Real Estate Executive Report 2009 – Still Standing

FOREWORD

Welcome To The Third Deloitte Real Estate Executive Report

On 16 September 2009 we marked the one year anniversary of the collapse of Lehman Brothers and the incredible impact this event had on the world economies. Despite the stock market rally in the last six months and consensus expectation of a return to weak economic growth in 2010, we do not believe there is any cause for complacency when looking at the prospects for the real estate industry. In a world where we have received a serious lesson in how hard it is to make accurate predictions, we can only say one thing with absolute certainty – that the future for real estate will be significantly different to the past.

In this third edition of the Real Estate Executive Report, we have asked our industry specialists to consider those key elements of our industry which appear to have been altered for good by the changes in the UK and world economies.

Richard Hyman is one of the UK's leading experts on retailing, having analysed, commentated and advised on the sector for 30 years, and is now an adviser to our Consumer Business practice. We sat down with him to talk about the ways in which the retail industry has been altered by the global recession and what this means for retailers' relationships with their landlords. Richard shares insights on consumer demand, retail space requirements and the competitive forces currently in play, which he believes will impact retailers in fundamental ways, possibly permanently.

A key factor in determining the future of the industry will be the availability of debt finance and the attitude of the key debt providers towards real estate. Our Debt Advisory team discusses the significant issues currently dominating the debt markets, looking at underwater bank loans, regulatory requirements, the impact of new accounting rules, new debt providers entering the market and the changes wrought by Government intervention. There may bargains to be had in the UK property market at present, but investors seeking UK property exposure by traditional means could find those routes blocked. We expect that an innovative approach will be needed from traditional property investors, fund managers and, of course, the nationalised banks, in order to drive increased activity.

Widening the focus to the industry as a whole, we have asked our Real Estate Solutions team to comment on their expectations for the shape of any potential recovery for the real estate industry. Will it be one of the much vaunted V, W or U shaped recoveries, or most likely none of the above? There is a clear challenge facing all real estate professionals in determining the shape and direction of our industry in the years ahead. Deloitte research into past recessionary trends suggests worryingly that our industry has perhaps a way to go to reach the bottom of the cycle.

Finally, when the 'music stops' after any period of strong economic growth it often creates situations where individuals feel pressurised to do 'whatever is necessary' to secure new business opportunities, in order to get ahead of their competitors. We discuss the factors management teams need to be aware of with regard to the risks of becoming involved in bribery and corruption, consider the reputational damage that can result if such risks are realised, and highlight recent regulations that have been put in place in the UK and internationally, to police this aspect of corporate behaviour.

We hope you find this publication useful and welcome your feedback on the contents. Please contact me or any members of our Real Estate team listed on the back page.

Best wishes.
Richard Thornhill
Editor & Real Estate Capital Markets Director

AN INTERVIEW WITH RICHARD HYMAN

Richard Hyman is one of the UK's leading experts on retailing, having analysed, commentated and advised on the sector for 30 years. He founded Verdict Research in 1984 to carry out retail research analysis and consulting. In September 2005 he sold the company to Datamonitor. Two and a half years later he joined Deloitte as an adviser to its Consumer Business practice. Here Richard Hyman talks to James Whitmore, Deputy Editor of Property Week, about the fundamental changes that are taking place in retailing and the implications for real estate.

It Appears As If The Recession Is Hitting Retailers Hard. What Is Really Happening In The Retail Sector?

This recession is the worst that any of us have ever seen and it is having a profound effect on retailing, but it would be a mistake to think that all the pressures on retail are being caused wholly by the recession. That is far from the case. Once this recession is over, the economics of retail will not return to where they were. In my view, they will never return.

Why Is That?

The key reason is that we have had 30-plus years of relentless capacity growth in UK retailing. And in the last ten or so years of that 30-year period we have also had the emergence of the internet as a major new retail channel. The internet has not persuaded consumers to spend any more than they would have spent. It has cannibalised capacity that was already there.

Over the last ten years UK retail has added, net of closures, 100m square foot of new 'floorspace'. Half of that is traditional, bricks and mortar square footage. The other half (if you apply an average sales per sq ft to total sales, to get a proxy for physical floorspace) is through internet 'virtual' floorspace.

This additional capacity represents an increase of around 22%. That is a very large figure. You cannot increase the capacity of something ad infinitum; sooner or later the laws of diminishing returns will kick in – unless demand grows ahead of capacity growth.

Which Is What Has Happened?

Yes, for most of the last 30 years demand has indeed grown. But we have reached the tipping point now and it happens to have coincided with a recession. Sales per sq ft are lower now than they were last year, and last year they were lower than they were in 2007. I believe they peaked in 2007. While they may not necessarily carry on falling as far as the eye can see, I think that the likelihood of them returning to where they were is remote.

Supply Has Soared And Demand Has Started To Drop – That's Not A Recipe For Success Is It?

The change in the relationship between supply and demand is changing the economics of UK retailing forever and it implies a changing relationship between landlord and tenant. It's got to change. It remains to be seen how exactly it is going to change. Nobody knows for sure because we are in a state of flux.

