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Building up hopes

27 Mar 08

Last year's commercial property round table foresaw challenges. But even though Northern Rock and sub-primes have hit home since then, it's by no means all gloom in the sector now

by Robert Outram

It was the only possible opening topic, and Colin Carmichael raised it: “What has been the impact of the credit crunch so far? And what is the outlook for the sector this year?”

Carmichael, head of property finance with Lloyds TSB Scotland, was chairing the commercial property round table panel, which was supported by Lloyds TSB Scotland and included leading developers, legal and financial advisers and surveyors.

John Clement, partner with surveyors King Sturge, said: “On the offices side, deal flow is pretty slow. Supply in Edinburgh is low, about as low as it’s ever been. From the agent’s point of view, if you don’t have the toys, you can’t play the game. Enquiry levels are still good, but if people can’t find what they want, they will stay put and wait.

“It looks to be a 12-month lull. At least, in contrast to the last recession when there was an oversupply, now we do not have a surplus of office property in the city.”

Clement added: “There will be more distressed assets to come through on to the market. There are institutions that would be happy to see their assets sold if they could get the right price. It’s all about sentiment.”

Miller Mathieson of surveyors CB Richard Ellis argued that pressure on funds to sell their property assets had been very high towards the end of last year but had turned lower. He said: “The big institutions have been selecting assets to sell that they know the market wants. To some extent the pressure on them is now easing. So the rate of decline in pricing has slowed down, at least for the quality end of the market.”

For Glasgow, John Clement said: “Supply is healthy but so is demand. There are a number of professional firms and others in the market, looking to move to new accommodation. Demand for offices in town centres remains good, but for out-of-town centres it is a different story.”

Aberdeen is also a very strong market, buoyed up by the price of oil and activity in the upstream oil industry, according to Miller Mathieson. He added that, generally, market pricing “is at the level that will attract buyers”.

Mathieson argued: “Any further movement down will likely be an over-correction, although I don’t expect to see the price level get back to where it was.”

Robert Dick is a CA and chairman of CALA Properties and CALA Finance. He described Mathieson’s comments on pricing as “very encouraging”. He said: “We are talking to a number of funds in London and telling them that we are interested in buying.”

Shepherd & Wedderburn’s David Mitchell warned that one of the biggest hurdles for the market is sentiment. He said: “Even a fundamentally solid deal can be affected by sentiment. If you read in the press about mass redemptions, funds having to sell everything, it’s clearly not what’s happening. But if enough people say that or read it, deals can fall out of bed.”

John Mark di Ciacca, of property investment and development group EDI, argued: “There are still healthy deals to be done.”

“We are seeing plenty of opportunities,” Colin Carmichael agreed. “The challenge is getting them to the finishing line, especially when there’s a large difference between the vendor’s and purchaser’s aspirations.”

Over the past few years, investors have been able to build capital growth into their business model when looking at a property. That has changed, according to Scott Gibson of Dunedin Property, a UK-wide property investment and asset management company.

He said: “Returns over the next few years will be driven by income, not capital growth, so the ability to manage the income stream in your portfolio is key.”

Ernst & Young’s Bryan Crawford said: “There’s a reluctance to buy an asset when it could be cheaper next week. But the property guys that we speak to seem to be quite bullish.

“In Glasgow and Edinburgh, public sector asset sales are affecting the supply chain, as are regeneration schemes, so there are plenty of deals, potentially, for the property sector.”

For Scott Gibson, however, one relatively new factor is volatility in the supply of capital. He said: “Volatility is at a level we’ve not experienced before, because of the ease with which capital can get into and out of this market now. It is so much more a global market, and as soon as people want out they can get out.

“That has meant we have tended to overshoot in terms of pricing, whether on the way up or as now, on the way down.”

So have commercial property valuations reached a sustainable level? John Clement said: “The traditional prime market is probably where it should be – it got too hot. The secondary market [assets below prime quality], in certain sectors, still has some way to go. It got overpriced and will probably over-correct.”

Clement added: “Prime office yields seem to have crystallised at around 5.75 per cent, and rental growth projections for the major cities suggest that this is sustainable.”

