Wednesday, October 3, 2012

Who will buy distressed properties? - The Irish Times - Wed, Sep 26, 2012

The volume of properties now coming up for sale could push down prices even further and frighten off potential buyers unless decisive action is taken to set a floor to the market, writes BILL NOWLAN 

LOOKING THROUGH the long and growing list of secondary and tertiary commercial property coming on the market from banks and their receivers, I wonder to myself who is going to end up owning such buildings and if the volumes now emerging will impact negatively on current delicate property values. Values have been stabilising of late, but the absence of bank credit to support purchases makes the situation even more dangerous.

The traditional investors in such properties, before the madness set in the early 2000s, were of three types as follows:

Firstly, the professional investor with significant holdings of secondary assets and usually with their own property management office because, believe me, such assets are management intensive and usually require lots of TLC. Such professional investors work mainly below the radar and have a policy of investing in properties such as shopping centres, older office buildings and small industrial estates many with weaker tenants. These portfolios would generally be high yielding at 10 per cent-plus and borrowings would be limited.

Secondly, you have the location-specific investors. This type of operator tends to be confined to their “home” town. Often it is the local pharmacist or butcher who quietly builds up ownership of the buildings on his street or town – sometimes over several generations. They tended to use the profits from business, surplus rent and their pension funds to put together what becomes a type of informal family trust. Such property investors are everywhere in Ireland – in every town and village – but as to their ability to buy, currently many will be suffering economically and have limited funds to purchase new stock, no matter how cheap.

The third type of investor was and is the individual or family either setting up a new portfolio or maybe in an inherited situation. Usually such portfolios have no real coherence but are put together more or less by osmosis. For example, if there are some surplus funds from profits or inheritance they go into buying whatever is then on the market. This type of portfolio would be different from the two types mentioned earlier in that it would be random and unstructured and rarely focused or well managed. Its unspoken strategy would be wealth accumulation in bricks and mortar, and possibly tax management.

The overriding characteristic of all these investors would be low borrowings, high cash yield and, of course, vacant space – the current rate of vacant space probably being high.

Look across most developed economies worldwide and you will see the same three classifications of property investors. I am deliberately omitting the institutional investor as they require prime property and I am also omitting the quoted property companies and REITs who do hold considerable amounts of secondary properties. Ireland has no quoted property sector mainly for the taxation reason of income being double taxed. I have dealt with this in greater detail below.

So this was the situation up to the year 2000. After that date a new type of investor arrived into this market with a bucket of borrowed cash, greedy advisers, bank managers with no or poor judgment, a belief that the property boom would go on forever and often unrealistic expectations. Property in secondary streets or towns became classified as “prime”, and pub chat, gullible bankers, greed and a cycle that lasted too long all induced this “new” investor to believe that such properties were great long-term opportunities.

The enthusiasm to own property and the limited supply pushed yields down from 10 per cent-plus to less than 5 per cent over the space of a few short years. Rents also rose in response to the real activity in the economy. Values often more than quadrupled as yields went down and rents went up. A property that sold for €50,000 in 1996 and was changing hands at €300,000 by 2007, is now worth €100,000 or less if it sells at all.

Of course, it was all an illusion because secondary or tertiary property does not, or rarely, changes its location or its structure. The new “value” was in the intoxicated minds of the buyers. Trees don’t grow to heaven. Many of the vendors of such properties were from one of the old groups of investors who were delighted to sell poor property at thrice its cash flow related value. As one old investor said to me in 2004, “It’s a great time to get the junk out of my portfolio”.

But it has all come crashing down and while some of the traditional investors may have caught the stardust bug, most did not and are sitting more or less as they were in the year 2000– but with rents back and income back to 2000 levels or lower – and still going on sun holidays and not generally in serious trouble with banks.

But back to my original question of who is going to end up owning such buildings and whether the volume now emerging will impact on current delicate values?

It will almost certainly be the same old group that was there before the madness, but where is the cash going to come from for the large volume now emerging on the market? Looking at the results of the Allsops auctions I see only one new category of investor emerging which is the overseas investor, usually an expat buyer with equity, who sees value in such properties in Ireland. The reality is a new form of category one, two or three described above.

The big question is can the large supply match the demand or will a growing supply and limited buyers drive prices down?

Nama appears to be withholding big volumes both of prime and secondary commercial property from the markets and the banks should be considering the same approach. In my view, the banks should be thinking about setting up their own holding funds or vehicles to take such properties into their own “warehouse” and then release them later, as and when the market can take them. Forcing down values now even further will achieve nothing and will frighten off what buyers are there. Such action would set a floor to the market. One big British bank, RBS, has already set up such a fund called West Register and is acquiring properties in Ireland that don’t meet the reserve prices. RBS owns Ulster Bank here.

Such properties generally give a much higher yield than their cost of funds and by moving from the distressed side of the banks’ balance sheet to the normal loan category, it releases working capital.

While if REITs had been introduced some time ago, we would by now have a sophisticated quoted property market which could take up some of this property. This is what happens in the rest of Europe and the US. Such REITs give a high yield to investors and if they were now operating in Ireland would be quite capable of buying some of the bigger secondary properties that may be outside the capacity of individuals to digest. Enabling REITs now in Ireland won’t create a quick fix today but may enable bank vehicles such as Ulster’s West Register to have a vehicle for emptying their “warehouses” in the medium term. An announcement about introducing REITs in the forthcoming budget would be most welcome news.

Bill Nowlan is a chartered surveyor and town planner. He is managing partner of property asset management company W K Nowlan Associates

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