What happens to retail economics is also going to be driven by the extent to which there is a significant shakeout in the number of retailers. Despite all the headlines and despite common perceptions, I think that far fewer retailers have withdrawn from the race than expected, given that this is the worst recession we have ever seen, there is far less vacant space on the high street than could have been expected.

Why Haven't More Retailers Gone Bust?

Retailers have taken action sooner than they used to. A very good friend of mine, who is the Chairman of a national multiple retail business, has just gone through an administration process. Before, his company was making annual losses of £10 million and now he is making annual profits of £10 million.

It was painful because he worked very hard to build up his business but the administration process allowed him to restructure. An unviable business has been made viable, and many jobs have been saved. A number of businesses have gone through this process and have emerged in much better shape.

Has The Magic Wand Been Waved And Are They Now Fantastic Businesses?

No. They are probably still quite weak from a trading point of view but they are now not going to go under. Another advantage of the administration process is that quite a lot of shops, Zavvi for example, went to the wall but virtually all their stores are now occupied by somebody else. It is very easy for the non-specialist media to be confused. They see a company with 400 shops go into administration and think that means that 400 shops have shut. Actually, more often than not, they are not shut at all. They may even be trading under the same name, or a more productive retailer has taken over the site.

What Has Happened To Consumer Spending?

There are two contradictory stories. One is that spending has weakened considerably, the other is that it is a miracle that we are spending what we are. Spending has weakened considerably because people have got less money to spend. There are 2.5 million people unemployed. Retailing is a relatively low margin business, which means that it is all about scale and volume. You can have relatively small changes in the volume of sales, which have a very big, disproportionate impact on profitability.

Why Are People Spending What They Are Spending?

It is true that it has held up remarkably well. For many consumers, lower mortgage repayments have relieved the pressure. However, some of this is going to be short-lived. Those changes are one-off benefits.

With Economic Figures Around The World Now Indicating That The Great Recession Is More Or Less Over, Do You Think Retail Is Over The Worst?

I think we are not out of the woods yet. There is going to be a lot of optimistic talk. Everybody is desperate for all this to be over. Hence, the regular sightings of green shoots and that's in an environment where most people think unemployment is going to pass three million and that it will take until the middle of next year to reach that. How can we have a recovery that's worthy of the name, when so many people are losing their jobs? Even more significant is the knock-on effect on confidence because of job security. How many people feel secure in their jobs?

It may not get worse but I cannot see it getting better until the back end of next year, once unemployment has reached equilibrium.

When Things Finally Do Improve, How Will The Retail Sector Fare?

Consumer spending will grow more slowly. I think that we are going to see a retail industry where growth is slower and profitability is lower. Consumer spending will be a lot lower. We are still going to get wealthier but at a much, much slower rate than before. Economic growth generally is going to be slower than it has been.

What Effect Will That Have On Retail Property?

It has significant implications for retailers' ability to pay increasing occupancy costs because they are going to have less money. Retail is going to be a lower margin business going forward. The balance of profit taken from retail space by landlords and tenants will have to be redrawn.

What About Leases, Service Charges And Rents?

I think lease lengths will come down. They are coming down, but it is slow. Leases have got to be shorter. They have got to give both sides the flexibility and manoeuvrability that commercial realities require. The amount that retailers can afford to pay will come down because they will make less money. They have also got to find the money to spend on their websites.

Will Retail Rents Therefore Come Down?

The link has been rather remote because of the five-year rent review. As growth is going to be slower, we will not see the hikes that we have seen. Affordability is going to diminish and the property industry will have to take that into account. Clearly, it already is, although retailers will argue that it is not taking it into account far enough, or fast enough. I think there is some truth in that.

Who Would Want To Be A Retailer In The Future?

It is important to put a rider on this rather bleak background. It does not mean that no-one will ever make money in retail again, categorically not. Although there may not be the shakeout that we were expecting, these tougher times are going to highlight the differences between the really good retail businesses with really strong management who understand the demand side of the equation really well, and those which don't. The customer is going to become much more important.

Retailers have gone through their golden period. Open more stores and growth will come. That era has finished. A prerequisite of growth is going to be a better understanding of customers and the ability to translate that into incremental revenues.

Surely The Internet Will Play A Large Part In Revenue Growth?

The internet, frighteningly, has had a very big impact, but it only accounts for 8% of sales.¹ It is a matter of opinion as to where it ends up, but it certainly has quite a bit of growth to come yet.

Which Retail Sectors Will Be Worst Affected By The Internet?

A good example is music retailers. I have just come back from America and there were hardly any music shops left. Even the big book stores like Barnes & Noble and Borders, which not long ago were major sellers of music, have either withdrawn or significantly reduced their space. Music retail is an area that is very well suited to the internet.

Has Pretty Much Every Sector Been Affected To A Greater Or Lesser Extent By The Internet?

