Key Issues. Continued polarisation between prime and secondary / tertiary property, with yields trending weaker.
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1 CBRE MarketView Four Quadrants Issue 4 July 2012 Key Issues Continued polarisation between prime and secondary / tertiary property, with yields trending weaker. The definition of prime continues to narrow as investors continue to seek higher quality, secure income assets. Risk is the key factor in pricing and total returns. This has been seen in all of the four quadrants, with riskier assets being discounted. Differing perceptions between investors, with some pursuing active asset disposal strategies, whilst others struggle to find suitable stock. For anything other than prime, the cost of debt increases significantly, polarising the market even further. Public market debt for prime real estate is available at much lower lending rates than private debt. Increase in the number of trades seen in non-listed funds, with focus on lowgeared prime funds. Challenging CMBS market with low levels of new issuance, and an increase in defaults of current issuance. OVERVIEW Looking back at the previous Four Quadrants, it appears to be a case of same old, same old. The uncertainty surrounding Europe endures as leaders struggle to find a solution to the ongoing economic crisis which has put unprecedented pressure on the global markets. This continues to have a significant effect within the UK markets, which have so far been unable to separate themselves from the wider economic issues. The UK has effectively seen no economic growth over the past 18 months, and GDP still rests 3.8% below the peak output seen in Q Expectations for UK growth have gradually decreased during 2012, with the year as a whole now expected to see zero growth - a disappointing result given that until Q this was expected to be a bounce back year. Business investment, long heralded as a potential driver for a UK recovery is yet to materialise, with business expectations still very negative. Business investment rose by only 1.2% during the whole of The MPC boosted Quantitative Easing by a further 50bn at the July 2012 meeting, amid further concerns from the Bank of England that the UK is in a very fragile economic state. Despite this, there are a few positive signs surrounding the economy, such as increased employment and positive retail sales growth, giving at least some silver linings on what has so far been a very large, dark cloud. For the real estate markets, liquidity and risk are two recurring themes which investors are using as the d r i v e r s f o r p r i c i n g and investment strategies. As has been the case since the second half of 2008, the spread between prime real estate and the secondary and tertiary markets has continued to increase. The definition of prime is also contracting, with many a s s e t s, w h i c h w o u l d h a v e been classified as prime two years ago, now being discounted due to less than perfect attributes. The resounding theme seen in all sectors is that of risk pricing, and the polarisation between perceived low risk and high risk., the safe haven for overseas investors, is driving prime pricing compared with the regional secondary and tertiary markets where prices are falling rapidly, despite the large falls already seen. Generally, property companies and REITs with prime portfolios and low gearing have managed to benefit from lower costs of debt. In Europe, Unibail Rodamco recently issued a 6-year corporate bond at approximately 100bp over the swap rate. Grosvenor has issued 10-year notes priced at 190bp over the swap rate. For secondary assets or those with high LTVs, margins can be significantly higher or debt is not available at all. Whilst yields for most sectors and regions are softening and values meandering downwards, for Land Securities the equity dividend yield has decreased from 4.55% at the end of 2011 to 3.92% at the end of Q The 5 year CDS remained constant over the period at circa 150bp. This flight to prime has been seen across all the Four Quadrants whether that is equities and funds, or in the cost of borrowing. This trend shows no sign of slowing down, and we expect it to continue for at least the next 12 months.
2 Issue 4 July 2012 MarketView Four Quadrants DIRECT REAL ESTATE The polarisation between the different direct real estate markets continued in H1 2012, with geographical and grade factors continuing to influence investor decision-making in the gloomy economic background. Geographical position remains the key factor, with Central still a key growth node for the UK economy, driving more solid occupier market fundamentals at present. This is further driven by the large amounts of foreign investment amid global investors seeking safe havens. Elsewhere, the direct markets have been subdued and weakening for some time, with values falling and yields for both prime and secondary property moving out as investors take a muted view over short- and medium-term property ownership in these markets. There appear to be mixed messages coming from the institutional investors; some funds are pursuing an active disposal strategy with the view that pricing has further to move out. Other funds are struggling to find suitable stock, especially at the prime and very good