ELUSIVE LIQUIDITY

“India’s liquidity status continues to be a challenge, and the situation will prevail for at least the next three quarters. Private sector banks have stopped lending to real estate players, and there are now a very limited number of private equity investors looking at investing in the sector in the immediate future. By the same coin, there remain some pubic sector banks who are willing to extend credit for real estate development.

However, India is showing its traditional strength in coping innovatively with adversity by reverting to the funding routes established pre-2005. There is therefore still funding coming in – albeit very selectively – from private capital sources such as HNIs, trusts and corporates. While these sources are not fully adequate to meet the sector’s overall requirements, they will ensure an important degree of activity until more prolific sources open up again. Moreover, the Government’s unprecedented spend on infrastructure will ensure that the potential for many languishing areas and projects gets a shot in the arm, and that new locations will be become viable contenders.”

Anuj Puri – Chairman & Country Head, Jones Lang LaSalle Meghraj

THE GLOBAL RECESSION, GOVERNMENT INTERVENTION AND THE LIQUIDITY TRAP
Throughout the past month, estimates of global economic growth have been revised downward. Forecasts for a recovery have been pushed farther into the future than had been anticipated as recently as a month ago. Although the United States and Canada are expected to resume growth in fourth quarter 2009 after five quarters of contraction, France and the UK are not forecast to return to positive growth until first quarter 2010, and Germany and Japan are not expected to recover until second quarter 2010. Japan, the world’s second largest economy and a creditor nation, is now in the worst economic recession since the Second World War, having registered a 12.7 percent annualized fall in gross domestic product (GDP) in the fourth quarter 2008. Australia is expected to follow other global economies into recession, with the first negative growth appearing in first quarter 2009 and remaining negative until second quarter 2010. Growth in China is predicted to slow to 5.9 percent in 2009. However, some analysts believe that a Chinese growth rate of below 8 percent is equivalent to a recession in advanced economies.

The dominant Western consensus of the past 20 years ─that markets are self-regulating and best left to market forces─ is officially dead. No economist any longer believes that the world’s badly damaged financial system can be repaired without massive state intervention. Left with few alternatives, governments have responded to the liquidity crisis by pumping money into their financial systems in staggering amounts. Government-originated stimulus programs have reached 16 percent of GDP in China, 5 to 6 percent of GDP in the United States and 1 percent in Japan .

So, what impact has government intervention had on liquidity? Money markets may have reached what is known as the “liquidity trap” stage, whereby monetary policy and very low interest rates have limited effect on banks’ appetite to lend or on the demand for credit at current spread levels. The key recovery question remains: What exactly are these government programs stimulating and when will the impacts gain traction?

Although banks have received massive amounts of government aid, there is little evidence so far to suggest they have increased their lending activity. A recent U.S. Treasury survey of the 20 largest banks that have received funds from the $250 billion government capital-injection program reported that their lending activity in the final quarter of 2008 was flat or had declined slightly. Most banks cite a variety of motivations, ranging from their need to build capital cushions to protect against further loan losses to concerns about the creditworthiness of new borrowers. Others appear to be waiting for clarity regarding the prospects for nationalization, the formation of government aggregator banks or for more asset value transparency.

GLOBAL CREDIT

Improving availability?Even as worldwide economic activity decelerated and commercial property values declined further, credit conditions for high-quality debt eased—a necessary precursor to commercial property market recovery. Global credit markets experienced some amount of thawing during the past month in response to the unprecedented monetary and fiscal actions by governments around the world. The five-year swap rate for top-rated credits, an indicator of default credit risk, and shrinking TED spreads, an indicator of the willingness of banks to lend to each other, exhibited marked improvement in December 2008. European government and commercial bond spreads also narrowed in December. At the same time, the spreads between the yields on ”risk-free” U.S Treasury bonds and yields on both corporate and mortgage-backed securities narrowed significantly. In the most recent monthly data for January 2009, however, U.S. spreads widened out a bit—suggesting a more protracted period of domestic credit market recovery. In the UK, indicators such as the three-month treasury over corporate bond spreads and the mortgage rate spread continued to improve, and the “real” official interest rate remained at a record low.Investors’ resurgent need for yield was a key catalyst for tighter credit spreads. With government bond yields low and equity share dividends threatened, corporate bonds offered investors an attractive alternative. There is recent evidence of this returning appetite for corporate bonds: Investor demand surfaced with the issuance of two jumbo loans totaling €2 billion via the German Pfandbrief market, and demand for $28 billion of recent U.S. corporate debt placements outstripped supply. Demand for U.S. high-yield—meaning junk— bonds also grew. In other anecdotal evidence that the U.S. credit market is thawing, fewer bank loan officers indicated they were tightening credit standards. This loosening of standards may mark an important inflection point for credit, particularly if loan demand increases. Still, demand remains at or near record cycle lows for consumer, commercial and industrial real estate loans, as inevitable balance sheet repair and deleveraging continue.

REAL ESTATE LENDING While credit conditions are showing some improvements, commercial real estate lending largely is not. Although banks have received massive government aid, their commercial real estate lending remains frozen amid uncertainty about nationalization and capital preservation for further loan losses. Banks are still absorbing government credit infusions rather than making significant new loans.