Yes, even an area like fashion, which is the most touchy-feely of all retail sectors and the one in theory that you would not have thought was suited to the internet because the internet is not any good for shopping around – and clothing is mainly about women and they love shopping around. Most of the leading clothing retailers are developing extremely successful websites achieving excellent sales growth.

Has The Retail Success Story Of The Recession Been Food Retailers And The Growth In Their Non-Food Sales?

That is really important. The major food retailers have increasingly focused on non-food retailing. Not only is Tesco the biggest food retailer in the UK, but it is also the biggest non-food retailer. The share of non-food retailing that the grocery sector accounts for is way below its ceiling. They have got a lot to go for yet. That business is captured from existing non-food retailers.

Would Woolworths have fallen by the wayside had the supermarkets not captured large swathes of its traditional business? Probably not. In entry level segments of most product markets in the non-food arena the grocery companies have established a firm foothold and have the potential to grow further. Books, greeting cards, televisions, underwear – the grocery sector is a very important player and has captured a significant share of the value of that sector.

What Have Retail Landlords Got To Do To Become As Customer-Focused As, Say, Tesco?

Take a look at Westfield London Shopping Centre at White City/Shepherds Bush. One of the great things about that place is that they have made an environment where families can go and spend protracted periods of time. I think that's increasingly important. The leisure side of shopping trips needs to be catered for in retail parks as well. It has got to come. Competition will eventually force landlords to make them a more pleasurable place for people to go.

The thing about retailing and shopping is that the proportion that is driven by wants, rather than needs, is well over 50%. Given that, by definition, that spend is not only deferrable but, actually, not necessary, you have got to go that extra mile to persuade people to spend their money. Doing that requires you to provide an attractive environment.

Clearly, a lot of that is about the retailers themselves, but increasingly landlords are going to see in the future that this is a joint enterprise. If they want to give themselves a better hand of cards, they have got to make taking space in their development more attractive.

If I am right about the capacity issue, and if I am right about the fact that we are not going to get some magical realignment and floorspace just disappears, capacity competition will grow significantly. The smarter, more imaginative and more commercially-minded landlords need to think of new ways to give themselves an edge over the guy down the road.

PROPERTY FINANCING TRENDS

There may be bargains to be had in the UK property market, but investors seeking to take immediate advantage of the financial sector's issues may be waiting a long time. As at 31 December 2008, two UK clearing banks alone represented approximately 40% of the total £225 billion² of lending to UK commercial property. Rather than rushing to sell loan assets at firesale prices and recognise near term losses, banks and others are embracing the 'amend and extend' method of dealing with their defaulting loans. This approach is potentially creating a snowballing list of property loans to be dealt with in 2011–2012. Investment opportunities in UK commercial property are therefore increasingly hard to find. Against this backdrop, we discuss below our key thoughts and observations on each significant aspect of the real estate financing marketplace as it currently stands.

Underwater Bank Loans

Falling values in the real estate sector have meant that defaults and breaches of covenants on this debt have become increasingly common: as at May 2009, the De Monfort University Real Estate Debt Survey estimated that £15 billion of the outstanding debt is in breach and a further £6 billion in default.³

Indeed, working through the numbers it is clear that not only are a number of these loans in breach of loan-to-value (LTV) covenants, but they are actually in excess of 100% LTV.

Average LTVs were over 80% for most of the past 10 years⁴ and commercial property values have fallen by 44% since their 2007 peak according to the Investment Property Databank (IPD). The Royal Institute of Chartered Surveyors (RICS) predicts that office values will be down by more than 60% from peak to trough.⁵

Sinking valuations have meant that banks have had little choice but to 'amend and extend' with some seeking to avoid revaluing their loans wherever possible. Indeed, there is a strong incentive for them to hang on a few years rather than sell at current distressed prices. Banks had their fingers burnt doing just that in the 1990s and then missed out on the upside as markets came back strongly.

Figure 1. Aggregated Value Of Outstanding Debt (£ billion)

Figure 2. Timing Of Debt Due For Repayment (All Lenders, %) Total £227bn⁶

However, the trend for 'amend and extend' debt restructurings could potentially be creating a financing time-bomb. According to De Montfort University's Real Estate Debt Survey, £43 billion of UK commercial property debt was due for repayment this year and almost £107 billion by 2011.5 Most of the extensions are for only two or three years, meaning that the volume of debt due for refinancing in 2011-2012 is snowballing.

In response, the banks have recently sought to significantly strengthen their work-out teams recognising the fact that the volume of loans falling due over the next three years represents a significant logistical challenge.

Furthermore, it is possible that the quantum of real estate loans to be renegotiated will unduly dampen the banks appetite for new real estate lending running through to 2012.

Even where property lending does continue, it is unlikely to match the 'pre-crunch' highs in the short to medium term, if ever. Banks which were previously lending at over 80% LTVs are currently lending around 50-65%. Applying these reduced LTVs to substantially reduced valuations creates a significant funding gap.