secondary end of the market. Despite these opposing positions, transaction volumes are low as buyers and sellers have different price expectations. Commercial real estate investment levels depressed slightly, with 7.3bn spent in Q after the 7.6bn seen in Q1. As mentioned, remains a key strategic destination and its healthy status remains a buoyancy aide for the market as a whole, with around 5bn of transactions (68%) taking place in in Q2. A significant driver of this focus on is the profile of purchasers in the first half year, with a large proportion of interest coming from abroad. Overseas investors have traditionally favoured prime property in the capital due to both the relative liquidity and trophy status the location offers. Retail property saw a slump in transactions in H1, with Q2 being the weakest quarter since 2000, highlighting the aversion to the retail sector at present. This reflects the ongoing occupier fragility seen in the UK at the moment, with investors unwilling to risk deviation from prime credentials, and prime stock currently in short supply. Page 2 Occupier Markets The second quarter saw some improvement in the trend for All Property rental values, according to IPD, as divergent sectors offset one another. This follows on from a quarter of deterioration in rental values and largely leaves rents flat over the year, with ERVs down just 0.1% according to the June 2012 IPD Monthly Index. This inertia hides the divergence in sector performance, with offices and industrials seeing improvement whilst retail deteriorated. Rental values continue to rise for Central offices and shops, with both markets benefitting from a limited supply of space and also from momentum built over recent years, particularly in the office sector. The strong upward momentum in Central office rents from the middle of 2011 did lose thrust in the face of growing uncertainties over the outlook for the economy and financial markets in Q1, but has seemingly improved in recent months. Of the three main sectors, industrial and retail rents have fallen by the largest margin in the first half, and were down by 0.4%. Offices saw growth of 0.4% thanks to a large Central weighting. Investment Markets The investment market dynamics currently at play across the UK are impacting on yield levels. With markets outside the Capital now fully swung towards a buyer s market, yields are softening and values are starting to meander downwards. The outward yield shift that started in Q1 was maintained and amplified in Q2 and the All Property equivalent yield has moved out 13bp so far this year; equating to a capital value decline of 2.0% in H1. Retail yields continue to be affected by a weak consumer sector across the UK, moving out by 10bp in H1 2012, causing the largest sector level capital value correction so far this year at 2.9%; Offices saw values fall by 1.2%, whilst industrial capital values are down by 1.5%. Prime Vs Secondary All Property Yields Source: CBRE Research, July 2012
3 FTSE Indices Analysis INDEX REIT Total Return Analysis COMPANY TOTAL RETURN (Q2 2012) TOTAL RETURN (JAN TO Q2 2012) TOTAL RETURN (12 MONTHS TO Q2 2012) BRITISH LAND CO PLC 6.38% 13.43% % DERWENT LONDON PLC 7.66% 20.42% 2.40% GREAT PORTLAND ESTATES PLC 10.80% 23.46% -8.46% HAMMERSON PLC 6.57% 25.75% -5.17% LAND SECURITIES GROUP PLC 3.23% 18.51% % SEGRO PLC -7.45% 8.45% % REIT NAV Analysis COMPANY TOTAL RETURN (Q2 2012) MARKET VALUE ( M) TOTAL RETURN (JAN TO Q2 2012) NAV ( M) TOTAL RETURN (12 MONTHS TO Q2 2012) FTSE 350 REAL ESTATE INDEX 4.01% 14.94% -7.64% FTSE ALL SHARE INDEX -2.43% 3.65% -1.08% FTSE 100 INDEX -2.13% 2.55% -0.65% Source: Bloomberg, Source: Bloomberg, DISCOUNT TO NAV BRITISH LAND CO PLC % DERWENT LONDON PLC % GREAT PORTLAND ESTATES PLC % HAMMERSON PLC % LAND SECURITIES GROUP PLC % SEGRO PLC % Source: Bloomberg, 27 July 2012 NAVs are last published dates. As these are valued differently depending on company, caution should be used when looking at these discounts to NAV. EQUITIES The start of the year for equities showed signs of positive movements. Following on from the bearish market seen at the end of 2011, both the real estate equities sector and the wider equities market saw a positive total return during the first half of the year. The FTSE 350 Real Estate Index delivered a 4.01% total return in Q (H1: 14.94%). This outperformed both the FTSE All Share Index as well as the FTSE 100, which delivered Q returns of -2.43% and -2.13%, (H1 2012: 3.65% and 2.55% respectively). However, over the year to Q2 2012, the total return for all three is still negative, with the FTSE 350 Real Estate Index delivering the lowest total return of -7.64%. In H1 2012, individual REITs have shown a similarly positive story, with the majority of the major REITs delivering positive returns. However, the negative performance at the end of 2011 has still resulted in many suffering negative total returns for the year to Q Please see the table adjacent for a comparison of individual REIT total returns. The cost of insuring against default over a 5 year period has mirrored the trend seen at the end of Looking at a small selection of real estate companies and banks, the pricing of 5 year CDS for banks is significantly higher than real estate companies. For example, at end Q2 2012, the CDS for