Risk Management

Stress Test

In the aftermath of the subprime meltdown, how are property-sector CFOs coping?
Janet KersnarJune 2, 2008

“We are in the eye of the storm,” says Simon Melliss, the long-serving finance chief of Hammerson, one of the UK’s largest property groups. This particular storm started last summer after the US’s subprime mortgage meltdown, and is battering companies like Hammerson as property values plummet and funding, not to mention investor confidence, dry up. Hammerson’s share price, like those of many of its competitors, has already been hit hard, falling more than 40% over the past year.

But unlike the sector’s last dramatic downturn, which brought developer after developer to their knees in the early 1990s, Melliss says most of Europe’s property companies — contrary to popular belief — are financially fit to weather this storm. “The problems in the 1990s were in the trade and development type of company — buying and selling, buying and selling,” he recalls. “They had overstretched themselves in development, particularly in central London, they had little cash flow and they couldn’t finance themselves.” While he accepts that some property companies “have confused the [recent] bull market with genius” as others have done in previous market booms, he reckons that a big difference between the two downturns is that “in the early 1990s the property industry caused the financial crisis; this time round, it’s the banking world that is causing the property crisis.”

Whatever the cause, it’s not just Melliss who is feeling more confident than one might expect. Europe’s property companies today are large, diversified, less leveraged companies with investment portfolios that provide steady income, according to Tony Key, professor of real estate economics at Cass Business School in London. “Their CFOs are feeling a lot more relaxed than they once would have been,” he says. A report published in December by FitchRatings notes that well before the turmoil began last summer, CFOs’ treasury teams “showed good anticipation” of low interest rates and frothy property markets when carrying out bank refinancing and new bond issues.

Yet most concede that it could get worse before it gets better. A report in May by Morgan Stanley warned that UK banks are poised to “pull the plug” on some highly leveraged property companies. Its analysts believe this will lead to “distressed sales of properties and hence another upward lurch in property yields.” They forecast a further fall of 25% for a basket of European property companies’ share prices, with no recovery until the end of 2009.

Shortly after Morgan Stanley’s report, Moody’s Investors Service declared that “the fundamental credit outlook for the European real estate industry is negative,” with costly, scarce credit “creating a dearth of investor demand and causing property prices to drop.” But despite such bearishness, Moody’s analysts point out that not all parts of Europe’s economy are hit by the US fallout equally, and asset values of the sector’s investment-grade players can still withstand a significant drop over the next year or so without experiencing permanent damage.

So why don’t Melliss and other property CFOs believe that they will see a repeat of the 1990s downturn? Stronger balance sheets, for one. Gearing at Hammerson, for example, is in a “comfortable” 50%-to-60% range, says Melliss, while the firm’s weighted average maturity of debt is approximately nine years. What’s more, as of the end of December, the firm had access to more than £3 billion (€3.8 billion) in cash and other facilities.

There’s another reason for Melliss’ confidence — better focus. When he arrived at Hammerson in 1994, he recalls how the company “was spread out all over the place,” with businesses in seven countries besides the UK, including the US and Australia, and a portfolio divided into 60% office and 40% retail. Rents were under pressure, and “we suffered from lease expiries at the bottom of the market.” Today, with properties just in the UK and France, and a £7.3 billion portfolio comprising mostly retail, which generally tends to be less volatile, “we have a much different risk profile.”

The portfolio reshuffle is looking smart today. Office rentals in the City of London — an important market for UK-based companies like Hammerson — fell 40% in the six months to March, according to property consultants Jones Lang LaSalle, with a further fall on the way if predictions of 16,000 job losses in the area over the next 12 months come true.

Melliss also notes that France hasn’t suffered from the subprime fallout as much as the UK, and that Hammerson’s five major French shopping centres reported total returns of more than 20% last year.

Looking ahead, retail assets overall in France are expected to outperform office assets by nearly 4%, compared with an underperformance of 2% in the UK, according to a five-year forecast of total returns from Henderson Global Investors. (See “Office v Retail” at the end of this article.)

Go East

Another finance chief pleased with his company’s choice of locations is Erez Boniel, who joined Polish blue-chip property group Globe Trade Centre (GTC) in 1997. Set up in Warsaw three years earlier by a small group of entrepreneurs with a $6m investment, the office and shopping-centre company grew steadily into seven neighbouring countries with similar characteristics to Poland, in a region now experiencing little spillover from the credit crisis in the west. “Whenever I’m in London for business lately, everyone around me has all this bad news, and I’m thinking to myself, ‘That’s not what I’m hearing back in Poland,’” he says.

