By Sean Cronin, Soren Billing, Alex Morgan and Tom Arnold
Global real estate markets are in decline and investors are fleeing the sector as the era of easy credit comes to a dramatic end.
Global real estate markets are collapsing. From Manhattan to Malaga, house prices are falling and investors are fleeing the sector as the era of easy credit comes to a dramatic end.
The American Citigroup executive finished his speech with a warning that went largely unnoticed by the delegates of an otherwise uneventful real estate conference at one of Dubai's lesser known hotels.
He was talking about "subprime" - a word that hadn't then entered the popular English language - at least not outside America. It was April 12, 2007. What he went on to say was prophetic.
I think there will be a much more cautious approach to real estate but that is set against a much more cautious approach to investment strategy in general.
"Subprime," he said, would become a "bigger problem than people think, and may even filter throughout the world."
Stephen Coyle, then the chief investment strategist of Citigroup's property unit, would not have known that his prediction would have such personal ramifications. Within the year, Citigroup had become one of the first big casualties of subprime. On April 19, 2008, it posted a first-quarter loss of $5.1bn and cut 9000 jobs - including those of Coyle and his property team.
"I could see what was going to happen. It was plain even then. The stupidity turned into greater stupidity which turned into absurdity," says Coyle, now a fund manager at New York-based Cohen & Steers.
"We had a lot of people that got into this industry that really should never have been in it."
Around the world, the credit markets that sustained a decade of building, are crumbling. Banks worldwide are re-pricing the cost of risk, and in a sputtering global economy, property owners are factoring in lower rental income for years to come. Last week, the world got an inkling of the real cost of the last decade's property boom in the US.
The Bush administration has proposed to buy up to $700bn of bad debt in a bid to tackle the credit crisis crippling the economy, raising America's debt ceiling to $11.32 trillion. The US housing bubble that triggered a worldwide economic slowdown began in the wake of the dot com crash in 2001. Investors, wary of volatile equity markets, turned to property and kept buying amid record low interest rates.
As housing prices took off, so did the lending to subprime borrowers, many of whom would have been denied credit two decades ago. On TV, an ever-growing number of property shows compounded the belief that house prices never fall. Home makeover TV shows appeared on networks globally and a generation of buy-to-let investors started acquiring second and third homes in emerging property hot spots such as Dubai, Prague and the booming cities of new Europe.
In the US, the subprime timebomb continued to tick. Regulatory changes in the 1980s facilitated the growth in subprime lending but it wasn't until the mid-90s that the phenomenon began to gain traction. By 2007, the subprime industry was in meltdown, with adjustable rate mortgages (ARMs) to subprime lenders representing 43 percent of the foreclosures started in the third quarter of the year.
Through mortgage-backed securities (MBS) and collateralised debt obligations (CDO), bad debt had been passed on to some of the best-known names on Wall Street and in the City of London, including investment banks Bear Sterns and Lehman Brothers. The ensuing credit squeeze has had a devastating impact on both residential and commercial property markets such as the City of London, which attracted buyers from around the world.
Easy access to lending encouraged investors to acquire buildings with long leases and guaranteed rents. It was a no-brainer. The difference between the cost of lending and the guaranteed rental yield provided the profit to make the deal bankable.
But the real returns were generated by the massive increases in the price of the buildings, such as the Shell-Mex House in Central London, bought by property tycoons, the Tchenguiz and Reuben Brothers in 2003 for about $608m, and sold less than four years later for $1.69bn.
The easy money attracted an eclectic mix of buyers. Sheikhs from the Gulf bid against pension funds, property companies and even syndicates formed by accountants working in small towns across Ireland - who at one point became the largest investor group on London's Bond Street.
The bidding up of commercial property continued on both sides of the Atlantic, pushing prices higher and higher and squeezing yields to as low as 4 percent in London's prime office markets.When HSBC sold its head office at Canary Wharf to Spanish property giant Metrovacesa in April 2007, the selling price of $2bn produced a yield of just 3.8 percent for the new owners.