Land Securities and Hammerson was 147bp and 152bp respectively. However, for RBS and Lloyds, the cost was 280bp and 269bp respectively. The change in spreads has slowed considerably for the real estate sector, with a broadly flat CDS curve over the past 3 months. However, there was a significant decline seen from the beginning of The banking sector has been much more volatile, with a significant increase in CDS pricing over Q With investors looking to identify stocks with strong accounts and performance, low-geared, prime real estate companies appear to offer the required level of security. This is indicated by shares trading at slight discounts or premiums to last published NAVs. The biggest premiums are for the specialists, which all show low gearing, secure cash flows and growth potentials. As in the non-listed fund space, the discounts to NAV are greater where there is higher gearing, European exposure, or secondary assets. Page 3 MarketView Four Quadrants Issue 4 July 2012
4 Issue 4 July 2012 MarketView Four Quadrants NON-LISTED FUNDS The first half of 2012 saw PropertyMatch intermediate 350m of secondary trades in unlisted UK real estate funds, continuing expansion on the trajectory seen in Volumes for the year to date are similar to those seen in the entire twelve months of last year, a total of 90 trades in 25 different funds were carried out in the UK. Non-listed funds have shown the same risk-adjusted characteristics as the other real estate sectors. Funds which are highly leveraged or in secondary assets have both traded at discounts, as well as at a much lower frequency than ungeared funds. The Mall Fund and Ashtenne are good examples of geared funds trading at large discounts. Both funds are c.60% geared and have traded at -28% and -25% discount to NAV respectively in H Funds in retail property have been by far the most liquid, with a combined volume of 171m trading in the sector. This is in contrast to the low transaction volumes seen for direct retail property. The greater transaction volume for non-listed retail funds is likely to have been driven by events in specific funds as opposed to a reflection on the underlying sector in which they are invested. Discounts to NAV have increased slightly within the retail sector, for example Henderson UK Retail Warehouse Fund which was trading at -6.75% in March, has recently traded at a 10% discount. On the whole there have been more price discounts in Retail Warehouses, with Shopping Centre fund pricing remaining more stable. Balanced funds have also traded in abundance during the first half of the year. A total of 30 trades to the value of 78.5m took place in seven balanced funds. Pricing has moved marginally lower, with BlackRock and Threadneedle now trading at small discounts of 50bps and 25bps respectively, down from 100% of NAV at the beginning of the year. The only funds seeming to defy sentiment are Hermes Property Unit Trust and Lothbury Property Fund which have traded at premiums of circa 2%. The UNITE UK Student Accommodation Fund continues to be one of the most liquid funds on the platform, trading four times in the first six months of the year and once again there is active buying and selling interest as we move into the H Page 4 DEBT The availability of debt financing continues to pose a serious issue for real estate investors. The days of easy financing are well and truly over, and despite some evidence that competition is returning (albeit at the very prime end of the market), the overall cost of debt is high relative to swap rates. The preference of direct investors for prime is shared with lenders anything other than prime or very good secondary is highly unlikely to achieve any financing at all, and even if finance is made available, it will be at a very low LTV ratio and high overall borrowing cost. For secondary or high LTVs, lenders are pricing the risk aggressively, and margins are considerably higher than have been seen historically, resulting in a relatively high overall cost of finance. This lack of finance has increasingly put pressure on asset pricing, with investors often unable to source the debt required, or at such high cost that values are deflated further. As always in these secondary markets, cash is king, and vendors not using leverage or only requiring minimal debt are put in increasingly strong negotiating positions. Banks and other historically active lenders continue to look to decrease, rather than increase, the size of their loan books. This trend is likely to continue in the coming months due to the Basel III s tier one capital ratio target, and the additional uncertainty surrounding the impact of slotting on new issuances for UK banks. In the short-term many banks will be reviewing their lending activities, with a focus on finding an exit or restructuring for their high risk loan books. The lending market continues to follow the trend seen in the last report, with many of the historically active lenders, especially the German banks and funds, withdrawing from the UK market entirely. Over the course of last year, five previously active lenders withdrew from the market. Since the start of the year, four additional banks have announced their withdrawal from new lending: Clydesdale Bank, Yorkshire Bank, Nationwide Building Society and LLB.
