Depressed or positive?

Nia Williams

September 1, 2008

Recent reports in the commercial world reflect the residential market in terms of doom and gloom. Headlines such as ‘Business failures rocket’ do not help to inspire confidence in the sector. So what exactly is going on?

Well, with all the painful predictions that the UK’s economy appears to be on the cusp of a recession, Equifax has reported a significant rise in business failures across all sectors. Total failures in July 2008 rose by 29 per cent compared to the same month last year. Equifax is therefore urging companies to batten down the hatches and put in place tactics to weather the storm.

“The transport and communication sector was the worst hit, seeing a substantial 59 per cent year on year increase in failures in July,” explains Nic Beishon, head of commercial solutions for Equifax. “With the price of fuel spiralling ever higher many businesses are starting to feel the pinch as overheads continue to soar. The construction sector also saw a high year on year increase in failures at 57 per cent. This provides clear signs that the property downturn is having the expected impact on the industry.

“The manufacturing sector saw a 39 per cent rise in July 2008 compared to July 2007, which comes as no great shock following the recent ONS figures on manufacturing output which decreased by 0.8 per cent in the second quarter of 2008 compared with the first quarter.”

The high street spending slowdown contributed to a 33 per cent rise in business failures within the retail sector. Low consumer confidence and less spending probably contributed to this rise and in the wholesale sector, failures rose by 26 per cent year on year for the month of July. The service sector saw the smallest increase year on year, at just 12 per cent.

Slowdown

Capital Economics agrees that there has been a marked slowdown and warns of more to come: “Not only do we still think that the commercial property market’s correction has considerably further to run but the deteriorating economic outlook has caused us to downgrade our forecasts. We now think that capital values will be down by 17 per cent year-on-year in 2008 and will then drop a further 10 per cent or so in 2009. Total returns are likely to average about -9 per cent year-on-year in 2008 and 2009 (see table 2). These downbeat forecasts reflect our view that an outright recession is now more likely than not.”

Capital Economics believes that high living costs are adding to the strain on household finances and predicted higher unemployment will only add to the downward pressure on consumer spending growth. It does believe that falling inflation will allow the MPC to cut interest rates aggressively next year, but even then, the benefits of lower rates will take time to feed through.

“So with the economy set for a rough ride over the next few years, we anticipate that demand for commercial property floorspace will soften materially, causing all-property rental values to fall by about 3 per cent y/y this year and by 7 per cent in 2009. Sub-sectors where a supply overhang is also a problem – e.g. City offices – are likely to see even bigger rental value falls.

“To be fair, there are reportedly large sums of money – e.g. from cash-rich foreign investors – poised and ready to enter the UK property market when the time is right. A fall in bond yields in anticipation of lower inflation and lower short term interest rates next year would add to the case for an early return to property acquisitions.

“But to us, the case that property has returned to fair value is far from compelling. The prospective weakness of the real economy points to a more drawn-out adjustment, in line with past experience. Commercial property’s downswing in the early 1990s lasted for three years. Our forecast is that the ultimate fall in all-property capital values will be around 35 per cent, so given that they have fallen by about 20 per cent to date, prices have another 15 per cent or so to drop.”

Demand

To add to this, the number of surveyors is also reporting that demand for commercial property in Quarter 2 has fallen to the lowest level in a decade, according to the Royal Institute of Chartered Surveyors. In the survey, 50 per cent more chartered surveyors reported a fall than a rise in demand compared to 31 per cent in Quarter 1 2008.

All sectors reported falls for the third consecutive quarter with the retail, industrial and the office sectors dropping to the lowest balance in the survey’s history. The worst hit area continues to be the retail sector with 64 per cent more chartered surveyors reporting a fall than a rise in retail demand, compared to 42 per cent in Quarter 1.

New occupier enquiries also fell across all three sectors for the third consecutive month. Financial uncertainty has impacted upon decision making in the business community with many re-evaluating their demand for commercial property space, according to RICS. 54 per cent more chartered surveyors reported a fall than a rise in new enquiries for offices compared to 36 per cent in Quarter 1.

Commenting, Simon Rubinsohn, RICS chief economist believes: “The drop in tenant demand is indicative of the increasing pressure on business while the wider economic impact is starting to be felt in the drop in consumer confidence. Rental growth is on a downward spiral and evidence suggests that the levels of inducements are on the increase as landlords attempt to keep property occupied. The picture is looking depressed in the near term but investors are seeing yields begin to reach levels which will offer decent returns.”

Buy-to-let

So, it could be good news for landlords. But, in the middle of this economic downturn, the number of mortgage products available for buy-to-let landlords has also fallen. This time last year there were 4,384 buy-to-let mortgages available to landlords but there are only around 307 now. To make it worse, on top of the scarcity of products, buy to letters face steeper interest rates on those still available, according to figures from price comparison site moneysupermarket.com.

The average rate for 75 per cent loan-to-value BTL products has increased by 0.35 per cent to 7.33 per cent in the past year, and by 0.63 per cent to 7.46 per cent for 85 per cent LTV products. The increase in interest rates means landlords will have to increase rents or find the shortfall themselves. On a £100,000 interest-only mortgage, for example, the rent needed to cover the interest on the mortgage has increased from £569 to £622.

This hike is compounded by the fact, on average, lenders now insist the rental income is 19 per cent greater than the monthly mortgage repayments, up from 13 per cent a year ago. It means, in effect, landlords will need to increase rent by 15 per cent to keep up with these two changes (see box 1)

As Louise Cuming, head of mortgages at moneysupermarket.com, says: “These are worrying times for tenants, landlords and developers. With the cost of living spiraling out of control, tenants are unlikely to be willing to wear increased rental demands.

“Those landlords wishing to remortgage buy to let properties will find it difficult, with lenders demanding sizeable deposits or charging higher rates. This could force landlords to re-evaluate whether it is worthwhile staying in the sector in the current climate. With property prices falling though, there may well be many landlords having to sell their investment at a loss.”

So, why should anyone bother with commercial mortgages or commercial buy-to-lets based on all this bad news? And are there any lenders left in the sector? It is easy to become very despondent with news like this being reported on an almost daily basis.

However, there are still mortgages out there – both commercial and buy-to-let. And there are people out there who still want the mortgages. Whilst you have to be realistic about the state of the market – and no one is denying it is going to be easy over the next year or so – you also know that people will still want and need property. In fact the current market does offer huge opportunities for landlords so check out what is available and look for the positives.


Sign up to our daily email