Commercial Mortgage Backed Securities (CMBS)

In addition to the £225 billion of on balance sheet property lending, a further £50 billion in commercial property debt is funded through CMBS and the data in this sector of the debt markets tells a similar story.

Of the outstanding CMBS debt, Fitch estimate that 28% are in negative equity and only one in five CMBS securities features loan stock at less than 80% LTV.⁷

A Deutsche Bank report in mid 2009 estimated that $40 billion will be needed to salvage about $420 billion of CMBS mortgages worldwide over the next 10 years.⁸

Regulatory Capital Requirements

These are of unprecedented importance in the banks' decision making processes around both new lending, and exit planning on existing loans. The most costly exit options in terms of regulatory capital demands are those that involve realising a loss, such as a discounted sale of a loan or repossession of the underlying property and sale at an amount less than the loan.

It may therefore be the 'least bad' option for the bank to continue to lend and to try to reduce its exposure, by requiring new equity to be injected. However, finding new equity investors in the current climate may not always be feasible.

New Accounting Rules

While the 'amend and extend' tactic has so far limited the volume of losses realised by the banks, new accounting standards proposed by the International Accounting Standards Board (IASB) threaten its ongoing usefulness. The new rules, expected to be finalised by the end of this year, will mean that loans currently being held at amortised cost may have to be accounted for on a fair value basis and that provisioning would be based on an expected loss model as opposed to incurred loss model.

Under the new rules, loans and simple debt securities similar to loans would be held at amortised cost, provided that banks can show that the objective of their business model is to hold these instruments to collect contractual flows and that the contractual terms give rise to cash flows that are solely payments of principal and interest on principal. More complicated debt securities, derivatives and equities would be carried at fair values.

The banks would therefore have to show a commitment to hold their underwater loans for the long term or recognise any 'expected losses'. This in turn, could mean increased capital requirements and decreased lending appetite and capacity.

New Players

Even without taking into account the potential effects of the proposed changes to accounting standards, a substantial funding gap has opened up in the UK commercial property sector as banks reduce their real estate exposure and reduce LTVs.

Whilst some Private Equity (PE) houses have been keen to buy debt portfolios from the banks at a significant discount to par, the vast majority of banks do not want to sell at these levels.

The real estate sector needs new money – but where will it come from? Traditional equity sources have already been tapped. UK Real Estate Investment Trusts (REITs) raised more than £4 billion this year in a flurry of heavily discounted rights issues.⁹

Similarly, in the real estate funds arena, additional equity has been sought. However, concerns over the capability to refinance existing debt meant that half of Funds of Funds Managers declined when asked to commit fresh equity to existing investments.¹⁰

There may be additional equity available from new investors. There has been renewed interest in the UK commercial property market from overseas investors, which may be due in part to a weakened sterling value.

For example, Japanese investors have seen a 70% drop in the price of UK commercial property in Yen terms over the past 18 months (40% drop in prices and 30% stronger Yen).⁵ Similarly, Swiss investors have seen a 57% drop in the price of UK commercial property over the past 18 months (40% drop in prices and 17% stronger Swiss Franc).

Date	Company	Cash raised (£m)	Take-up (%)	Discount (%)
January 2009	Workspace Group18	87.2	49	69
February 2009	Land Securities19	755.7	95	52.5
February 2009	Hammerson16	584.2	99	62.2
February 2009	British Land20	740	97	53
March 2009	SEGRO plc21	500.1	95	88
May 2009	Great Portland Estates17	175	96	53.4

But with significant amounts of commercial mortgages coming due in the next three years, there will be demand for loans that some traditional lenders, such as banks, may be unwilling or unable to make.

In the US, REITs are raising money to buy distressed property loans, and – more importantly – to provide new property lending.^{11 /12} In the past two months, eight US REITs have filed Initial Public Offerings (IPOs) seeking to raise up to $3.9 billion.7 These funds may therefore be able to augment the banks as a key lender for property investment. That said, the appetite for such funds is still unclear: Invesco more than halved the funds raised on the IPO of its Invesco Mortgage Capital fund to $170 million.¹²

Unlike their UK counterparts, US REITs can invest in mortgages on 'real property', whether inside or outside of the US, tax efficiently. Although the UK legislation allows our REIT structure to make this sort of investment to a limited extent, profits will not be covered by the REITs exemption. However, the British Property Federation (BPF) and the banks have been in discussion with HM Treasury on this point, so it is a potential solution for the UK market.

There is uncertainty over the attractiveness of the pricing of the sale of distressed loans from the banks to the REITs,¹³ since selling at a loss is worse than doing nothing for the banks' capital requirements. But the tax efficiency of the REIT structure may allow them to improve pricing compared to the levels previously offered by financial investors or PE investors, to levels which may be more attractive to banks.

New Structures

Some innovation has already been seen in the market which addresses some of the issues for property debt restructuring.

