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Just getting started

Events in the real economy are starting to catch up with the valuations of listed real estate companies and trusts. The average sector discount on UK direct property companies is about 35%.

These discounts to net asset value (NAV) reflect the very high gearing of many of these companies, but also growing pessimism towards UK commercial real estate – a sentiment that seems to be well founded. For cash-rich private equity groups this may be the beginning of a bargains bonanza.

According to corporate insolvency specialist Begbies Traynor, the UK could be on the verge of seeing a plethora of retailers going bust in the new year. It reckons that banks will support many of them until then to allow them to clear stock in the run-up to Christmas.

Begbies Traynor cited 323 as being on a critical watch list with a 70%-plus chance of failing. This will potentially leave many retail sites vacant and put downward pressure on rents across the sector. The office sector will also be hard hit, with financial institutions scaling back jobs and merging or being taken over.

But that’s not all. According to some experts, about £250bn has been lent against UK commercial real estate by banks when there is only a capacity to lend £150bn. This suggests shrinking lending capability against a backdrop of slipping loan-to-value (LTV) ratios, which will see banks asking for more collateral to renew loans.

Furthermore, real estate companies probably need to raise a further £100bn in equity to bring their LTV ratios down to more reasonable levels, some observers said. And this is in a climate where there is almost no appetite to buy equity in property companies or to invest in actual bricks and mortar. Analysts predict this could lead to a flood of new buildings coming to market next year compared with relatively subdued sales so far this year.

Many of the real estate investment funds launched at the top of the real estate market during 2006–07 on high leverage will struggle to refinance. They initially stemmed the need to sell lots of real estate by refusing investor withdrawals, in the case of unit trusts. However, with banks nervous about property and in a cash conservation mode, an increase in distressed real estate sales can probably be expected next year.

For specialist private equity groups this may at last be their opportunity to start buying. With so little fresh capital available to the real estate sector, their negotiating position will be exceptionally strong.

There will be growing opportunities for mezzanine type deals and there may even be a possibility of listed real estate companies being taken private. This may well come about with the acquiescence of funding banks keen to see better collateral against their loans.

However, patience and caution should still be the order of the day. The UK economic downturn is likely to be quite bad, thanks in large part to the credit drought, and it is only just getting started. It may also drag on for quite a long time, throwing up one real estate casualty after another, which is likely to send values plummeting.

Unfortunately, events suggest that the downturn in commercial real estate may only be in the early stages, despite values having fallen by about 15%–20% already. Until now the main issue with the sector has been over-values, but now it is spreading to rentals – the source of cashflows that service the debt.

The smarter private equity players will no doubt gun for high quality buildings with equally strong rental revenues. The seeds of the next property fortunes are now starting to be sown as the fortunes of others face ruin. Such is the cycle of the markets.