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

LXi REIT

21/10/2022 07:57

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      Borrowing costs set to soar over next 5 years
    

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      Some firms already ditching fundraising plans
    

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      Rents under pressure as tenants trim property requirements
    

  
 (Adds detail about cancelled REIT capital raising)
    By Sinead Cruise, Elizabeth Howcroft and Lucy Raitano
       LONDON, Oct 21 (Reuters) - Owners of Britain's largest
malls, skyscrapers and industrial hubs face hikes in borrowing
costs and a recession that could depress prices by up to a
fifth, forcing lenders and investors to reassess their appetite
for commercial property.
    Developed economies globally are grappling with far-reaching
consequences of an end to years of ultra-loose monetary policy,
which kept asset prices high and the cost of debt low. 
    So far, nowhere has the shock of this reversal hit harder
than in Britain, where clashes between policymakers on how to
revive growth and halt inflation have triggered a dramatic
repricing across sterling money markets.
    As homeowners reel from a sudden surge in mortgage costs, a
spike in five-year UK swap rates has also sent chills across
Britain's $1.6 trillion commercial property sector, where asset
prices could slump by as much as 20% by end-2024, analysts at
Goldman Sachs said.
    Data from MSCI, which tracks monthly changes over 1,794
properties valued at around 37 billion pounds ($42 billion),
showed values fell by 2.6% in September, the largest monthly
decline since July 2016, the month after Britain voted to leave
the European Union. 
    Commercial property investors like real estate investment
trusts (REITs) rely on being able to earn more in rents and
profits from sales than they shell out in expenses, including
costs of debt and equity capital.
    Bellwethers like Land Securities  LAND.L , British Land
 BLND.L  and Hammerson  HMSO.L  have pushed major refinancing
beyond an expected mid-2023 peak in Bank of England's benchmark
rate, earnings statements show. 
    But good financial housekeeping is just one challenge, as
labour, fuel and commodities expenses also raise risks of
cash-strapped tenants handing back their keys. 
    Although less exposed to risky property loans than before
the 2007-2008 global financial crisis, banks are already on
alert for breaches in loan terms linked to an asset's market
value or the rental income relative to the debt secured on it,
sources said.
    If these terms, or covenants, are breached, investors may
need to refinance earlier than planned, at higher rates. Goldman
Sachs analysts predict gross finance costs for the listed UK
real estate firms it covers may rise by 75% over the next five
years.
    James Liddiment, managing director in Real Estate Advisory
Group at Kroll, said commercial property prices were already hit
by higher borrowing rates, which were a fundamental cost for
occupiers and investors alike.
    "Given the likely number of those impacted, and the level at
which rates are projected to rise, lenders may be forced to
agree covenant waivers in an attempt to stabilise loan books,"
he told Reuters.
    UK REITs are using less leverage now than before the
financial crisis. But as property values dip, average
loan-to-value ratios have crept up to 28% from 23% at the start
of the year, according to Zachary Gauge, head of real estate
research at UBS.
      
    OCCUPATIONAL HAZARD
    Worries about financing costs follow years of concern over
rents for some REITs, as the pandemic emptied offices, shops,
pubs and restaurants, reducing businesses' demand for space.
    UK office occupancy rates were around 30% in recent weeks
compared with an estimated pre-pandemic average of 80%,
according to Remit Consulting.
    Leisure and retail property vacancy rates also remain above
pre-pandemic levels, Local Data Company figures show, at 10.6%
and 15.4% respectively. Footfall at UK retail destinations is
down around 15% on average in 2022 compared to 2019, according
to Springboard data. 
    Central London office space demand, particularly in older
buildings, is also weakening. 
    Just 2.6 million square feet (241,548 square metres) of
space was let in the third quarter, 30% down from the second
quarter and 14% below the 10-year quarterly average, CBRE
 CBRE.N  said.
    Some occupiers are scaling back to curb costs and energy
consumption, which is likely to further compress property firms'
rental incomes further.
    HSBC  HSBA.L  told staff this month it was cutting its
office space globally by around 40% from 2019 levels. 
    The lender could ditch its iconic skyscraper home in
London's Canary Wharf as part of a broader review and in the
meantime is consolidating staff across fewer floors at the
45-floor tower, reducing the occupied space by 25%. 
    Marks and Spencer  MKS.L  is accelerating plans to shut 67
larger "full line" stores over five years in a blow to its
landlords and nearby businesses.
    Uniform Business Rates (UBR), a tax levied on commercial
property, are likely to leap by 3 billion pounds next April, the
biggest annual jump since 1991, after inflation hit 10.1% in
September, the month in which rates for the following year are
set.
    "...further business failures and shop closures will result
unless the UBR is frozen again," Jerry Schurder, Business Rates
Policy Lead at Gerald Eve, said. 
    The $2.2 billion LXi REIT  LXII.L  scrapped a planned sale
of new shares expected to price at a premium to its net asset
value (NAV) to support a 500 million pounds acquisition of 18
Sainsbury's  SBRY.L  stores.
    But the government's Sept. 23 announcement of its ill-fated
growth plan sent the stock down 11%, below NAV, making it
impossible for the company to raise equity at an acceptable
price for investors, a person close to the deal said.
    Cyrus Ardalan, Chairman of LX, said that given "the
challenging macroeconomic backdrop" investors could "take
comfort" in LXI's resilient, diversified portfolio of long-dated
and inflation-protected assets, and highlighted its 100% fixed
or capped debt position.
    The stock market also signals growing investor caution
around UK commercial property, with an index of 15 UK REITs down
44% so far in 2022  .TRXFLDGBPREIC  compared with a 9.8% fall in
the wider FTSE 350  .FTLC  .
    Some international investors are also reporting British
developers' concerns about their ability to finance
construction.
    "The developer is saying: we would want to sell it now, or
we are more open to selling it now, and so much so that we are
willing to give away a proportion of (...) the developer profit
in order to keep us moving forward," Martin Zdravkov, lead
portfolio manager at German asset manager DWS, said.
($1 = 0.8906 pounds)
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UK REITs index vs 30-year gilt yield    https://tmsnrt.rs/3gqOkrb
Sterling 5-year interest rate swap    https://tmsnrt.rs/3gpauty
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 (Editing by Tomasz Janowski)
 ((Elizabeth.Howcroft@thomsonreuters.com; +44 02075427104;))