A new structure used in a recent significant property transaction saw the lender and borrower set up a 50:50 JV which bore striking similarities with a debt/equity swap. The borrower contributed existing property assets and debt to the JV, and the lender provider the JV with additional loan facilities. The JV agreement was set up such that all profits generated in the JV were used for repayment of its debt. The attractive attributes of this structure from the perspective of the lender were that it gains security over the assets that the borrower has added to the JV vehicle, the lender keeps some of the upside on any future recovery in property values (which would not be the case if they had either sold the loan or put the borrower into administration), and the structure is less onerous on the lenders regulatory capital requirements as the property assets remain unconsolidated investments. Profits of the JV to go towards repaying the debt. The key outcomes of this innovative structure are that:

• the investor/bank will gain security over 'other' assets which the borrower has added to the JV vehicle;
• the investor/bank will keep a percentage of the upside on any future recovery of property values (which would not be the case if the bank either sold the loan or put the borrower into administration); and
• the investor/bank's regulatory capital requirements do not become onerous as the property asset remains an unconsolidated investment.

A further incentive which may be driving banks to employ this structure is that, in the current climate, asset owning banks and other entities may be reluctant to enter into property disposals for fear of creating a downward spiralling market for these assets. The completion of transactions might establish a pricing precedent which could lead to a pro-cyclical devaluation of portfolios across the commercial property market, potentially sending balance sheets into freefall.

If the banks can identify portfolios of real estate debt which they would like to unwind, it is possible that similar structures to the above could be implemented on a larger scale between the banks, new equity players and property managers, allowing restructuring of the offending loans without directly impacting valuations.

Government Intervention

With Governments now deeply embedded in the global banking system, their influence over future lending patterns should also be considered. As well as the regulatory demands on capital demonstrated above, Government intervention in the banking markets could affect the lending preferences of the banks.

The Government has received lending commitments from two UK banks. Whilst these do not contain quantitative targets for lending to the real estate sector, the banks have undertaken to implement their lending commitments to the business and mortgage sectors. Only time will tell whether the commercial real estate sector will get a proportionate allocation of new capital. However, the lack of quantitative targets on a sector by sector basis may allow banks to rebalance their lending books away from troubled sectors without breaking their commitments to HM Treasury.¹⁵

A further potential example of Governments influencing the commercial property market might be seen in the Irish National Asset Management Agency (NAMA). NAMA will buy €80 – 90 billion of property loans from Irish banks, 30% of which (€24 – 27billion) are secured on UK and non-Irish properties.¹⁶

The loans secured on non-Irish assets, are according to some market commentators, expected to be the first back onto the market. This potentially means the sales at the most distressed point in the process will be affecting non- Irish property prices, with significant impact in the UK.

In the run up to the general election both the political parties have made proposals for new increased capital requirements and further restrictions on lending. The Parties differ as to whether this should be enforced by the Bank of England or a 'super-committee' of the Bank of England, Treasury and Financial Services Authority, but whichever way the election goes, new regulation is likely to further reduce liquidity.

What Next?

There can be no doubt that structural issues exist for lenders in the UK commercial property market. The changing regulatory backdrop may impact positively or negatively on lenders' behaviour towards property borrowers. Indeed, the coming general election will be closely watched by the City.

Whilst Government intervention may have provided bank lenders with time to work through their property loans and hope that valuations come back to mitigate potential losses, it appears that longer term solutions are likely to come from innovation in the market. However in the short to medium term, commercial property investors will have to brace themselves for a period of reduced liquidity and availability of credit. They will need to work harder than ever to restructure existing loans and source new ones.

LESSONS TO BE LEARNED?

The Deloitte Real Estate Solutions team examines past recessions to see if there are any lessons to be learned for the corporate occupier sector.

As we move into Winter 2009, economists are attempting to read the runes to forecast the UK's return to economic growth. Fledgling green shoot indicators of economic recovery are enthusiastically reported, yet the Organisation for Economic Co-operation and Development's forecast proved correct with a further fall in UK GDP in Q3. Performance for Q4 is forecast to show, at best, flat or minimal growth. The optimists are reading this as indicating a likely return to positive GDP growth territory in Q1 2010, leaving 2009 destined to be remembered as undeniably the 'annus horribilis' of the UK property industry.

But what will recovery look like for our industry? Will it be the much vaunted V, W or U shaped recovery, or most likely none of the above? Against a backdrop of the severest economic collapse in the living memory of most professionals in our industry, the challenge now is to assess the shape, direction and challenges of our industry for the recovery years ahead. Deloitte research into past recessionary experiences suggests worryingly that our industry has perhaps yet to reach its nadir.

Our research has drawn upon published Investment Property Databank (IPD) metrics that are accepted as the reliable baseline indicators of our industry's past performance. Helpfully, these metrics extend back before the early 1990s property recession, allowing us to analyse full cycles of property boom, bust, wobble and recovery over 20+ years. Whilst the circumstances of past recessions can never be taken as slavish indicators of the likely out-turn of this recession, not least because of key differences such as inflation and interest rates, there do appear to be some key themes that could validly indicate – in terms of direction if not scale – the shape of any recovery from our present recessionary depths. These themes potentially raise some intriguing challenges – and conversely also opportunities – for the corporate landlord and occupier market.

