Is it really different this time?

The phrase “this time it’s different” is usually a signal for savvy investors to sell and run for the hills. It frequently becomes a mantra towards the end of booms.

With the Japanese boom in the eighties, it was “different” because they had discovered a superior economic model to everybody else’s. As it turned out, Japanese companies were buying shares in each other on cheap credit, thereby inflating values to ridiculous levels.

Something similar happened to Japanese real estate. With the dotcom boom, it was because the internet had created a new paradigm, consigning the old of ways of doing business to the dustbin of history. Once again, investors became wildly over-optimistic.

Of course the phase “this time it’s different” has been applied to real estate on many occasions with an equally disastrous outcome. Yet in the UK it may, with caveats, have a genuine application.

The UK has witnessed a boom in commercial real estate thanks to more than a decade of highly favourable economic conditions. With prices having slid by up to 20% in the last year, this particular boom appears to be over. Yet where this one differs from the last big one is in the aftermath. So far, there’s been no crash.

Nonetheless, looking at the City of London, which appears to be one of the more vulnerable sectors due to the credit crunch, there have clearly been some fundamental changes.

According to Savills, during the period 1988–91, there were 26m square feet of completions, much of it speculative. For the period 2008–11 it is estimated that there will be just an extra 12m square feet.

Also, the composition of City tenants has changed. Professional firms such as lawyers are taking more space, with investment banks accounting for a smaller percentage.

This is important because professional firms tend to be less prone to mass sackings than investment banks. Also, City tenants are less likely to put lots of extra floor space on the market as they haven’t over-expanded this time.

“Doing a back of the envelop calculation, to get the vacancy rates of 18%–19% you saw in 2003 after the dotcom boom, I estimate you would probably need to see 100,000 redundancies in the City,” says Matt Oakley, a senior analyst with Savills. Most estimates peg potential redundancies at 20,000–40,000 with a few at around 60,000.

More discipline

“There’s been a lot more discipline from developers this time around,” notes Joseph Stecher, managing director of Morgan Stanley’s AIP Real Estate Fund of Funds Group.

So, although rents are softening, it’s nothing like as disastrous as after the eighties boom, when entire buildings were left empty. The problems with real estate this time around seem to be more a function of the dislocation in the financial markets. That has got many private equity groups sensing opportunity.

“You are going to see distressed sales,” says Paul Vosper, executive director of Morgan Stanley’s real estate fund of funds business. “But not deep distressed sales. So far, banks are giving their debtors time to sort things out.”

That’s partly because most of these real estate assets are still producing income. Vosper noted that many owners were over-leveraged and would have to reduce debt to be able to refinance.

“That may involve selling some assets from their portfolios to find that equity,” he says. “There could be good deals to be had from those sales.”

Another prospect, according to Stecher, is that private equity groups will provide the equity to make those buildings re-financeable. “It’s basically about providing mezzanine finance,” he says.

Yet another angle mentioned by the Morgan Stanley team is that heavily undervalued publicly listed companies could go private with private equity help. So is it really that different this time around? Well yes and no, according to Oakley.

“Commercial real estate remains cyclical and is very much tied to GDP growth,” he says. “It’s just that the economic cycles have become less volatile in recent years.”

The UK economy is currently navigating through one of those uncertain periods with slowing GDP growth and rising inflation. Most commentators expect a mild economic slowdown with inflation more or less under control followed by a mild pick-up.

However, the caveat is the warning from Bank of England governor Mervin King about the nice decade probably being over. If a nastier economic climate emerges, then another clichéd phrase springs to mind: “Plus ca change, plus c’est la meme chose.”