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  Real Estate Reality Check: Property Crunch Could Whack Brit Banks

Real Estate Reality Check Property Crunch Could Whack Brit Banks

By Mark Scott

Part 2: Sovereign Wealth Funds See Investment Opportunities

Similarly, a European Central Bank report in December, 2007, cautioned against the rise of commercial, mortgage-backed securities, which sprang up as banks repackaged assets to be sold to third parties, a process similar to the securitization of US subprime loans. And just as the subprime market implosion left banks unsure of who owed what to whom, the ECB worries that defaults in securitized loans resulting from a weakened commercial property market would "make it difficult for investors to understand the risks involved."

Is this Chapter Two of the subprime mess? Yes and no. The downward trend is unmistakable, but the losses are likely to be on a much smaller scale because commercial property lending is a safer and more stable business than writing home mortgages for people with bad credit histories. Kelvin Davidson, property economist at London-based consultants Capital Economics, notes that developers protect themselves better than they used to in the 1990s (when overbuilding promoted a brief collapse in the British commercial real estate market) by signing long-term leases and hitting higher occupancy targets before breaking ground on new projects.

What banks are most exposed to the downturn? According to estimates from the Bank of England, there were $369 billion in outstanding commercial real estate loans at the end of the third quarter of 2007 in Britain, which is Europe's largest market. Research from brokerage Dresdner Kleinwort shows HBOS and the Royal Bank of Scotland are the most exposed, with $86.3 billion and $103.3 billion worth of loans, respectively. Analysts disagree on how much could be lost, although conservative estimates predict 5 percent of assets might be wiped out.

"Banks that have gone after the sector aggressively will have to face defaults from developers if there's a downturn," says banking analyst Alex Potter at stockbroker Collins Stewart in London. "It might not be a vast amount, but it could come back to bite banks where it hurts when they're already suffering."

More Bargains for Sovereign Funds

That's tough news, but for other investors, particularly for cash-rich sovereign wealth funds, the possibility of banks selling off distressed assets to cover debts could provide an ideal investment opportunity. Without needing to raise financing in the contracting debt markets, these government-backed investors could snap up bargains only to resell them when the cyclical commercial property market once again turns bullish.

"They don't have to take leverage, so won't be too affected by the change in credit conditions," says Tony Horrell, head of European capital markets at Jones Lang Lasalle in London. Indeed, he argues that the change in ownership from cash-strapped developers to cash-rich funds could help stave off bank writedowns at a time when sentiment has turned negative.

The move is already under way. On Jan. 9, GIC Real Estate, an investment fund owned by the Singapore government, paid $266 million for a 3 percent stake in British Land, the shares of which have fallen 41 percent since the beginning of 2007.

Whether sovereign wealth funds will once again bail out banks still remains to be seen. But with billions of dollars invested and property values set to sag in 2008, banks are set for a bruising year that will only compound their current economic woes.

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