"The loan to value effectively became 100 percent with borrowers trumping each other in terms of price. Meanwhile yields were going down to ridiculously low levels," says Coyle.
"In the late 80s and early 90s we had a problem of oversupply and debt markets that had no restraint. In this cycle the problems varied from market to market. In New York or Los Angeles they've had decent restraint in terms of building but the lending markets showed the same lack of discipline as they did in the 80s."
China's property market, so vital to the health of its economy, has witnessed a sharp slowdown this year.
Now the real estate financing industry is in a state of upheaval which could radically change the way future projects are funded around the world.
"It's the end of the highly leveraged model," says Stephen Hubbard, deputy chairman of CBRE for Europe, Middle East and Africa (EMEA).
"We had a market because it was led by debt. The bond market was lapping up this plentiful supply of debt and this forced prices to go beyond the fundamentals of real estate performance."
In the UK, the allure that property once held is fading fast. Much like in the UAE, prices there were underpinned by bottlenecks on the supply side.
"I think come the next upturn there will be much less restriction on new housing development which is the real cause of the house price boom," says Tony Key, a professor of real estate economics at City University's Cass Business School in London.
"I don't think we'll see a return to that ‘inflation plus four' kind of growth rate in house prices that we've had for the last 15 or 20 years."
In the next five to six years, UK banks are unlikely to lend money to anything but the best projects and the highest quality borrowers.
But even after that, the heady growth of the noughties is unlikely to return.
"In a rational country, house prices nudge along with inflation, like in Germany and Holland," Key says.
London's West End, home to some of the most expensive property in the world, has seen strong interest from Gulf buyers over the last decade.
"I think there will be a much more cautious approach to real estate but that is set against a much more cautious approach to investment strategy in general," says Ker Gilchrist, head of West End investment at Knight Frank, the global property consultancy firm.
As property valuations slide, fund managers in the UK have begun to reduce their exposure to the sector. Individuals (as opposed to institutions) who have invested in UK property funds are also desperately trying to pull their money out, as the gloom deepens.
"People are reducing their weighting in real estate. The perception was that values would never fall in commercial property and it was preservation of capital from a good income," says Marcus Langlands Pearse, director of UK property at London-based New Star Asset Management.
"Of course we move into an exceptional set of circumstances and a lot of people at this point were holding 40 to 60 percent of commercial property out of their total investment holdings. We have encouraged them to diverse and spread their risk. I think people have become very over-exposed [to property] and quite rightly have diversified," he adds.
That has been underlined in recent weeks by a slew of negative property data emerging from markets worldwide. Britain's biggest lender Halifax, reported that UK house prices fell 1.8 percent in August and values had plummeted 12.7 percent since August 2007. US house prices fell for the 15th month in a row in September according to the US Office of Federal Housing and Enterprise Oversight.
Prime yields in most European markets have moved outwards in the last year-with Spain particularly badly hit- due to plunging investment activity.Even the Far East, where property markets have been less affected by the credit crunch, is starting to feel the squeeze.
China's property market, vital to the health of its economy and accounting for 10 percent of GDP, has witnessed a sharp slowdown this year.
Transactions in Beijing fell 36 percent last month, according to the country's biggest developer Soho China.
The collapse of real estate markets around the world has led to a new and more sober way of appraising the asset class according to Cohen & Steers' Coyle.
"We are getting back to fundamentals. This is about cash yields, it's about what type of returns do the rents provide to the investor after the expenses," emphasises Coyle.
"At the end of the day, what you're selling to the end investor has to be yield.
"That has to pay the mortgage. We got up to so some crazy things throughout the world especially here in the US in the financing markets," he says.
And what of the future? Coyle was correct when he predicted that the subprime crisis would become a global threat, but is the return of confidence to the market as easy to forecast?
"History has shown us that after every horrible crash there's been a great buying opportunity. It took a long time to happen after the 1920s," he says.
"I think we have the institutions in place to make sure a complete meltdown doesn't happen," continues Coyle. "But we have come close. It is truly frightening."
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