Commercial Property News November 2019 Compiled by Hayven Property Tax

Commercial property is always a very newsworthy topic. Here is a roundup of the latest news concerning commercial property and investments in the UK, including which sector is outperforming the rest of the commercial property sector.

Commercial Property Rents Rise by 0.4% in Q3 2019

The CBRE have released there quarterly report on commercial property rents. Whilst they report that prime commercial property rents have risen by 0.4% in Q3, the 11th consecutive quarter of increase, it is not all good news.

Retail property saw a decrease of 0.8% in Q3, better than the fall of 1.1% in Q2, and so a positive in the decline.

Prime office rents increased by 0.7% in Q3.

Industrial prime rents increased by 1.7%

In the capital:

Central London take-up was 3.4m sq ft in Q3, rising above the 10-year quarterly average of 3.3m sq ft.

Availability fell by 3% quarter-on-quarter, to 12.7m sq ft at the end of Q3.

Under offers continued to increase, rising by 5% to 4.4m sq ft.

The largest space-take of the quarter saw BT take 328,100 sq ft at One Braham, E1.

For these are more reports please visit the CBRE website.

From the same report and information “cityam” report that office sector rents increased 0.7 per cent, boosted by strong performances in central London as well as east of England, the northeast and Yorkshire and Humber.

However, retail rental values continued to decline, although at a slower rate than the previous quarter, according to the latest research by CBRE.

The decline in high street shop rents slowed to minus 0.8 per cent, from minus 1.1 per cent in the second quarter. Shops in northeast England suffered the steepest decline of four per cent, followed by a fall of 3.4 per cent in Yorkshire and Humberside.

Shopping centre rents were down 0.8 per cent in the quarter and retail warehouse prime rents decreased 1.7 per cent.

Robin Honeyman, senior research analyst at CBRE UK, said: “Third quarter results across the main sectors continued the trends seen in 2019 so far.

“A very slight easing of the downward pressure on retail prime rents meant all property rental growth returned to positive territory.

“However, the 0.8 per cent decrease for shops last quarter is still the third biggest fall for the sector in the last five years”.

Largest commercial property firm in UK to be carbon neutral by 2030

The UK’s largest commercial property company, Landsec, has announced that it plans for its 24 million square feet portfolio to achieve net-zero emissions by 2030 in line with the Paris Agreement on climate change, reports “”. Landsec, which has a £13.8 billion portfolio of office, retail and leisure property in the UK, including its flexible office arm Myo (pictured), has had its updated greenhouse gas reduction target approved by the Science-Based Target Initiative (SBTI).

At the start of 2019, Landsec’s existing sustainability strategy in place since 2017 meant the company had reduced its carbon footprint by almost 40 percent compared to  2014. However, since the original SBTI target was set, firms have been encouraged to adopt emissions goals in line with a 1.5C target and in February the SBTI tightened the criteria for its targets in line with the latest scientific warnings about climate change. Landsec’s new target to cut absolute carbon emissions by 70 per cent from a 2014 baseline over the next 11 years has now been approved by the SBTI, meaning the business will become net-zero carbon by 2030.

In order to achieve this, the firm will include a ‘shadow price’ to account for the carbon in each of its commercial property investment decisions as well as replacing a range of construction materials such as traditionally manufactured steel and concrete with recycled and low carbon material such as timber. The firm will also install photovoltaic cells wherever possible and set an energy reduction target of 40 percent across its portfolio by 2030.

Landsec claims it is already implementing these measures across its existing portfolio and new properties, with its first net-zero building planned for a 130,000 square foot office development in the London Borough of Southwark. Another 400,000 square foot office development in Southwark will be constructed using a steel and timber hybrid structure, saving 6,000 tonnes of carbon compared to traditional design, which would use more steel, the firm said.

“Landsec’s net-zero target may be set at 2030, but we’re making tangible changes to the way we do business now,” said Landsec’s director of corporate affairs and sustainability, Caroline Hill. “We’re progressing our first net-zero building at 105 Sumner Street, we have solar PV installed on nine of our assets and we have set a new and stretching science-based target.”

The hidden leverage in the UK’s commercial property sector

Commercial property is all about leverage. Investors are not just buying into shopping centres, logistics sites and office blocks. To state the obvious, they are also borrowing huge amounts from banks or the bond markets to do so, reports the FT.

But, at a time of low-interest rates and high asset prices, something intriguing is taking place in the UK. It appears that ground rent – a kind of rental payment with ancient origins in the country’s land system – is being manipulated to disguise the amount of leverage in the system.

In the UK, ground rent is subject to numerous definitions depending on which century you’re in. It is thought of as the rent you pay for the land alone, rather than buildings. If you buy a flat on a leasehold for a fixed number of years, you will need to pay a sum – typically a few hundred pounds a year – to the freeholder.

This can also apply to commercial buildings. And while the market for residential ground rent has been subject to controversy and demands for reform (a complicated but separate story), the market for commercial ground rents has risen in popularity over the past two years, especially from institutional investors seeking long-dated returns.