Indeed, in the first quarter, GTC’s operating profit tripled year on year to €60m, and the value of its investment property increased by nearly 70%, to €950m. And its pipeline looks promising, having recently announced plans to build another 1m square metres of commercial space by 2010, increasing its portfolio fivefold. Part of that growth involves a potentially risky departure from its previous course, investing in Russia for the first time. As Boniel concludes, a company of GTC’s size “can afford to take a little bit of risk, in a very methodical manner and in a sector that we feel we are the strongest — offices.”

Most real estate investment in Russia is in Moscow, which accounts for nearly three-quarters of national real estate investment transactions in 2007, note consultants Jones Lang Lasalle. And its popularity looks set to continue. In their annual study of European real estate, the Urban Land Institute and PricewaterhouseCoopers polled nearly 500 industry experts — investors, brokers, property companies and so on — late last year, who voted Moscow as the top city in terms of investment and development prospects, displacing London. Moscow, however, was also voted the riskiest city by survey respondents.

To mitigate this risk, GTC announced in April plans to join Menora Mivtachim Holdings of Israel in a 50:50 joint venture to develop 110,000 square metres of office space in the Vyborgsky district of St Petersburg, far from the crush of development in Moscow. This was no hasty decision. GTC executives spent the previous 18 months investigating opportunities in both Russia and Ukraine. “We didn’t invest that whole time because we felt the level of risk didn’t suit our appetite,” says Boniel. When GTC did decide to invest, “we went for a relatively safe project. We’re talking about a project that is small for GTC, only 52,000 square metres — against our total portfolio of 2.3m square metres — and requiring an investment of only €26.8m.”

Sending Signals

Handling jittery investors is an area where property companies need to tread carefully when launching new projects in these uncertain times. Some are proving better at this than others. One that’s fallen short is Meinl European Land, an Austrian property developer with a €2.7 billion portfolio in Poland, Russia and Turkey. Last spring, it announced plans to repurchase 10% of its shares in a buyback programme that would, in the words of a company press release, “send a clear signal to investors regarding the company’s growth potential.” Rather than seeing the buyback programme as evidence of Meinl’s growth potential, however, investors saw an overstretched balance sheet. The ratings agencies agreed, leading to downgrades that caused the bottom to fall out of its share price.

In contrast, when PSP Swiss Property recently announced a buyback programme, approved at its AGM in April, CFO Giacomo Balzarini didn’t talk about growth potential for the Zurich-based company, which owns around SFr5 billion (€3 billion) of prime property in Switzerland’s main cities. Instead, he stressed the company’s need for “optimal capital management flexibility.” The buyback programme allows a maximum of 5% of issued capital to be purchased over the next three years and PSP will only initiate it “if there’s a significant market turmoil — nothing to do with Switzerland or PSP, but if there’s a threat of the stock price sinking below PSP’s net asset value,” explains the CFO. What’s more, he says, “it should be done with the conviction that you can access capital when needed.”

Is the programme a good way of giving PSP’s share price a boost to ward off advances from potential acquirers? Balzarini’s answer is a matter-of-fact “Our responsibility is to act in the best interest of shareholders.” Besides, he adds, its share price hasn’t yet needed any boosting. Thanks to PSP’s “focus, quality of the portfolio and the very conservative financing policy,” its shares rallied from a year-end close SFr57 to between SFr65 and SFr70 in recent weeks.

Gentle Shifts?

But with share prices in the industry generally trading below property net asset values, some suggest that property CFOs should get ready for sector-wide consolidation. CFOs themselves are sceptical. Most reckon that there are few synergies or other benefits from large-scale M&A among property companies.

Rather, many CFOs believe that their priority is to making improvements to risk management. To help them, some are turning to derivatives — fortunately not the exotic instruments that played such a big role in the subprime fiasco, but those based on property prices.

In fact, swaps on the Investment Property Databank’s real estate return indices are gaining considerable traction in Europe, though trading remains small in comparison to other derivatives. By the end of 2007, €14.4 billion had been traded in the UK, Italy, Germany and France, up from €5 billion in 2006. In the first three months of this year, €4.6 billion of the derivatives were traded, increasingly by property companies, in addition to traditional users such as banks and institutional investors.