When the credit crunch first hit the property sector around mid-2007, the initial focus of concern for the property industry was the sharp decline in capital values. However, as the UK economy has moved yet deeper into recession, the focus has moved onto the health of the occupier market.

Since the end of 2008, the occupier market has continued to weaken significantly across all sectors: the retail market has been hit by several large-scale and high-profile administrations and is facing unprecedented vacancy rates; large corporates have cut headcount, particularly in the financial services sector; cuts are expected within the public sector as the future Government of any colour wrestles with unprecedented levels of national debt; and the demand for industrial property has been hit by crises in key sectors such as automotive.

Weakness in the occupier markets has fed through to rental levels as demand falls and supply increases caused by surplus space being put on the market. Between Q1 2008 and Q3 2009 the IPD All Rent Index is 9% down. The Nomura deal, reported in the press in the summer, as effectively providing a six-year rent free period (four years actual plus a contribution to fit out costs) on a new 20-year lease in the City of London, brought the emerging market reality into stark relief.

How far rents will fall, and for how long, will clearly impact both investors and occupiers. For investors it will affect the recovery of capital values, potentially creating a second wave of bad news for landlords as a proportion of leases invariably expire or can be broken and their tenants seek to aggressively rebase leases at rents substantially below those of today. This will similarly drive the viability and timing of future development schemes. For occupiers it will undoubtedly influence corporate occupancy decisions including stay/go and lease/buy decisions.

Lessons From The Past?

In considering what could happen to rental values as we emerge from the current crisis, we have looked at what happened to rents in a previous economic recovery to see if there are any apparent lessons to be learned. We have focused our analysis on the recession of 1991-92, as this is the first recession for which there is robust IPD property-related data.

The stark finding is that rental recovery substantially lagged GDP recovery. Indeed rents continued to decline for several years after GDP had started to recover.

Figure 1. Capital / Rental Indices vs UK GDP

Figure 2. Rental Indices For Retail Prices Index (RPI)

The 1991-92 recession saw a 2% drop in GDP (compared to circa 6% in the year to Q3 2009 in the current recession) and, during the same period of the economic cycle, rents (as measured by the IPD Rental Value Index) dropped by circa 27%.

When the IPD data is plotted against GDP it highlights several disconcerting trends. After GDP bottomed out in Q2 1992, rents continued to fall until Q2 1995, a full three years after GDP had started to recover. And then when rental levels did start to recover in Q2 1995, the IPD All Rent Index took a staggering six years to return to even its post-crash levels. So, in simple terms, the 1991-92 recession saw rents taking a peak-to-peak dip of circa ten years. Hardly the V-shaped recovery we are hoping for this time.

This rental lag was caused in part by occupier decisions lagging changes in the real economy. The 1991-92 recession saw unemployment continue to rise for nine months after GDP switched back into positive growth, highlighting that GDP can be very much a leading indicator, with economic reality taking many months, even years, to follow its lead. Many occupiers back then did not let staff go until there were visible signs that their business recovery was going to be slower than they had hoped for and any surplus accommodation was then not released until the staff had been made redundant. This in turn created an excess of surplus property sitting on the market, further driving down prices. The rental lag in the last recession was undoubtedly compounded by over-hang from the speculative property boom of the late 1980s, which is not the case immediately prior to this current recession. However, there is also a case to say the current recession is much deeper than the last recession, so occupier demand may yet fall more sharply than in 1991-92.

Where Did All The Growth Go?

As noted above, nominal rents took six years to recover from their low point in Q2 1995. However, if the impact of inflation is stripped out of the IPD All Rent Index, then it could be said that there has been little real rental growth since rental levels bottomed out in 1995.

The reasons for this are complex and are likely to be the outcome of several contributory factors:

• The widespread availability of development finance may have meant that the supply market responded far more quickly to increasing demand than before; as a result the real increases in rent previously required to stimulate the market were avoided.
• Tenants may have clawed back some of the exceptional returns investors have made in recent years through attractive rental packages thereby reducing real rental growth.
• It may be that investors, satisfied with their exceptional capital returns, have not managed rental returns as effectively as before. This could be compounded by the increase in financial investors and decline in traditional property investors in the later stages of the last property bull run.
• It may be that real rental growth was easier to achieve in the periods of high inflation (late 1980s) than in periods of low inflation (mid-1990s onwards).

There is a line of argument that rents, having not been inflated by as much in the run up to this recession as in previous recessions, will not fall as much as they did through and post the 1991–92 recession. However, with the level of surplus property already coming onto the market and highly cautious occupier behaviour overtaking new space, even when headcount growth returns, it is questionable whether rents can maintain current levels. This may place 'real' rental levels at a historic low.