If valuations in UK property are coming down to affordable levels, who will take advantage? One answer, the panel believed, is sovereign wealth funds, national investment funds from oil-rich countries and others that have built up a surplus.

Miller Mathieson said: “Sovereign funds tend to buy landmark assets, iconic buildings. We could see them being active in this market.”

David Mitchell agreed: “Fundamentally, the UK is seen as a safe place to invest. It’s benign politically it’s got stability, constraints on planning and building, and a growing population.”

Anne Fergusson, real estate partner at the law firm MacRoberts said that, in her experience, this year institutional investors are having a dominant impact on the market, though they remain cautious.

She said: “Many clients I act for, including smaller and medium- sized developers, are waiting till the end of the year. Banks are a bit more stringent with them when it comes to lending, so they are holding their fire.”

The panel also considered sources of funding. As the chairman, Colin Carmichael, put it: “Where is capital investment in the property sector coming from and where is going? How does the market feel, specifically, about the banks’ lending policies with regard to property?”

He said Lloyds TSB’s lending policy had always been “pretty cautious”, which meant that it still had the capacity to lend, including on property transactions, at any stage in the cycle.

The cost of funding has gone up since the credit crunch started to bite. LIBOR (the short term London interbank offered rate, at which banks lend to each other) has been significantly above Bank of England base rate, reflecting banks’ reluctance to lend to each other. As John Mark di Ciacca put it: “The world has changed, but we don’t yet know what it has changed to.”

Carmichael said: “For many banks, the business case was ‘originate, and then securitise’. But the securitisation market has died. You can no longer take business on at rates which only make sense if you can securitise.

“Not many will admit it, but there are a number of banks whose doors are effectively closed to new business.”

Change creates opportunity, though. John Mark di Ciacca said so-called “vulture funds” are taking on assets from distressed sellers, with finance from the banks. “In some ways, banks are feeding on themselves,” he said.

Private equity from overseas is finding its way to the UK, according to Miller Mathieson. He said: “In the last couple of years, the Irish have been very focused on Europe, as have the Germans, and now they are back again looking at the UK.”

Another potential boost to the market, in terms of deal flow, could be disposals of public sector assets. Bryan Crawford said a number of asset appraisals were under way, driven partly by the need for councils to find funds while freezing council taxes, and by the Commonwealth Games.

But how much is Government policy helping or hindering the property industry? As Neil Craig pointed out, its changes to the rules on capital allowances make investment in industrial property less appealing.

Scott Gibson argued: “In England, the end of rates relief for empty buildings will cripple the market. This is not being introduced in Scotland, and that is a godsend. If [in England] the Government thinks it will have the effect of stimulating investment because landlords cannot afford to leave buildings empty, that’s just naïve. It will have the opposite effect – they’ll demolish buildings.”

John Mark di Ciacca said: “It has been the fashion for some time for the property sector to pick up the tab, such as affordable housing, changes in stamp duty, development land tax and potentially, some form of ‘sustainability’ which is, conceptually, the way the industry should go, but we’re all grappling with the costs entailed.”

There are tax incentives for regeneration, for example, but Bryan Crawford said: “Sometimes the things you have to do to trigger the relief make the whole scheme uncommercial. Above all, you need certainty about the tax assumptions when you are putting a deal together.”

Crawford cited the proposal last year for a “planning gain supplement”, a national levy on property development. The proposal was deeply unpopular with the property industry, and it is considered that a locally determined “community infrastructure levy”, at least for England, is the most likely outcome.

Di Ciacca said: “Developers can cope with new taxes – they can be reflected in land values – but what they take exception to is these changes taking place in mid-contract. It is unfair.”

“Every attempt to ‘simplify’ property taxation just makes it more complicated,” commented Jim Burberry “It must be an inhibitor to getting deals done.”

Planning policy has also long been a bone of contention for the property sector. As David Mitchell argued, however, the problem may not be so much a question of policy as of resources. He said: “No local authority has the people, at present, to make the planning system work.”

