Property Crumble

Commercial Property Time Bomb?

The affect of the commercial property sector – which is linked to the health of companies using warehousing, offices or retail space – on the residential property sector should be negligible.

Sadly, this decoupled effect isn’t going to work in this property recession.

Here’s why:

Residential property values are closely linked to the ability and willingness of banks to lend or issue residential property mortgages (okay, also known as home buyer mortgages).

The growth in prices in the US and UK and other developed western European economies since 2004 has largely been a result of increased credit and not fundamental shifts in demand or capacity to purchase.

Therefore, the role of finance in determining property prices has grown significantly in the past 5 years such that what affects the banks now directly and significantly affects the availability and price of residential mortgages and therefore house prices.

Remember that at the peak in 2007,

the average loan was 5 times annual salaries where as the typical average was closer to 2.5. Therefore, we argue that the level of lending was double the normal rate and therefore needs to reduce.

So, if banks get hit with bad loans, then they will retrench to a lending level closer to the long term average.

And what might hit the banks? Well, initially not residential property and probably not companies loans, so what might cause the problem?

The answer is commercial property.

As this FT article skillfully points out, the amount of commercial property debt maturing (ie needing to be refinanced) in 2010 is nearly 170% of the 2009 rate of US$65 billion.

In fact, the situation will continue to get worse in 2011 with US$164 billion worth of commercial property loans requiring refinancing.

And the question is, will the banks be willing and able to offer new loans and will the terms of the loans offered keep the commercial property owners in business or force them to sell at distraught prices?

Curiously, this question fits neatly with the view expressed by economist Roger Martin-Fagg that a bank’s balance sheet is at its worse in year 3 following the onset of a recession – that is around 2011.

And, this negative view is backed up by Martin-Fagg’s comment that the CEO of HSBC is attempting to hold onto cash in order to improve the capital ratios of his bank – in preparation of further impairment and debt write-downs in 2010 and 2011.

So, the banks are forecasting a worsening situation and slowly withdrawing credit or offering credit on worse terms for the borrowers.

By any measure then, we are facing a ticking time bomb in which the fundamentals for residential property are getting worse and will reach a nadir in 2011.

The question now is not what is the property price forecast for 2010, but what state will the property market reach by the end of 2011?

One economist is predicting 35% property price declines by 2011 for UK property. We still believe that is unlikely, but do agree that over a longer period – to 2013 – the real decline in property prices will be around 30%.

The current glut of property price rise news from developed economies’ property markets is, therefore,  a temporary bubble and will shortly be reversed as banks deteriorating credit position moves back to centre stage. This view, however, has to be tempered with the fact that today’s property market is much smaller and made up of much cheaper properties than the comparable market of a few years ago.