As has been widely reported, the credit crunch resulting from the failure of the US subprime market has had a huge impact on the fortunes of the UK real estate market.
Its real effect has been to reverse the tidal wave of positive sentiment in property, ending a bull market that had lasted for more than a decade.
The biggest single challenge is the change in attitude of the banking market to the real estate sector.
Principally, the market must decide how to overcome the inevitable funding gap caused by a banking market that is retreating to historic levels of lending not seen since the early 1990s.
Lending on purchase cost (as opposed to value) is creating a new reality for the market.
With senior debt levels averaging 70 to 75 per cent of purchase price, where will the equity come from?
It would be an exaggeration to suggest all transactions undertaken in recent years were with little or no equity. Undeniably, though, the recent bull run in the market has been exacerbated by financial engineering and ever flexible banking in a market that until 12 months ago was home to more than 100 lending institutions.
Mezzanine funding could in some cases plug some of the gap, although in this new environment its cost will reflect its real risk in sitting behind the senior debt provider.
Opportunities do exist for this type of funding, but certain companies in the sector may well have to face the painful realisation that the ‘blended funding’ provided by many of the clearing banks in particular was not in truth real mezzanine funding. It was instead a hybrid used to provide a competitive edge in pursuit of a enlarged market share.
Investors will need to accept that to obtain the required level of support, one must share in the upside as opposed to a nominal exit fee. Following the recent years of free liquidity where investors bathed in cheap credit this will be a painful pill for the real estate sector to swallow.
On a positive note, the sharp decline in values over the past 12 months in the commercial market has simply allowed the market to return to a more logical path where (after debt) the fundamentals for investing in property are favourable.
Once the cost of debt in the banking market settles, this ‘short sharp shock’ should see the market recover.
Clearly inflation and the price of oil are affecting the timing of the inevitable recovery and may cause the current market turbulence to be prolonged into 2009.
In any market, transactions are undertaken and investors can have considerable success.
Many investors holding property are reluctant to move from the ‘high tide’ values of 2007, as there seems little pressure from the banking market to trigger breaches in loan to value covenants.
While some commentators suggest a ‘doom and gloom’ mentality, current evidence would suggest we are simply seeing the market return to activity based on sound fundamentals.
Jason Briggs is director of corporate finance at accountant BDO Stoy Hayward