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Real Estate Reality Check

Property Crunch Could Whack Brit Banks

By Mark Scott

The US subprime crisis is putting the brakes on Britain's commercial property boom, driving down real estate values and putting banks in jeopardy.

Walking around London's financial district is like touring a construction site. Giant cranes dot the skyline around St. Paul's Cathedral as workers busy themselves putting up the latest additions to Britain's long-running boom in commercial property.

But cracks are starting to appear in the edifice. The fallout from the US subprime crisis has slowed demand for office space -- particularly from the financial services sector -- at a time when more mega-skyscrapers are in the works than ever before. According to real estate tracker Investment Property Databank, after surging 17 percent in 2006, British commercial property prices fell 12 percent in the last half of 2007. Analysts are now predicting a further 15 percent drop by the middle of this year.

Writedowns Likely to Accelerate

That's bad news for property companies like British Land and Hammerson. Perhaps even more worrisome, many major European banks, such as Britain's HBOS and Germany's Deutsche Bank, have lent billions of dollars to developers during the boom, which now could be at risk of default as projects lose value.

Estimates vary about how much is at stake, but Morgan Stanley reckons as much as $212 billion (€143 billion) in outstanding commercial real estate loans worldwide -- including assets left on banks' books and other securitized financial instruments -- could be vulnerable. How much of that might be written off depends on the property market's performance over the next 18 months, say the bank's economists. They argue that the probability of writedowns has increased since the third quarter of 2007 because investors are now shying away from complex, property-related financial products, such as securitized loans.

"There's no doubt that billions of dollars are at risk," says Ian Harnett, European strategy director at the London consultancy Absolute Strategy Research. "The whole sector has really fallen off a cliff."

Plummeting Property Values

Market fundamentals have indeed changed quite dramatically for commercial property. One indicator is the so-called "average prime yield," which has risen during the past year -- a sign of cooling demand and weakening returns on property investments. Data from realtor CB Richard Ellis show the underlying price of real estate assets in Britain has declined relative to rents, causing the yield to rise. It climbed 50 basis points, to 5.7 percent, in the fourth quarter of 2007 -- some 90 points higher than during the same period in 2006.

Downward trends look likely to continue this year, and not just in Britain, which remains Europe's largest and most dynamic commercial property market. Strains are showing up as well on the Continent, especially in Germany and Spain, where overbuilding and subprime losses are taking a toll. Since December, for instance, Spanish property firm Inmobiliaria Colonial has been forced to sell more than $450 million of its commercial portfolio to ease its rising debt obligations, which stood at $13.1 billion as of September, 2007. Given the spreading woes, real estate firm Jones Lang LaSalle predicts the value of property transactions across Europe will decline 20 percent this year, to $260 billion, from 2007 levels.

Central Banks Sound the Alarm

The potential implications for the financial sector already have caught the attention of central bankers. In the wake of massive writedowns from the subprime crisis, the last thing banks need now is further losses tied to commercial property. In its October, 2007, financial stability report, the Bank of England highlighted the problem, saying the risk of defaults could put extra strain on the already stretched financial system.