Fire sales coming as capital values ​​fall 35%, major reports say


With unaffordable interest payments making it almost impossible to refinance property, many UK office and retail owners will be forced to sell on fire.

The resulting pressure could reduce equity values ​​by up to 35% in a process of value destruction that will extend even to prime real estate, according to two analyzes of the state of real estate finance. Prime UK property yields of 3%-4% across many sectors may need to soar to 6%-7% to support new funding costs.

Together, the warnings from Oxford Economics and Bayes Business School show how a perfect storm has quietly gathered over UK commercial property – particularly the office and retail sectors – a storm that the recent sudden change in monetary policy could now trigger.

The bleak analyzes of rising interest rates precipitating a fall in capital values ​​are the result of UK policy shifts from fiscal and monetary loosening to extreme fiscal and monetary tightening in an effort to control inflation . This is starting to clash with the need to maintain financial stability, Oxford Economics warned in its latest bulletin.

“We believe central banks and governments have the tools to avoid the worst outcomes, but continued tightening increases the risk of an illiquidity event,” Oxford said.

“Dangerously low” interest coverage ratios, along with refinancing shortfalls, threaten to send some UK commercial property markets into distress, he added.

The greatest risk of a crash is in the office and retail sectors in the UK, where it will be difficult to meet interest payments for floating rate loans or loans that need to be refinanced, with refinancing being made more difficult by falling capital values.

“Capital values ​​rose in the first half of the year, but since the summer downward pressure has emerged,” Oxford said. “With high volatility in financial markets, growing risk of default by occupiers, tightening bank lending standards and a recession beginning to take hold, the risk of a forced sell-off and a deeper price correction has increased. .”

A funding gap looks set to emerge for retail and office space, exposing these sectors to an increased risk of forced sales. Capital values ​​of retail and office assets have fallen or been low over the past five years – the typical loan term for commercial property in the UK – while lending conditions have tightened, meaning a lower loan to value ratio is now offered compared to five years ago.

As a result, refinancing loans will be difficult, while it may be impossible to meet current interest payments.

Value destroyed

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The Bayes Business School Commercial Real Estate Lending Report has a similar analysis and highlights the underlying parameters, whose average values ​​in some sectors could fall by 25% to 35%.

It exposed the seeds of the fire sale scenario predicted by Oxford Economics, and its potentially disastrous consequences, even for prime real estate.

“Current ICR levels are now approaching 1x or less for prime property types, limiting growth in capital value, potentially causing value to fall in the near future,” Nicole Lux wrote. , principal investigator at Bayes, in the report.

“Interest payments and property income were approaching a 1:1 ratio in June 2022, and with the five-year Sonia swap reaching 5.2% at the end of September 2022, property income will only be insufficient to refinance some properties at these rates, leaving a potential financing gap.”

The risk of contagion to ostensibly prime real estate was hidden on page 54 of the report. The risk of negative equity due to falling real estate values ​​could affect not only loans and higher-lending development or secondary assets, but also the very high-end segment of the market, he said.

“The net return on property on different types of properties needs to increase to 6-7% in order to maintain a 5-7% loan interest for a senior loan. This potentially means a drop in property value of 25% at 35%.”

Interest rate woes

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The analysis then focuses on interest rates, where the Bayes report exposes the risk of further interest rate hikes. Forty per cent of UK loans are at floating interest rates, and almost half of those variable rate loans are made by UK banks, according to the report.

Oxford Economics has suggested that homeowners’ interest coverage ratios – the ratio of income before deductions to interest payments due – now appear to be stretched. ICRs are closing in on one in the markets analyzed, with Oxford Economics raising a red flag over UK desks in response to all-in interest rates doubling to 7.7%.

“The interest coverage ratio for an average UK office acquired in 2018 will be below 1.0 in 2023, posing a huge risk to the stability of the property market,” Oxford said.

Those with fixed rate debt will be protected, but with policy rates set to remain high next year, the refinancing situation looks unsustainable without debt costs retracting. It could be argued that the UK economy is an outlier, but ICRs in France, Germany and the US are also expected to be very weak in 2023, with the office and retail sectors looking the most exposed, a added Oxford.

ICRs in all sectors of the US and UK property markets are below 1.5%, generally considered a referenceand in offices and industry in the UK they are below 1%.

The situation is getting worse as Oxford “notes with concern” that direct private equity leverage has been consistently high, but relatively opaque.

“Little is known about the use of indirect leverage (at the firm or SPV level) or underwriting lines of credit (against dry powder) – both of which could add to debt total, raising the prospect of forced sales,” he said.

Oxford estimated there could be a loan gap of up to 40% on refinancing in 2023 for UK retail, which has seen capital values ​​fall by 30% since 2018. Retail is also doing poorly in Australia, France, Germany and the United States.

The lending gap in the office sector is around 20%, but “in addition, the office sector appears exposed as concerns about the overall level of future demand, given the proliferation of hybrid working, have a impact on investor sentiment and pricing”.

Only the industrial and logistics sector seems immune to loan extensions, new junior debt or new equity.

The analysis concluded that “the risk of a major illiquidity event increases” as policymakers double inflation risks.

“We believe central banks and governments have the tools to avoid the worst outcomes, but this increases the risk of illiquidity given the current high financial stresses.”


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