Opportunities in the Property Investor Sector

Opportunities in the Property Investor Sector


Stephen Johnson, Commercial First’s Sales and Marketing Director.

In its recently published annual Financial Risk Outlook, the FSA highlighted the fact that overall capital values across housing and commercial property have declined 11.7% from their peak in July 2007, and may continue to do so. In the context of falling prices, lenders are predicted to lower LTVs, raise rates and tighten credit criteria to mitigate the risk of loss. 

This all sounds like bad news - both for established commercial mortgage brokers and for residential mortgage brokers looking to diversify into the commercial property sector, who could see their scope for earning fee income much reduced.  However, there are new opportunities that can be seized, even within current market conditions, and especially within the investment sector that makes up such a high proportion of the total commercial mortgage business transacted.

It is generally acknowledged that the greatest potential for investment is always when markets are at their weakest, because this is when investors will have an opportunity to snap up a bargain.  Successful commercial property investment depends on the economic relationship between capital values, the rental income generated and interest rates. Capital value divided by annual rental income provides a value for the yield.  Most sensible commercial property investors will try to ensure the deal is self-funding, ie the rental income services any debt on the property with some headroom for expenses, interest rate movements and any voids that may occur - although the length of the lease and tenant covenant can minimise this last risk.

Our interest rates were sub 4% just a few years ago, with average property yields between 6% and 8% for good covenants. Most investors would borrow between 70% and 80% so the rental income alone could service a mortgage of around 5% per annum on say 80% of the property value.  Rental income can often lag behind property values as landlords can only increase rents at certain periods in a lease so it invariably means a time delay occurs between trends in values and rents. Now we are faced with the reverse situation in that base rates are 5.5% and commercial yields between 4% and 6% as the values have outgrown the rental income from tenants.

Many investors bought at low yields speculatively during  the bull market, hoping for continued capital appreciation and/or quick rent reviews. Consequently, there are now many investors with property that does not service debt - especially as rate increases have increased their funding costs, capital values have actually decreased, and wider negative economic sentiment is limiting their ability to increase rents to existing tenants or find new ones.

There will undoubtedly be a number of distressed sellers during 2008 who need to exit their property because there is a funding gap on the debt that the property cannot service.  Savvy investors that are able to service this themselves and take a long term view to the investment will be the fortunate ones who, despite potentially over paying in the past, will still enjoy a performing investment.  Investors could also see this year as an opportunity to enter the market because the outlook appears attractive.  Interest rates are predicted to fall to between 4% and 4.25% if you believe the futures market, capital values have already fallen since their peak (see above) and rents are starting to catch up.  Now, yields look like being 7% to 9% and funding costs between 5.5% and 7% and the numbers work.  Both investors and owner occupier businesses should be able to take advantage of these numbers and the increased supply of properties on the market. 

As we face up to the threats of a slowing global economy, continued distress in the capital markets and nervousness around property values, we cannot expect an easy 2008.   However, credit becoming harder to obtain has gifted a competitive edge to the intermediary market and a real platform for the commercial mortgage broker - those that can identify the opportunities and act on them will be most likely to come through this period with their business in a position of strength when conditions improve.

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