Analysis: Money market woes cast shadow over $1.6 trln UK commercial property sector

  • Borrowing costs will skyrocket over the next 5 years
  • Some companies are already scrapping fundraising plans
  • Rents under pressure as tenants cut housing needs

LONDON, Oct 21 (Reuters) – Owners of the UK’s largest shopping centres, skyscrapers and industrial centers are facing rising borrowing costs and a recession that could push prices down by as much as a fifth, forcing lenders and investors to slash their appetite for commercial property to reconsider.

Developed economies around the world are grappling with the far-reaching consequences of an end to years of ultra-loose monetary policy that has kept asset prices high and debt costs low.

So far, nowhere has the shock of this turnaround been harder than in the UK, where clashes between policymakers over how to revive growth and halt inflation have sparked a dramatic repricing in sterling money markets.

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While homeowners are reeling from a sudden spike in mortgage costs, a surge in UK five-year swap rates has also rattled the US$1.6 trillion UK commercial property sector, where asset prices could fall by as much as 20% by the end of 2024. so said analysts from Goldman Sachs.

Data from MSCI, which tracks monthly changes in 1,794 properties worth around £37 billion ($42 billion), showed values ​​fell 2.6% in September, the biggest monthly drop since July 2016, the month after Britain voted to leave the European Union.

Commercial real estate investors like real estate investment trusts (REITs) rely on being able to earn more on rents and sales profits than they spend on expenses, including debt and equity costs.

Leaders such as Land Securities (LAND.L), British Land (BLND.L) and Hammerson (HMSO.L) have propelled the significant refinancing past an expected peak in the Bank of England’s benchmark interest rate in mid-2023, earnings statements show.

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But managing well financially is just one challenge, as labor, fuel, and merchandise costs also increase the risk of cash-strapped tenants returning their keys.

Although banks are less exposed to risky real estate loans than they were before the 2007-2008 global financial crisis, they are already wary of breaching loan terms, which are tied to an asset’s market value or rental income relative to the debt secured on it, sources said .

If these terms or covenants are breached, investors may be required to refinance earlier than planned at higher interest rates. Analysts at Goldman Sachs predict the gross cost of financing for the listed UK property companies it covers could rise by 75% over the next five years.

James Liddiment, managing director of Kroll’s Real Estate Advisory Group, said commercial property prices have already been impacted by higher lending rates, which are a fundamental cost factor for both occupiers and investors.

“Given the likely number of people affected and the level to which interest rates are projected to rise, lenders may be forced to agree waivers to stabilize loan books,” he told Reuters.

UK REITs are now using less leverage than before the financial crisis. But as property values ​​fall, average loan-to-value ratios have risen to 28% from 23% at the start of the year, according to Zachary Gauge, head of real estate research at UBS.

Sterling 5-year interest rate swap

OCCUPATIONAL RISK

Concerns about funding costs follow years of rent concerns for some REITs as the pandemic emptied offices, shops, pubs and restaurants and reduced corporate demand for space.

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Office occupancy rates in the UK have hovered around 30% in recent weeks, compared to an estimated 80% pre-pandemic average, according to Remit Consulting.

Leisure and retail vacancy rates also remain above pre-pandemic levels at 10.6% and 15.4%, respectively, figures from Local Data Company show. On average, footfall at UK retail destinations fell by around 15% in 2022 compared to 2019, according to Springboard data.

Demand for office space in central London, particularly in older buildings, is also weakening.

Just 2.6 million square feet (241,548 square meters) of space was leased in the third quarter, down 30% from the second quarter and 14% below the 10-year quarterly average, CBRE (CBRE.N) said.

Some occupiers are cutting back on their costs and energy use, which is likely to further depress rental income from real estate companies.

HSBC (HSBA.L) told employees this month that it would reduce its office space worldwide by around 40% from 2019 levels.

The lender could abandon its iconic skyscraper home in London’s Canary Wharf as part of a wider review, and in the meantime is consolidating staff on fewer floors in the 45-story tower, reducing occupied space by 25%.

Marks and Spencer (MKS.L) is accelerating its plans to close 67 larger “full-line” stores over five years, dealing a blow to its landlords and nearby businesses.

Uniform Business Rates (UBR), a tax levied on commercial property, is expected to rise by £3billion next April, the biggest annual jump since 1991 after inflation hit September, the month in which interest rates for the following year fall, set 10.1% reached.

“…more business disruptions and store closures will follow unless UBR is refrozen,” said Jerry Schurder, head of business tariffs policy at Gerald Eve.

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The $2.2 billion LXi-REIT scrapped a proposed sale of new shares, which were expected to be valued at a premium to its net asset value (NAV), in a £500m acquisition of 18 Sainsbury’s (SBRY.L) stores to support.

But the government’s Sept. 23 announcement of its ill-fated growth plan sent the stock 11% below NAV, making it impossible for the company to raise equity at a price that investors could accept, said a person close to the deal.

Cyrus Ardalan, chairman of LX, said investors could take “comfort” in LXI’s resilient, diversified portfolio of long-term and inflation-linked assets given “the challenging macro backdrop” and highlighted its 100% fixed or limited debt position.

The stock market is also signaling growing investor caution about UK commercial property, with an index of 15 UK REITs down 44% so far in 2022 (.TRXFLDGBPREIC) compared to a decline in the broader FTSE 350 (.FTLC) by 9.8%.

Some international investors are also reporting concerns from UK developers about their ability to finance developments.

“The developer says: We would want to sell it now, or we’re more open to selling it now, so much so that we’re willing to give away a portion (…) of the developer’s profit to keep it to move us forward.” , said Martin Zdravkov, senior portfolio manager at German asset manager DWS.

UK REITs Index vs 30-year Gilt yield

($1 = 0.8906 pounds)

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Edited by Tomasz Janowski

Our standards: The Thomson Reuters Trust Principles.

Elizabeth Howcroft

Thomson Reuters

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