Di Ciacca agreed: “The present system might not require too much tweaking if you had fully staffed, well-paid, consistent planning departments. It’s as much about the quality of the engagement with the planning authorities as the rules of engagement.”

As Colin Carmichael pointed out, this problem is partly of the private sector’s making, given that so many planners end up leaving the public sector.

CALA’s Robert Dick said: “There is a major issue with the big applications – such as the Lewis wind farm and Donald Trump [the golf resort plan] – and the Scottish Government is getting bogged down. it needs a more efficient system for dealing with planning applications, and that means more efficient when it comes to representing everyone’s interests, not just developers’.”

Bryan Crawford said: “There’s a very large scheme we’re aware of, a flagship development that has taken a long time to go through planning. But it has taken so long that the dynamics of the market have changed and the scheme has had to be remodelled, backers have pulled out.”

One suggestion – from Colin Carmichael – was that the private sector could transfer some expertise back to the public sector, for example by seconding staff to planning authorities, taking care over possible conflicts.

There was also a question, the panel agreed, over what form the proposals for a successor to PPP [public-private partnerships] in Scotland would finally take.

Robert Dick stressed: “The development industry should not be pigeonholed as whingers. The Scottish Property Federation and Homes for Scotland have had some very constructive dialogue with this, and the previous, administrations. The right people appear to be talking from the Government side, and listening.”

In the previous year’s discussion, some of the panel argued that opportunities in the UK were limited – partly because pricing levels meant poor value for investors – and that the UK property sector should look to continental Europe next.

Robert Dick said: “Whatever business you are in, you need a critical mass and the resources to expand into overseas markets.”

Miller Mathieson said his firm, CB Richard Ellis, had expanded significantly in Europe. He said: “You don’t set up in competition, you go in and buy the competition.”

The panel felt that the retail sector was probably the most challenging in the commercial property market. Retailers are facing the twin effects of Internet shopping finally becoming mainstream, and the strong possibility of a consumer slowdown.

Miller Mathieson said: “Retailers who are very good at what they do are doing well. Those who are not are struggling. In retail generally, you can’t see where any rent increases are going to be coming from.”

In hotels and leisure, the panel reported a mixed bag – E&Y’s Bryan Crawford said: “In hotel developments we are seeing investment into four and five-star schemes, not into budget hotels.”

David Mitchell added: “Overseas investors such as sovereign funds will mainly be looking at prime, iconic resort hotels such as Gleneagles or Turnberry.”

For industrial property, the outlook is perhaps surprisingly good, according to our panel. Mathieson said: “Building new industrial developments in Scotland is very expensive, but if you have existing industrial assets they should do well.”

Scott Gibson said: “We [Dunedin Property] moved into industrial property in 2005 and since then rents have risen. There are relatively low vacancy rates now. Industrial property is the ugly duckling of the investment sector – nobody seems to want to acknowledge that it actually performs well!”

Finally, what of construction costs? Colin Carmichael asked: “Is there an effect from the Commonwealth Games or Olympics?”

Yes, was the consensus. Miller Mathieson argued: “If you add building costs to the increased cost of finance and lower asset values, the effect of all three factors is massive.”

Robert Dick said that, especially in England, labour costs have been kept lower because of immigration from Eastern Europe. But, he warned: “Those workers will not be here forever.”

Mathieson said: “There are so many potential problems facing developments – as soon as you fix one, you find another three. So not all the projects in the pipeline will get built.”


Fluctuating prices, rapidly changing capital markets: these are considerations that keep the property sector on its toes. As Scott Gibson of Dunedin Property (centre of table on left), said: “Volatility is at a level we’ve not experienced, because of the ease with which capital can get into or out of the market”


The discussion turned to the planning system, long the bane of property developers’ lives. The talk moved over inadequate resources, the quality of staff, whether private enterprise could help here by seconding personnel, inconsistency between and within planning departments, and delays in the system that are sometimes long enough to require major changes to schemes. Nobody demurred when CALA’s Robert Dick, pictured left in the blue shirt, said: “They need a more efficient system for planning applications – more efficient when it comes to everyone’s interests, not just developers”

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