5 This is creating an opportunity for new, legacy-free entrants to the UK lending market and we are seeing an increasing number of insurance companies and other non-traditional lenders becoming active. New entrants are also attracted due to the perceived higher risk-adjusted returns. This has been helped by Solvency II regulations, which have meant that nontraditional lenders will potentially have a lower cost of capital. Looking at the whole of Europe, activity in the loan sale market has continued to accelerate. There has also been an increase in interest from senior lenders looking to provide the more complex loan-on-loan senior debt financing to support loan portfolio acquisitions, prompted mainly by the sustained high market-driven margins. For example, Lone Star s acquisition in Q2 of Société Générale s 200 million non-performing European real estate loan portfolio at around 40% discount was financed by Bank of America Merrill Lynch providing loan-on-loan financing of around 50% LTV, priced at between bps above 3-month Euribor. Lone Star s acquisition of 960 million of notes from Deutsche Bundesbank (Project Excalibur) was financed with a near 300m senior loan from Citigroup and Royal Bank of Canada, priced at around 600 bps above 3-month Euribor. Both lenders also financed Lone Star s acquisition of Lloyd s 900m loan portfolio (Royal) which closed at the start of the year. Again, the pricing is thought to be around 600bps above 3- month Euribor. CMBS Given the difficulties seen with CMBS issuance over the past four years, it will come as no surprise that with the difficult economic climate as well as the significant capital value falls in the real estate market CMBS issuance is likely to remain restricted for some time. Additionally, UK investors are seeing increasing number of missed redemptions on CMBS issuance. Recapitalisations in the CMBS space remain challenging with so many conflicting creditor requirements as illustrated by ELOC 27 (Citypoint) where a restructuring proposal was blocked by one creditor group. Investors have also been put off by a low level of transparency, poor documentation, and Class X note structures prioritising originators. It is clear there needs to be a fundamental shift for the market to return. The Commercial Real Estate Finance Council Europe has launched a consultation document for CMBS 2.0 Issuance which hopes to address these issues, and provide a more investor-friendly framework in order to stimulate the CMBS market. There has been some new issuance seen in the first half of the year which is typical of more usual CMBS markets. One example is the 210m DECO-MHILL, which was backed by the Merry Hill shopping centre in the UK. The 145mn AAA was tranche priced at 300 bp over Libor and was fully subscribed. There was also a fifth issuance by Tesco, for a 29-year fully amortising fixed coupon with an issuance of 450.5m. However, this was more of a target for real money investors, as opposed to more typical CMBS investors. For existing CMBS issues, we have seen an increased trend for Special Servicers to adopt liquidation strategies on either a consensual or non-consensual basis. However, the relatively long tail period to most note maturities is likely to limit the volume of liquidations in the short term. It still appears that the hard deadline imposed by the legal final maturity dates of the CMBS notes will be the main catalyst for restructuring success. The Opera Uni-invest deal is the current template for this, but most legal final maturities are in 2014 and beyond. The wave of maturities for vintage issues is now in full swing and has seen a marked decrease in repayments on maturity, illustrated by the fall in the Fitch repayment index to 40.3%. This index is widely expected to fall further, reflecting the generally secondary quality of the underlying real estate originated in 2006 and For the core CMBS product issuances, the pricing of senior CMBS has generally been higher since the start of the year. However, despite spreads on AAA bonds being down by circa 50 basis points, prices are still below those levels seen a year ago. Pricing on more junior bonds has been far more volatile and in many cases pricing has reduced reflecting the deterioration in secondary quality real estate the higher likelihood of losses through early liquidation. MarketView Four Quadrants Page 5 Issue 4 July 2012
6 Issue 4 July 2012 MarketView Four Quadrants INVESTMENT ADVISORY Investment Advisory provides institutional, financial and property company clients with real estate investment advice ranging from global portfolio strategies to asset lease restructuring. There are numerous ways in which investors can gain exposure to commercial real estate. Our platform provides the infrastructure to evaluate and assess alternative investment mediums to best meet client s objectives where the investor wishes to retain executive decisions. For more information regarding this Four Quadrants report, please contact: CBRE Real Estate Finance Investment Advisory Anthony Martin Executive Director Investment Advisory CBRE Real Estate Finance t: e: anthony.martin@cbre.com Rod Lockhart Director Investment Advisory CBRE Real Estate Finance t: e: rod.lockhart@cbre.com Disclaimer CBRE Real Estate Finance Limited (CBRE REF) is an appointed representative of CBRE Indirect Investment Services Limited which is authorised and regulated by the Financial Services Authority. Neither the information, nor any opinion expressed herein constitutes a solicitation, or recommendation by us of the purchase, or sale of any securities, or any other financial instruments. The material provided by us is intended for the sole use of the person or firm to whom it is provided. Any reproduction or distribution of this overview, in whole or in part, or the disclosure of its contents, without our prior written consent is prohibited. Nothing in this document constitutes accounting, legal, regulatory, tax or other advice. CBRE REF do not accept any responsibility to any person for the consequences of any person placing reliance on the content of this information for any purpose. The information contained in this document, including any data, projections, and underlying assumptions are based upon certain assumptions, management forecasts, and analysis of information available as at the date of this document, and reflects prevailing conditions, and our views as of the date of the document, all of which are accordingly subject to change at any time without notice, and we are not under any obligation to notify you of any of these changes. Page 6 Michael Haddock Senior Director EMEA Research and Consulting t: e: michael.haddock@cbre.com Tim Monger-Godfrey Analyst Investment Advisory CBRE Real Estate Finance t: e: tim.monger-godfrey@cbre.com
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