Impact of weakening fundamentals on property values

Further weakness in the global economy has accelerated the decline in commercial property asset values. Asian markets such as Singapore and many Chinese and Indian cities are overbuilt. That reality is acutely felt in Beijing, where roughly 40 million square feet of office product will come to the market over the next five years, while in Delhi, a similar volume of supply will be delivered over the next three years. Efforts to raise capital for listed property groups in Australia, Singapore and Japan are accelerating at discounts of 40 percent to 50 percent of the current share price, compared with discounts of 10 percent to 15 percent just months earlier.
From London to New York to Tokyo, prices for office buildings in central business districts have fallen anywhere from 30 percent to nearly 50 percent. In the United States, sellers need to entice unlevered buyers with internal rates of return of 13 percent to 16 percent. The value that buyers place on vacant U.S. properties is virtually zero. The value of empty retail space in the UK also has plummeted.

WHERE ARE THE REAL ESTATE OPPORTUNITIES?

Stress and distress forces sellers into the marketIn what may prove to be an early indication that property markets are close to resolving pricing uncertainty, some stressed and distressed owners finally are being forced into the market. In the United States, a number of highly leveraged assets are being brought to market as their mezzanine lenders exercise their contractual and legal rights, and some first lien holders deal with loan maturities. Several investors from the Middle East who need to repatriate capital have brought their hotel holdings to market with aggressive discounts and a willingness to take creative approaches to retain existing debt. This asset clearing needs to happen before real recovery can occur.
Real estate investment trusts (REITs) also could be forced sellers in the coming months. Their market capitalizations have diminished considerably over the past 18 months, and they need to raise capital.

Banks, too, are likely to be sellers, given their large real estate holdings and the need to deleverage their balance sheets. For example, RBS and Lloyd’s Banking Group hold commercial mortgage debt that roughly equates to the year-end market capitalizations of the world’s eight largest REITs combined. The sheer scale of these holdings at government-aided banks in both Europe and the United States dictates that a return of liquidity in global property markets recovery remains largely in government hands.

London: A leading indicator? London, one of the first and hardest-hit global property markets, may be the first to recover, given that it started to correct in 2007 while other markets remained in denial. It is attracting increased interest, particularly from investors in the Middle East, Continental Europe and Japan. All are interested in purchasing direct real estate assets at cap rates up from the mid-4 percents to mid-7 percents today. In addition, the UK offers investors some of the best niche opportunities worldwide to purchase strong cash flows with low levels of leverage. The weakness of the Sterling is adding to the market’s attractiveness for foreign investors. A trend indicated in recent London commercial property trades shows 8 percent to 9 percent yields. Internal rates of return range from the mid-to-upper teens. This may signal that broader investor interest is to come as sellers set realistic, market-clearing prices.

The opportunity fundsFollowing the significant decline in global commercial property values in 2008, many real estate investment companies recently have opened opportunity funds, aiming to raise more than US$90 billion for global investments by the end of January 2009—a figure equal to about 25 percent of 2008 transaction volumes. With commercial property yields currently exceeding 7 percent globally, funds that raised capital in 2008 but delayed investment due to the market turmoil are coming under increasing pressure to invest or return the capital. Although a number of factors may constrain their investment programs, opportunity funds are likely to bolster transaction volumes in 2009.

Corporate consolidationMany major corporations around the world are accelerating their responses to the economic downturn by initiating new workforce reductions or expanding existing programs. The trend is expected to continue through most of 2009 at a minimum. This rightsizing of companies will translate into a reduction in demand for space and an increase in sublease space this year and in 2010.

As vacancies increase, both marketwide and in internal shadow space, and as rents decline in property markets around the world, corporations without a focused strategy will be challenged to effectively and efficiently dispose of excess real estate in the near term. Rightsizing also is likely to prompt more corporations to outsource non-core businesses such as real estate in their search for additional cost reductions. For confident tenants with upcoming core and strategic facility requirements, the markets will present very appealing opportunities in the next 12 to 18 months. The high cost of raising money in the corporate bond market is likely to lead to sale-leasebacks of high-quality assets. ConclusionWhile the factors affecting global property markets likely will get worse before they get better, several indicators point toward movements that potentially will mitigate declines. One of these is the wave of massive economic stimuli that are being injected by governments around the world, most notably in Beijing, where the government is committed to doing all it can to stem the tide. The credit markets, which led the global economy down, hopefully will lead it back up.

The value declines in the UK have made it one of the world’s most attractive markets with yields above 8 percent, albeit with a host of economic risks. This trend of equity investor interest now is beginning to filter slowly to the United States. As we move through a year of adjustment in 2009, it is worth remembering that there is a distinction between distressed assets that have occupancy problems or capital expenditure needs and distressed owners who have urgent needs to raise cash and will sometimes sell strong assets as well as weaker ones.

You’ve heard our opinion, now give us yours. What recovery signposts do you see in today’s market? Send your viewpoints to global.perspectives@am.jll.com.

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