Lessons For Occupiers: Aggressive Management Of Lease Events

Faced with falling rents, occupiers who are looking to sublet surplus space to reduce costs may struggle to do so at the passing rents. This will lead occupiers to obsessively focus on exercising break clauses and lease expiries, as these may allow them to reduce costs effectively. We have already seen several occupier clients substantially revisit their portfolio strategies in order to position themselves to take aggressive advantage of these opportunities. A recent press report suggested that some major property companies were facing 25%+, even as high as 50%, of their tenancy arrangements coming up for renewal/break in the next three years.

Against a potential declining, or at best flat rental trend extending to or beyond this timeline, the opportunities for savvy occupiers to take real advantage of this delayed recovery are already clear.

In a falling or even just distressed market, few landlords would be likely to reject an occupier's approach to renegotiate a lease renewal on beneficial terms, rather than face the prospect of holding a vacant property in a still difficult market place.

This all presupposes that occupiers have the lease flexibility in their portfolios and that they are sufficiently prepared to action these opportunities. A recent survey of corporate property executives highlighted that the majority recognised that the depressed property market provides real opportunities for forward-thinking property executives to reshape their portfolios and that now is the time for aggressive innovation. However, the survey also highlighted that the majority of these executives also feared their employers' current short-term 'survive today' corporate planning horizons may well prevent them from maximising these opportunities.

In conclusion, the emergence of the property industry from the current recession is likely to be slow and complex, if you subscribe to the lessons of past recessions. Sitting here in Winter 2009, past evidence may suggest that a return to positive GDP growth in 2010 could indicate just the beginning of a much longer road to recovery for the UK property industry. There will invariably be both winners and losers. For those occupiers willing and able to take some bold steps to reshape their portfolio commitments, this tortured time for the industry may also be a once in a lifetime opportunity.

IS BRIBERY AND CORRUPTION RISK ON YOUR RADAR?

With the global economic crisis continuing to significantly affect real estate and construction businesses in the UK, employees at various levels within these organisations may be under increased pressure to do 'whatever is necessary' to secure new business opportunities, in order to get ahead of their competitors.

It goes without saying that senior management need to be aware of the risks to their business of becoming involved in bribery and corruption and consider the reputational damage that can result if such risks are realised.

The possibility of corruption allegations and their impact on a company's reputation, ability to maintain current and forge future business relationships, and its ability to conduct future business should cause construction and property development companies increased concern in this environment. This issue is particularly pertinent to those businesses which deal with Government agencies – especially as the construction industry looks to a raft of new public sector projects supported by increased Government expenditure to see it through the current recession.

Bribery and corruption, broadly the offences relating to the giving or receiving of consideration in order to gain improper influence over a person in a position of trust, is increasingly featuring as a major issue for many organisations in their assessment of their legal, regulatory and business risks. If you find yourself answering 'yes' to any of the following questions then bribery and corruption risk should be high on your agenda:

• Do you conduct property business through the use of agents, joint ventures or other business partners?
• Do you consider acquisitions or joint venture projects in foreign jurisdictions without performing appropriate due diligence designed to identify potential corruption risk?
• Are you or your subsidiaries developing projects or involved in construction projects in countries with a high perceived risk of corruption, for example certain Eastern European countries (e.g. Russia), India or China?
• Do you conduct business with Government agencies or entities in which a foreign Government has an ownership interest, for example when dealing with large public sector construction projects?

The Global Environment

Prosecutors and regulators across the globe are becoming increasingly active in enforcing anti-corruption legislation. The number of enforcement actions, the number of jurisdictions within which enforcement actions have been brought and the size and nature of fines and penalties have all increased significantly over the last few years.

Transparency International has reported that amongst the Organisation for Economic Co-operation and Development (OECD) signatory countries, there is significant enforcement action being brought by Governments in more than 15 jurisdictions.

Up until now, the US Government has led the way in this area bringing 33 enforcement actions in 2008 under the Foreign Corrupt Practices Act which prohibits the payment or attempted payment to a foreign Government official in order to obtain, retain or otherwise gain an improper advantage in the conduct of business.

The largest penalty levied by the US Government to date totalled US$800 million. However, penalties are not limited to monetary fines and disgorgement of profit. Regulators will often require that an entity's anticorruption policies, procedures and controls are subject to assessment by an independent third party and that appropriate remedial actions be taken and are subject to further review.

What Is Happening In The UK?

The UK has been under increasing pressure in recent years, both to reform its current corruption legislation and to keep up with the rest of the world in the enforcement actions it brings. The UK Government published its Bribery Bill in March 2009 proposing reform of the corruption legislation which is currently in force in England and Wales. The Bill is currently under review and it is anticipated that the new legislation will come into force sometime in 2010.

Under the new Bribery Bill, as well as it being an offence to bribe another person or request or receive a bribe, there is a proposal to introduce a new corporate offence of negligently failing to prevent bribery by an employee or agent of the company.

Furthermore, under the Proceeds of Crime Act 2002, employees and companies themselves may also be liable for a money laundering offence if they receive any proceeds of corruption, such as the profits generated by a contract which is won through the payment (or offer of payment) of a bribe.

