Fire Sales To Come As Capital Values To Fall 35%, Major Reports Say

With unaffordable interest payments making refinancing property nearly impossible, many UK office and retail property landlords will be forced into fire sales.

The resulting pressure could slash capital values by as much as 35% in a value destruction process that will extend even into prime property, according to two analyses of the state of real estate financing. Prime yields for UK property, 3% to 4% in many sectors, may have to blow out to 6% to 7% to sustain new financing costs.

Together the warnings from Oxford Economics and Bayes Business School show how a perfect storm has been quietly gathering over UK commercial real estate — particularly the office and retail sectors — a storm that the recent sudden shift in monetary policy could now unleash.

The gloomy analyses of rising interest rates precipitating falling capital values is a result of UK policy swings from fiscal and monetary looseness to extreme fiscal and monetary tightness in an effort to control inflation. This is starting to clash with the need to maintain financial stability, Oxford Economics warned in its latest bulletin.

“We believe that central banks and governments have the tools to avert the worst outcomes, but continued tightening does raise the risk of an illiquidity event,” Oxford said.

“Dangerously low” interest coverage ratios, plus refinancing shortfalls, threaten to push some UK commercial real estate markets into distress, it added.

The greatest risk of a crash comes in the UK office and retail sectors, where meeting interest payments for floating-rate loans or loans that need to be refinanced will be tough, with refinancing made tougher by falling capital values. 

“Capital values increased in the first half of the year, but since the summer downward pressure has emerged,” Oxford said. "With elevated financial market volatility, rising occupier default risk, bank credit standards tightening, and recession starting to bite, the risk of forced selling and a sharper correction in pricing has increased."

A financing shortfall looks set to emerge for retail and offices, placing these sectors at greater risk of forced sales. Capital values for retail and office assets have declined or been weak over the past five years — the typical loan term for a UK commercial property — while lending conditions have tightened, meaning a lower loan-to-value ratio is now on offer relative to five years ago.

As a result, refinancing loans will be tough, whilst meeting current interest payments could be impossible.

Value Wiped Out

The Bayes Business School Commercial Real Estate Lending Report has a similar analysis and highlights the underlying metrics, which it said mean values in some sectors could fall by 25% to 35%.

It revealed the seeds of the fire sale scenario predicted by Oxford Economics, and its potentially dire consequences even for prime property.

“Current ICR levels are now reaching close to 1x or less for prime property types, restricting further capital value growth, potentially resulting in a value decline in the near future,” Bayes senior research fellow Nicole Lux wrote in the report.

“Interest payments and property income were approaching a 1:1 ratio by June 2022, and with the five-year Sonia swap reaching 5.2% by the end of September 2022, property income will not be sufficient to refinance some properties at these rates, leaving a potential funding gap."

The risk of contagion to ostensibly prime real estate was tucked away on Page 54 of the report. The risk of negative equity due to falling property values could affect not only higher-LTV loans and development or secondary assets but also the very prime end of the market, it said.

"Property net yield across different property types has to increase to 6-7% in order to sustain a loan interest of 5-7% for a senior loan. This means potentially property value decline by 25%-35%."

Interest Rate Woes

The focus of the analysis then narrows to interest rates, where the Bayes report exposes the risk of further interest rate rises. Forty per cent of UK loans are on floating interest rates, and almost half of those floating-rate loans are provided by UK banks, according to the report.

Oxford Economics suggested that landlords' interest coverage ratios — the ratio of earnings before deductions to interest payments due — now look to be stretched. ICRs are approaching one across the markets analysed, with Oxford Economics raising a red flag over UK offices in response to all-in interest rates doubling to 7.7%.

“The interest coverage ratio for an average UK office acquired in 2018 will be below 1.0 in 2023, posing a huge risk to real estate market stability," Oxford said.

Those with fixed-rate debt will be shielded, but with policy rates set to remain elevated next year, the situation at refinancing looks untenable without debt costs retracting. It could be argued that the UK economy is an outlier, but ICRs in France, Germany and the U.S. are also expected to be very low in 2023, with the office and retail sectors looking most exposed, Oxford added.

ICRs in all sectors of the U.S. and UK property markets are below 1.5%, usually regarded as a benchmark, and in UK office and industrial are below 1%. 

It gets worse, because Oxford “notes with concern” that private equity direct leverage has been consistently high, but relatively opaque.

"Little is known about the use of indirect leverage (at company or SPV level) or subscription credit lines (against dry powder) — both of which could add to total debt, increasing the prospect of forced sales," it said.

Oxford estimated that there could be a loan shortfall of up to 40% at refinancing in 2023 for UK retail, which has seen capital values decline by 30% since 2018. Retail also fares poorly in Australia, France, Germany and the U.S.

The loan shortfall in the office sector is around 20%, but “in addition, the office sector looks exposed as concern over the aggregate level of future demand, considering the proliferation of hybrid working, impacts investor sentiment and pricing”.

Only the industrial and logistics sector looks safe for loan extensions, new junior debt or new equity.

The analysis concluded that “the risk of a major illiquidity event is increasing” as policymakers double down on inflation risks. 

“We believe that central banks and governments have the tools to avert the worst outcomes, but it does raise the risk of illiquidity given current elevated financial stress."