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Despite a transaction uptick, the dearth of debt in the UK property sector means M&A activity remains elusive. Rob Thompson reports
In early 2008 many commentators predicted a surge in activity in the UK commercial real estate M&A market, as share prices in large property companies were trading at big discounts to net asset value - some at more than 25 per cent.
An opportunity for consolidation appeared to exist for those with equity or access to increasingly scarce debt. But the anticipated consolidation never arrived. Then, in September 2008, the financial markets were plunged into crisis with the Lehman Brothers collapse. Property values fell through the floor and bank bailouts became the norm, followed by the start of a prolonged period of loan book reviews by the banks in 2009.
Last year saw a 43 per cent increase in transaction volumes, albeit from a low base in 2009. Although we have seen values rebound considerably over the past 18 months they are still nearly 35 per cent below their 2007 peak. This rebound was largely supported by the prime market in the South East, particularly the Central London office market, with strong investor demand from sovereign wealth funds and institutions for high-quality core assets with long income.
2010 also saw some large listed property companies restarting major developments mothballed during the downturn, particularly in the City and West End, driven by a shortage of quality office product coming on stream and by rising rents.
British Land agreed to develop a new HQ for UBS at Broadgate in the City and Great Portland Estates began a major redevelopment of Marcol House on Regent Street. British Land and Land Securities also looked to spread their letting and construction risk by entering into joint ventures at their ’Cheesegrater’ and ’Walkie Talkie’ developments. With the lack of available and affordable finance, these looked like sensible moves.
As we enter the second quarter of 2011, the outlook for prime commercial property continues to be positive. However, the secondary markets remain weak, particularly in the office and industrial sectors, where pricing is reflecting increased occupier risk. Perhaps the biggest obstacle to an early recovery in the wider commercial property market is the debt mountain of approximately £250bn, £160bn of which is set to be refinanced over the next five years.
Borrowers face the need to raise greater amounts of capital to obtain debt financing for both new deals and refinancings. A De Montfort University/Savills study last year estimated that there is only £115bn of new lending capacity over the next four to five years, with lenders continuing to demand low-risk lending criteria comprising higher margins and maximum loan to values of between 60 and 65 per cent.
De Montfort also reported that the aggregate value of debt secured by UK property fell by 6 per cent between the end of 2009 and mid-2010. With the introduction of the Basel III banking regulations, this is likely to decline further.
As the large UK real estate investment trusts have now stabilised their balance sheets and reduced their borrowings following a programme of rights issues and disposals in 2009-10, consolidation looks less likely than in 2008. Those with cash and proactive management teams look likely to pursue more individual asset transactions in the prime sector in 2011 (although there may be a move towards buying good-quality, higher-yielding secondary assets rather than risk overpaying for prime stock) rather than a raft of corporate activity. Buyers may be reluctant to take on tax liabilities and employment issues unless they can find significant discounts in share prices to net asset value. Yet CBRE recently estimated that across the quoted sector the average discount was just 3 per cent to net asset value.
The focus for the rest of 2011, then, looks like being on strategic deals such as CBRE’s recent acquisition of most of ING’s real estate investment management operation. Some of these deals may focus on asset management opportunities rather than outright ownership.
The lack of debt will continue to be an impediment to corporate activity in the sector for many new deals as well as refinancings, although there are signs that some property companies are looking at innovative ways to plug the funding gap. Lenders can still be expected to back strong assets, but the position remains a lot less certain in the secondary markets. If banks do decide to go down the route of more forced sales in 2011 then there are a number of investors, such as Delancey and Max Property Group, well-placed to exploit any opportunities.
Overall, then, despite signs of more M&A activity in the US, given the wider economic uncertainty at home, there are still few indications of a raft of M&A activity in the real estate sector in the UK for 2011.
Rob Thompson is a partner at Irwin Mitchell