoration of healthy markets for lettings and investment properties.
In the wake of the collapse in 1973 the institutions came to the rescue and then went on to fuel the following boom in 1979-81. Thereafter they retrenched and were replaced by the banks, who started off the next cycle and have dominated the field ever since.
The question now must be, will equity again come to secure the equilibrium. Frankly, I think that a “sea change” has taken place. While direct long-term investment will continue, this can now provide only part of the solution, since it is clear that the majority of pension funds appear to be in the process of leaving the field. It is also apparent that some of the other long-term investing institutions have reappraised their asset shares, and this has resulted in a reduction of cash flow for property.
Consequently it follows that, unless something changes, equity will emerge only slowly to replace bank debt. Creativity will therefore be needed, involving a combination of the use of term debt in addition to making the most of the reduced flow of equity/direct investment from institutions and private investors.
It will be interesting in future to see the pendulum swing back, with long-term debt financing a major part of property development.
In the years following the war, property companies used debentures and mortgages at fixed rates of interest, which left all the equity to the developer. That was fine until inflation and interest rates rose and the supply of funds dried up. Sale-and-leasebacks followed and they ceased to work when the top slice left to the developer became so thin as to become unattractive. In turn this led to short-term trading, which was the death knell of the last cycle.
The major problem for the property industry and investors alike during the past 20 years has been the ease of entry and access to funds by new entrants, almost irrespective of experience and covenant value. Competition eroded returns to a point where at best, over the medium term, the shares of property companies mirror the index or, at worst, go bust. As for the institutions who hold property direct, their return is below that of a passive investment in a basket of ordinary shares, in spite of increasing volatility, illiquidity management and regular calls for capital expenditure. Clearly the risk/return balance is wrong: property has been mispriced in the market and pension funds have been signalling this for some years by selling.
However, I believe that commercial property has inherent attractions. We will now go through a period of readjustment to a point where property can clearly be demonstrated as having as good a prospect as equity shares, without having to make heroic assumptions on growth and with proper allowance made for depreciation and capital expenditure.
Had there been a sufficiently strong supply of good investments of institutional quality, we might by now have seen the full extent of the adjustment in yields necessary to provide a meaningful and continuing flow of investment funds. The reason for the weak supply might be that there is little of institutional quality in overgeared property company portfolios or that the liquidators are not prepared to sell into the present market — probably a bit of both.
An analysis of bank lending, following market research recently carried out by Chesterton indicates that about a third was in respect of developments. These development portfolios are more likely to be the main source of prime institutional quality investments once they are completed and let. However, under certain circumstances institutions and the well-capitalised property companies might take out these developments now.
The approach to the projects which may have been “orphaned” following the demise of property companies will need to be creative. Those who take them over should provide the “patient money” to finish off the projects in some cases and to carry them through the lengthy and highly competitive process of trying to let the buildings with the attendant cost of advertising and running expenses. The risks are high and the patient money could run out before the job is finished.
These instances are like venture capital transactions and will require similar leveraged structures. The risks and time-scale are similar and equity will need an equivalent return. Since the outstanding amount of development dwarfs the annual supply of direct investment/equity and not many institutions will wish to play, bank debt may have to be renegotiated and left in place with new equity funds oiling the wheels. It is unlikly that new lenders will finance what are now speculative projects, since most face similar problems. Therefore, these properties will end up as long-term portfolio investments.
The ultimate home for these existing development loans will probably be in either the commercial mortgage market or the securitised debt market. Once the properties are let and income-producing, the loans are seasoned and could be packaged as bonds. Our entry into the ERM, with the cross-party commitment to the disciplines that are involved, will lead to European low levels of inflation. In turn this will lead to long-term stability of sterling, make our bonds more attractive to overseas investors and increase the size of the market, since European and many other foreign investors have a much greater appetite for fixed-income securities than we have in this country.
The remainder of bank debt consists of loans on investment properties. Most of the investment property sold by the institutions since 1985 has been to property companies and to private buyers who pledged them as security for loans to facilitate the purchase. The institutions obviously will not want to buy these back, even at reduced prices, since they were sold because they no longer fitted in with investment policy.
These properties will be around for a long time and the fact they are will serve a purpose. However, they are income-producing and are now high-yielding, or will be, through rent reviews. These, too, may have to be helped out through the door. We can only speculate on possible solutions. However, the tools are there and have been used in the USA in similar circumstances; they include combinations of the following:
- Purchase money mortgages with the vendor providing the purchaser of the property with a mortgage facility for a very large part of the purchase price.
- Equity swap for debt in property companies where part of the debt is converted to equity, with part of the debt turned into a mortgage. Mergers between companies, where the strong take over the weak in a paper-for-paper swap, are a possibility.
- Packaging of debt/mortgages into a bond — credit enhanced as necessary and then sold into the bond/securities market. Today it is possible even to securitise credit card receivables in the Eurobond market.
Undoubtedly, as we pass through this year into next, interest rates will drop progressively. Bond yields will follow down as inflation falls, making it increasingly more attractive to sell mortgages and bonds. All this will generate activity and move us forward in the cycle.
As for the traditional direct institutional market, this seems likely to remain thin until prime developments are completed, let and become available for sale. The institutions themselves own almost the whole of the stock of seasoned prime investments, and while some might want to continue with the regular process of portfolio reorganization, they will be reluctant to do so in what they consider a distressed or buyers’ market.
However, later this year or early next, there should be an improvement in the letting market, which is vital to the cycle. Falling interest rates, an improving economic environment and a bouyant stock market are clearly pointing to an upturn.
Next year should be good for the UK equity market as it looks forward to the return of growth in corporate earnings. By comparison, the total returns for property will not appear good and, as a result, some investors may be inclined to reflect on their policy to property. To these I would say “Don’t quit now”.
Those who regard property as a core-asset class and can take a strategic view on the emergence of returns now have in prospect returns which in the medium term will compete with equities. This is essential in order for property to improve its position, since it has to be recognised that life assurance and pensions are savings products and that it is a competitive business. We have to stand by the quality of the returns that we produce from managing these pools of the nation’s savings.
I am optimistic about the longer-term future for a number of reasons:
(1) The next 20 years will not look like the last two decades: in one sense they were an aberration. Too much money chased a new type of product for the pensions market, which led to overproduction. In future there will be greater control over the flow of funds into the sector.
(2) There will be fewer players in the recognition of the facts that the business is management-and capital-intensive and contains risks. Shopping centres and office blocks, for example have to be refurbished relatively frequently. The scale of some investments exceeds £50m, and only the largest long-term investors can cope with these.
(3) The overhang of secondary properties will be with us for a long while, serving to discourage short-term financiers from mismatching their liabilities with long-term investments.
(4) Long-term debt will be much more important: it will be needed to complement the reduced supply of direct investment and equity from the institutions. Therefore, development will be undertaken only on returns that match risk and that will allow long-term debt to be put in place. This will provide a resurgence and a rationale for publicly quoted property companies and also the prospect of outperformance. In future it will simply not be possible for developers to contemplate £100m schemes for a gross initial yield of 7%, and they will not have to do so, since the money will not be there.
For all these reasons and more, I believe that during the 1990s and beyond we will ultimately achieve a much better balance between supply and demand which will remove the excesses from the cycles and make them manageable. Growth will come much more evenly, rather than in those exaggerated bouts of fits and starts that we regretfully have come to expect.
Restarting the cycle, then, is about clearing away the fall-out from the last one, leasing the vacant space, helping those with problems to sort them out and permitting new growth to emerge. The next chapter, I believe, will be different from the last but the message for property remains the same: it is all about long-term investment and not short-term speculation.