Since early last year, Grosvenor Group, a privately held UK company that owns and manages property worth nearly £13 billion in 16 countries, has been testing the waters by executing small trades in the instruments. Nick Scarles, Grosvenor’s finance director, says property derivatives are a good way of reducing the risk of its investments and developments, and perhaps also for its fund management business.

There is another attraction. Derivatives allow the firm “to gently shift the balance of asset allocation globally” from one country to another and “to give us the luxury of time to find the right asset” in a particular market, says Scarles. As he explains, “To migrate capital takes time — it is easy enough to have a fire sale and to bid at an auction — but you can overpay and undersell. By using derivatives, we can speed up the process of shifting portfolio allocations.” At an individual company level, he says, Grosvenor will use property derivatives for hedging purposes — for instance, in its development business in the UK it might use sector derivatives to hedge out long-term projects.

Grosvenor has started out small, “to make sure that we understand the documentation [in each new jurisdiction], accounting, how to measure counterparty risk and provide our team with experience if we have a trade at a more material level,” says Scarles, who was appointed chairman of the Property Derivatives Interest Group earlier this year. And reflecting the current mood of the sector, Grosvenor is cautious. “If my background had not included derivatives and treasury, I would not feel comfortable in the course that we’re taking,” he notes.

Wall of Money

Other CFOs may feel that such instruments are a step too far in today’s climate. Many will prefer to wait and see how the current cycle evolves, particularly given that many observers believe that, though the banks are currently on the sidelines, there is “a wall of money” — as one property lawyer describes it — raised by funds waiting to invest in the sector. “Although both equity and debt [will be] tighter than last year,” nearly two-thirds of respondents to the Urban Land Institute and PwC survey expect there to be “enough — or even a moderate surplus — out hunting for European real estate when the market settles down.”

But when the market will settle down is a subject of much debate. At a recent conference in Berlin organised by the Investment Property Databank, there was plenty of disagreement about the current state of play. A crisis? A freeze? A crash? Delegates also argued over how long the turmoil would last. Six months? 12 months? Much longer?

Based on his research, Key of Cass Business School told conference delegates that property CFOs should expect to wait until 2013 before feeling relaxed about credit conditions. “If you look back at the 1970s, and even the early 1990s, in both cases there was a credit contraction of bank lending to real estate of 20-odd %,” he said. In measuring the leverage — the outstanding debt against the total property stock — he found that it fell for about six years following a cycle’s peak. “The credit in absolute terms actually contracts for at least three years, but the leverage continues to contract, because after that you have a period when the value is still recovering, but the debt is not rising as fast,” he explains.

Can Europe’s property companies survive for such a long stretch? Many CFOs believe they can, arguing that the lessons they’ve learned from past downturns have shown them how to weather the crisis. But, as Key cautions, “history is not always as robust a guide as we might hope.”

Janet Kersnar is editor-in-chief at CFO Europe.

Public Property

There was a big development in the UK’s property market last year, but it didn’t involve any bricks or mortar. Around three-quarters of the UK’s major quoted property companies — including Land Securities, British Land and Hammerson — took advantage of new rules allowing them to become real estate investment trusts (REITs), giving them a tax-advantaged status and more flexibility to buy and sell their property that REITs in other countries — including the US, Australia, Germany and France — enjoy.

Of course, the timing could have been better. After a promising start, UK REITs’ share prices ended last year 40% lower. But the switch is more positive when viewed from a longer-term perspective, says Simon Melliss, CFO of Hammerson. “If you owned a property on which there was a large capital gains tax, you probably didn’t sell it,” he notes. “Once that inefficiency was removed and you are on the same footing as a UK pension fund and every other investor, tax doesn’t become a consideration.”

Will the new legislation help newly formed REITs in the UK weather the credit crunch? “It’s too soon to say,” Melliss contends, during an interview at Hammerson’s headquarters off London’s Bond Street. “You need to come back and speak to whoever is sitting in this chair in 2018 and see how it has worked.”

Retail assets in Europe are expected to outperform offices over the next five years.
Debt has been rising faster than assets for UK property firms.
European yields vs. cost of finance

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