The Serious Fraud Office (SFO)²², assisted by the City of London Police's new Overseas Anti-Corruption Unit, are the main bodies responsible for investigating and combating corruption and money laundering in the UK. The SFO has recently established a dedicated anti-corruption team to combat corruption in the UK.

In July 2009, following discussions with business and professional advisers which revealed significant interest in a system of self reporting, the SFO published a comprehensive guide setting out its approach to dealing with cases of overseas corruption and in particular how self reporting by companies will be perceived and dealt with. There is no reason to believe that the SFO will deal with cases of corruption in the UK any differently once the UK Government's new Bribery Bill comes into force next year.

Long Term Impact

The conduct of internal procedures and/or co-operation with an independent external investigation, which can often look back a number of years, are lengthy and complex processes which can cause disruption to the operation of the business. This could include generating significant legal and professional costs in managing the processes, and often diverting the focus of senior management away from current and future business strategies, both detrimental to the overall performance of the company.

Indeed, the impact of an SFO investigation on a business can reach far beyond any fines, penalties and restitution orders levied on it by Government agencies and can cause the business problems in the future. For example, The World Bank debarred a multi-national company convicted of corruption in connection with a contract on the Lesotho Highlands Water Project, making it ineligible to be awarded World Bank financed contracts for a period of three years. In addition, as part of its settlement with The World Bank, the company agreed to certain time limited debarments and voluntary shut-outs from bidding for World Bank business. As well as potential World Bank debarments, there are also mandatory debarment provisions under the EU Public Procurement directives where a company has been subject to a conviction for bribery or corruption.

Management Response

In order to manage the criminal, regulatory and reputational risks arising from any involvement in corrupt activities, businesses in many sectors are increasingly investing significant resources into developing and strengthening their controls over bribery and corruption as well as promoting greater transparency and openness through discussions with stakeholders about their commitment to ethical business.

For example, businesses are progressively incorporating bribery and corruption risk assessment into processes relating to interactions and negotiations with customers and business partners such as joint venture parties, (including Government officials), project risk assessments and contract tendering decisions. As well as this, they are also building anti-bribery and corruption criteria into the performance management processes of personnel and developing guidance and training programmes to deal with the treatment of intermediaries, business partners including joint venture associates, entertainment, gifts and donations.

Businesses are also increasingly considering obtaining assurance over their anti-bribery and corruption controls, including from their legal and professional advisers.

If you suspect that bribery and corruption risks have been realised in your real estate business, as set out in the SFO's guide to dealing with overseas corruption, the benefit of self reporting could be the prospect of a civil rather than a criminal outcome as well as the opportunity to proactively manage, with the SFO, the issues of any publicity. Furthermore, if you are a construction or property company which tenders for major Government funded projects, a negotiated settlement rather than a criminal prosecution could mean that the mandatory debarment provisions under EU Public Sector Procurement directives may not apply.

It remains to be seen how this new regime will actually work in practice in tackling cases of overseas corruption committed by UK companies and how it will be applied once the UK Bribery Bill comes into force.

Footnotes

1. Verdict Research Limited.

2. "UK banks may transfer commercial property loans into REITs", Bloomberg, 15 July 2009, De Montfort University Real Estate Debt Survey, May 2009.

3. "Fears grow over commercial property defaults", FT.com May 14 2009, De Montfort University Real Estate Debt Survey, May 2009.

4. De Montfort University Real Estate Debt Survey, May 2009.

5. "A Great Time to Buy?", FundStrategy.co.uk, 4 May 2009.

6. "Fears grow over commercial property defaults", FT.com, 14 May 2009.

7. "UK's CMBS market on shaky ground", WorldFinance.com

8. "REITs to capitalise on credit crunch in commercial realty", Reuters, 19 July 2009.

9. "Real estate stocks climb as prices fall", FT.com, 27 July 2009.

10. European Association for Investors in Non-listed Real Estate Vehicles. (INREV) www.inrev.org

11. "Mortgage REITs are suddenly back in favor", Real Estate Investment SmartBrief, 7 June 2009.

12. "U.S. REITs seeking billions in IPOs, follow-ons", Thomson Reuters, 19 July 2009.

13. "Investors Finding No Fire Sales In Commercial Property", Dow Jones Newswires, 27 July 2009.

14. "Valad Forms Property JV With Bank of Scotland", Wall Street Journal, 1 July 2009.

15. "Draft agreements between HM Treasury, Royal Bank of Scotland and Lloyds Banking Group."

16. "Hammerson rights issue focuses City on real-estate sector and its need for equity," The Independent, 10 February 2009.

17. "Great Portland Estates goes on the hunt with £175m," The Telegraph, 19 May 2009.

18. "Workspace launches £87m rights issue," Propertyweek.com, 27 January 2009.

19. "Land Securities announces £755m rights issue," The Telegraph, 19 February 2009.

20. "British Land launches £740m rights issue," The Times, 12 February 2009.

21. "Segro rights issue gets 95% takeup," Propertyweek.com, 7 April 2009.

22. Serious Fraud Guidance: http://www.sfo.gov.uk/

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.