The average yield on commercial ground rents was 2.6 per cent in 2018 (compared to inflation of 1.9 per cent, as measured by the consumer price index). Yields are so low because freeholders have very strong security. If the leaseholder fails to pay them, they have the right to claim the property.

So what does this have to do with borrowing? In a report this week, Fitch, the rating agency, says it has learned of examples in UK commercial property of “ground rent structures that add substantially to traditional loan financing while disguising overall leverage”. This involves selling the claim to the ground rents.

Commercial Property News November 2019

Let’s take an example of how this might work. An investor buys a shopping centre for £100m and expects to make £5m a year in rent from the tenants (for the sake of simplicity, ignore all other costs). The investor might simply borrow £50m from a bank – at a loan-to-value ratio of 50 per cent – and put in £50m of its own money. If all goes well, they make 10 per cent annually, before interest costs.

But the investor can also add leverage through selling on the freehold. In the same example, the investor might buy the same shopping centre. It might then sell the freehold, which is entitled to £1m a year of ground rents. At a yield of 2.5 per cent, this would fetch £40m. The investor could then borrow £50m from the bank and put in £10m of its own money. If all goes well, they would make 40 per cent annually (receiving £4m of the £5m made in rental payments), before interest to the bank.

In effect, the investor has dramatically increased their leverage, adding to both potential returns and the risk of default.

One important point here is that many commercial property deals are constrained by loan-to-value ratios. Banks might not lend above a certain percentage LTV.

But even if they stick to, say, a 50 per cent limit, leverage can still be increased through freehold sales. If the bank noted that £40m had been raised for the freehold, and only lent another £30m (50 per cent of the total remaining value), at a higher rate to adjust for the risk, the total borrowing against the building will still be at an effective 70 per cent LTV.

As above, typical buyers of freehold claims are insurance companies or other institutional investors that cannot find adequate sources of long-dated income elsewhere. The investment is thought of as low risk because it is low risk – if a shopping centre generates £5m of income from tenants, and ground rent is £1m, something dramatic would need to happen for the leaseholder to default on the latter, and even if they did, they’d surrender the asset to the freeholder.

The risk instead increases for the other lenders. This might be a bank, but commercial real estate loans can also be sold off to investors, split into different tranches according to risk (and rated accordingly, which is where Fitch comes in), as commercial mortgage-backed security. A handful of these (all in the retail sector) have defaulted recently, but overall default rates remain extremely low.

Such lenders to a commercial real estate deal rely, ultimately, on income flowing in from tenants to the leaseholders. But with ground rent leverage, the volatility of income to the leaseholder is more volatile than the overall rental market, as Fitch points out. Here’s why: imagine, in the above shopping centre example, rental income halved, and only £2.5m came in. £1m would still be owed for the ground rent. Therefore, leaseholder income (income from tenants minus ground rent) would go from £4m to £1.5m, a fall of 63 per cent. The greater the decline in income, the more leaseholders suffer (i.e., if rent falls by >50 per cent, leaseholder income falls by >63 per cent).

Both banks and the CMBS market will surely be attuned to the impact of ground rents on risk-reward. But some of the way the data is presented – average LTVs on shopping centre loans, for example – might fail to account for the increased leverage through ground rent sales, implying that deals are less levered than they are.

It is unclear how many people are doing this – Fitch does not point to any specific examples. It’s, at this stage, an early glimpse of how things are evolving, unpredictable as ever, to accommodate new market conditions. In this case, unprecedentedly low rates have driven insurance companies to find alternative income. That desire, in turn, provides an additional avenue of leverage for commercial property investors, a sector already exposed to several thematic challenges (such as the internet’s impact on retail). In the separate but not entirely disconnected world of sales of student accommodation to retail punters, we have also come across cases where ground rents were sold on to investors.

As Fitch points out, ground rent is typically deducted from property income – an approach which does not account for the effect on the leverage of selling it, which in turn stands to impact CMBS ratings. It is perhaps precisely because ground rent is often thought of as a tiny or negligible expense that it makes for an effective tool to increase borrowing by stealth.

Cafés and restaurants outperform rest of UK commercial property market

Propertywire reports that cafés and restaurants have outperformed offices and retail spaces when comparing price growth within the UK’s commercial real estate market, new figures show.

Analysis by HARNESS Property Intelligence examined the change in prices per square foot across shop, office and café/restaurant classes between 2010 and 2017. The analysis was focused on key regional cities across the UK, including Birmingham, Manchester, Liverpool, Leeds, Bristol and Cardiff.

The data showed that the café and restaurant premises had experienced an average uplift of 8.5% over the seven-year period. Birmingham (15.8%) witnessed the fastest growth, with Cardiff in second at 10.8%.

Manchester and Liverpool saw rises of 9.9% and 9% respectively, while Bristol recorded a 6.2% rise. Leeds was the only city to post a fall (-0.52%).

Conversely, both office and retail space in those same cities declined across the board. The only exception was shops in Birmingham, where the average value increased by 11.2%.

