by Daniel Tamman
During the past few years we have witnessed a noticeable increase in the number of foreign investors buying UK property and as 1992 approaches fast we expect this trend to gather momentum.
London has long been considered a key world financial centre and consequently many multinational corporations have chosen it as their European headquarters. Indeed, most foreign companies are taking 1992 very seriously and accept that a London base is an important element of international recognition.
The single European market will not only affect the ways in which Europeans trade and conduct their banking but it will also have a noticeable effect on other markets — including the property market.
Current high UK interest rates mean stiff competition for our prime sites from foreign investors with domestic access to much more favourable financial terms.
This does not necessarily mean that the UK investor will be forced out of the market, but in order to compete effectively he will have to be more creative in his borrowing.
At the moment there are several options available from UK lenders — deferred interest schemes, for example, which add on part of the interest to the loan, and medium- to long-term fixed interest loans which can be subject to high redemption costs.
Against this backdrop of expensive sterling loans, financial advisers have been looking abroad for cheaper alternatives to offer their clients, but because of the volatility of the currency markets they have, on the whole, been reluctant to recommend them with very much enthusiasm.
Unless the borrower has a sound knowledge of the mechanics of the currency markets and can react quickly to fluctuations in exchange rates, the risks involved in taking out loans in a single foreign currency can be high.
For instance, a lender will generally advance 65% of the property valuation for a single foreign currency loan at an interest rate of the currency’s domestic base rate plus a margin of 1.75% to 2.5%.
Problems arise when sterling is weak — if the pound loses, say, 20% of its value over a year against the currency of the loan, at the end of the year the borrower will owe 78% of the value of the property. This level of borrowing will be unacceptable to the lender, and could be bad news for the borrower, especially in today’s property market.
Nevertheless, as certain safeguards exist to limit these risks, foreign currency loans can also be extremely viable propositions — provided they are managed correctly.
The risk of fluctuation in exchange rates can be limited by hedging — where, for about 1% of the loan, the borrower buys an option to sell sterling against the currency of the loan, at a rate agreed in advance.
For example — a borrower can take out a loan of £1m in US$ ($1.7m at present exchange rates), and at the same time purchase an option to buy $1.7m for £1.1m. If, at the end of the year, the pound has fallen in value by more than 10% against the dollar the borrower’s loss is limited to the first 10% of the fluctuation.
In other words, if the pound loses 20% of its value against the dollar without this kind of option, the borrower would owe £1.20 for every $1.70 of his loan. With an option he would pay back only £1.10 for each $1.70.
The choice of currency, too, is equally important — its strength against the pound and the possibility of a rise in its rate of interest must be carefully considered. The case of the Swiss franc illustrates this point: until recently, it was considered to be a strong currency with a low rate of interest — now it has weakened against the deutschmark and the yen, and its base rate has risen to 9.5% with further rises likely.
Perhaps the safest bet of all is a basket of currencies such as the European Currency Unit (ECU), which is less volatile than any single European currency and certainly deserves consideration.
The ECU is made up of a number of European currencies — the pound, French franc, Dutch florin, Italian lira and so on, in varying proportions. The DM is the most influential currency in the ECU and comprises the largest proportion. The current interest rate for the ECU is 10.75% — still substantially lower than the 15% rate for sterling.
Less subject to fluctuation, the ECU has become an important trading currency, in many cases replacing the US$. Most important of all is the counter-balancing of each currency in the ECU against the other and the influence on it of the European economy rather than the US or international economy.
A major issue, yet to be fully addressed by the UK, is membership of the European Monetary System (EMS) which will certainly affect the scope of foreign currency loans in Britain. Membership of the EMS will further reduce the risk of fluctuation and will increase the availability of European currency loans.
Whether or not we become full members of the scheme in the near future remains to be seen, however.
In addition to straightforward single foreign currency loans, or ECU loans, there is another idea which is becoming more and more popular: creative commercial finance. This is a term which we would apply to foreign currency loans secured against a bank guarantee rather than the property itself.
Step by step, this is how it works in principle: a potential borrower obtains a guarantee of, say, 75% of the property from one of the top 300 banks, using the property as security.
Certain merchant banks which do not normally lend against property will then lend up to 85% of the guarantee, provided of course that the guarantee comes from a reputable bank, in whichever currency offers the most attractive and safest terms.
The merchant bank will charge 1.25% above the interest rate of the chosen currency and, because it is constantly in touch with the foreign exchange markets and can react within minutes to any adverse changes, will be able to monitor the loan effectively. The merchant bank might, for example, recommend a loan in yen which, at today’s rate of interest and including arrangement costs, works out at 8% plus the cost of the bank guarantee. There are no redemption fees.
The higher the percentage of the guarantee or letter of credit (which is also accepted by the merchant bank) the more creative the finance becomes.
Although, despite the risks, foreign currency loans can be very attractive, they are suitably only for borrowers experienced in property dealing. The borrower should already have substantial resources, a sound knowledge of the currency markets and consider this type of financing only as part of his whole portfolio.
Any deal financed by a foreign currency loan should stand up on its own merits, regardless of the lower interest rates of the loan. Any saving on interest should, ideally, be regarded as a bonus.
Finally, it must be said that this is no DIY operation, and we strongly recommend that anyone considering this kind of transaction should approach a reputable, experienced broker who will create a package which is tailored to suit individual needs.
