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Time to review commercial books

Julien Holmes, managing director of Crown Mortgage Management, argues that recent housing market data offers little in the way of comfort for the commercial lending sector and that should prompt lenders to assess their exposure to risk

The latest Bank of England inflation report, published mid-February, and Mervyn King’s acc- ompanying comments contained little of comfort to the commercial lending sector.

In addition to a downbeat outlook for the economy in coming months (more of which later) the report considers the current state of the commercial property market. According to the Investment Property Databank, prices have fallen by around 4% in both November and December last year, and are 10% down on January 2007. Furthermore, derivative contracts imply a further sharp fall in commercial property prices during the course of the year.

As the chart below right illustrates, both prices and total returns (defined as the sum of monthly capital growth and net income expressed as a percentage of capital employed) have fallen, although this must be put in the perspective of the 30% fall in the previous crash of 1990-92. This is set within a faltering economic environment of slowed growth and continued inflationary pressures, an environment in which many businesses are likely to struggle. With businesses struggling, the rate of defaults is likely to increase and lenders with an exposure to the commercial sector should assess their commercial portfolio with a view to actively managing properties at risk.

Retailers appear particularly vulnerable to a slowdown in consumer spending. Furthermore, it appears that many are not passing on to the consumer increases in their costs, choosing instead lower profit margins. Should the economic situation worsen and their costs continue to rise, they may well struggle. This is possibility is supported by the view of the recent Moore Blatch research which found that over 50% of lenders identified retail properties as vulnerable to possession.

If we consider the last economic slowdown of 2001/02, when growth rates fell to levels that many commentators expect to see again in the coming months, we can see which sectors were most affected by the downturn. Manufacturing, construction and transport all remained pretty constant. However, motor vehicle wholesalers saw a threefold increase in the number of liquidations, as did the provision of business services.

If a similar pattern is followed this time round, then further pressure may well be placed on office space yields, ultimately increasing the likelihood of both offices and garage spaces being repossessed.

Against this slowing scenario, there will be, in many areas, an increase in property available. Office space in London’s West End is likely to increase by 30% during 2008 and 2009 and one only has to walk through the City of London to appreciate that, with many of the investment banks downsizing, there is unlikely to be the demand for the large amount of office space currently under construction.

It is not only London that is at risk. In general, sentiment in the regions remains much more upbeat than in the capital where the mood is so strongly influenced by the City.

However, it may be that some of this optimism is misplaced.

In the previous downturn, the regions were buoyed by government spending, regeneration, a growth in consumer spending and a housing boom.

However, the government finances are currently tight, the housing boom is tailing off and consumer spending is slowing. Should economic growth fall to the lower range of that anticipated by the Bank of England, it may well be that the regions feel the impact more than many anticipate. A great deal hinges on how faltering house prices damages consumer confidence.

For lenders now is the time to review their commercial books. The property boom of recent years attracted new investors to the commercial market, investors perhaps with limited experience of managing through a downturn.

It is in lenders’ interests to consider not only the property’s vulnerability to vacancy in the event of worsening economic conditions, but also the landlord’s capacity to ride through these conditions. Only then will lenders have a real assessment of the risks their commercial books contain.

But the analysis should not be an end itself. It enables the lender to actively manage these risks, by contacting and engaging in a dialogue with the landlords they consider most at risk. It may well be that, by intervening at an early stage, some possessions can be avoided.

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