“Analysing the changes in values of commercial property across categories and regions provides a useful bellwether for the health of different sectors,” said Ben Mein, CEO of HARNESS Property Intelligence.

“The eat-out culture has long been a firm favourite amongst the British population and has remained resilient despite being threatened by the emergence of delivery service heavyweights and a generally unpredictable economic environment.”

Bank lending against commercial property continues to grow in H1 2019

Lending grows despite the lack of property transactions and political risks reports the University of London.

  • New loan origination reached £23.3bn for the first six months in 2019, against a low with £21bn 12 months earlier
  • Lending margins against prime London offices continue to be under pressure, falling to 196bps in June 2019, especially for international lenders who have been fighting hard for winning transactions, reducing margins in H1 2019 at low LTV levels
  • UK bank loan books ending on a high in June 2019

According to the Cass Business School UK Commercial Real Estate Lending Reportauthored by Dr Nicole Lux,new lending for H1 2019 was four per cent ahead of volumes reached twelve months earlier, at £23.3bn.  Against this Costar recorded £23bn of property transactions over the same period, resulting in £1 of new debt originated for every £1 of property value transacted.

The long-term ten-year average has been 74 pence of new debt per £1 of property value, indicating that most debt originations were the result of refinancing and restructuring activity. As such only 39 per cent of new debt was used to finance property acquisitions, leaving the debt market at the risk of overheating.

Another indicator for some change in market dynamics was seen around secondary loan distribution; while syndications were slow the securitisation market has picked up significantly as an exit strategy. During H1 2019, the securitisation market announced six new UK deals, with another five in the pipeline. However, of the total 4.5bn of transactions, which were securitised, only £3bn were sourced from newly originated loans, the remainder were seasoned loans from 2017- 2018, still making room on balance sheets for new loans.

Outstanding development finance stood still, but undrawn facilities increased to £27bn during the first six months in 2019 from £22bn at year-end 2018. This indicates a further amount of development finance is available for drawdown later this year.

Pricing of loans remains extremely competitive for prime London office properties ranging from 140 – 200bps within the 25th and 75th percentile. Pricing for loans against secondary properties and locations remains 80- 100bps wider than prime, especially loan pricing against secondary retail property remains above those of other asset classes reaching 330 – 600bps for relatively low LTV’s 45 – 55 per cent.

On an annual return basis a five-year fixed rate CRE senior secured loan generated a return of 2.9 per cent compared to a five-year gilt with a return of 0.5 per cent and UK corporate investment bonds at 1.4 – 1.7 per cent in June 2019, which makes it still one of the most attractive investments in the current market. However, some lenders are experiencing pressure on loan performance on loans against secondary retail assets, and correct risk pricing is crucial.

Peter Cosmetatos, Chief Executive of CREFC Europe said:

“Dr Nicole Lux deserves praise for the increasingly sophisticated analysis presented in this research. Unlike the UK commercial property lending market, which is in its sixth year of stability, the research and analysis contained in the Cass report has not stood still.

“This report confirms the growing structural importance of less mainstream lenders. Not only does the research show the outsized role played by Other Lenders (and smaller lenders more generally) in higher LTV lending. It also shows that, with the activity of Insurers and UK and German Banks dominated by refinancing, Other Lenders and smaller lenders (along with Other International Banks) are also providing a disproportionate amount of the acquisition finance available to the market.”

Neil Odom-Haslett, President of the Association of Property Lenders said:

“The first six months of 2019 have been challenging due to a number of reasons, notably, the lack of transactions, the structural changes to the retail sector, the uncertainty that Brexit has bought and many lenders being in “risk-off” mode.  Notwithstanding these headwinds, real estate lenders have had an incredibly busy first half as they refinance their legacy loan books and reposition some of their retail lendings.  There has been strong competition at the prime end of the lending market, particularly in central London, with financing opportunities been aggressively priced by some lenders, while at the other end of the spectrum, lending against secondary shopping centres, has proved a bit more tricky and margins have widened.”

Nick Hume, Director at Savills said:

“Lending figures for the first half of 2019 are stronger than anticipated, particularly given that commercial investment transaction volumes over the corresponding period were down by 29.9 per cent.  This perhaps demonstrates a continued focus of lending towards refinancing, the main beneficiaries appearing to be the UK Banks, Other Lenders and Insurance Companies.  The debt market remains liquid and pricing is competitive, particularly for prime assets in central London.”

Ion Fletcher, Director of Policy (Finance) at the British Property Federation said:

“The bulk of commercial property lending continues to be to assets in London and the south-east, reflecting the region’s dynamism versus the rest of the country, but perhaps also reinforcing disparities in economic and social outcomes. To get lending flowing across the country, the government must prioritise extensive investment in physical, digital and skills infrastructure to increase productivity.”

The report is available to be purchased here.

About Hayven Property Tax:

Hayven Property Tax is an independent property tax consulting firm specialising in capital allowance claims for commercial properties.

Based in Cardiff, Hayven Property Tax are able to service clients nationwide.