How will this recession affect commercial property?

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Recession affects on commercial property

Last week, the Bank of England made a number of very worrying statements.  They started by saying the UK is facing its longest recession since records began.  They then went on to say the UK would face a very challenging 2 year slump and unemployment will double.  These warnings were issued at the same time as interest rates increased by the largest amount in 33 years.

We all know that during any recession people and companies suffer financially.  Companies go bust and people go bankrupt which leads to some losing their jobs and homes.  However, how will this recession affect commercial property?

The UK economy, and most economies around the world, are facing extremely turbulent times.  The UK Government is seeking to decrease debt, as inflation is at an all-time high, the cost of living is rising at its fastest rate in 40 years, unemployment is increasing and businesses generally are struggling.  The main threat is high inflation and to combat this, the Bank of England started to increase interest rates just under a year ago.  When interest rates rise, it becomes more expensive to borrow which affects those with residential mortgages, commercial mortgages, bank loans, personal loans, credit cards debts, car finance, pay-day loans and all other loans.  The commercial property market is affected more by interest rates than anything else and here is why:

  1. Decrease in consumer spending

     

    As interest rates increase, peoples debts become more expensive.  As a result of this, they have less disposable income.  This means less money to spend in shops, less money to spend online, less money to spend on cars, less money to spend on holidays and less money to spend on investments.  Consequently, companies who occupy high street shops, offices, warehouses and other commercial properties will find it difficult to pay their rent.  Some will survive but be unable to pay their rent whilst others will go bust and disappears altogether.  Without rent, most landlords cannot pay interest on the loans they took out to buy these properties.  Banks will soon repossess these properties and try to sell them quickly and cheaply.  Selling them cheaply makes all other similar properties worth less.

  2. Companies going bust

     

    As consumer spending falls, companies bring in less money.  At the same time as this, some of their costs increase, particularly their borrowing costs (commercial mortgages and bank loans).  This soon becomes unsustainable and they can no longer survive.  When companies go bust, the first people to suffer are landlords.  Those landlords who manage to avoid having their properties repossessed are left with vacant properties which very soon fall in value.  If these properties stay vacant for longer than 6 months, and depending on where they are, they could fall in value by as much as 50%.

  3. Loan-to-value breaches

     

    Most investors who buy commercial property take out commercial mortgages/loans.  These loans are based on a percentage of the lower of the cost or value of the property and this percentage must remain the same throughout the duration of the loan.  Interest rates and commercial property values have an inverse relationship.  This means when one goes up, the other comes down and vice-versa.  As interest rates rise, and the value of property falls, loans increase as a percentage of the lower values.  This is known as a breach of the loan-to-value covenant.  If this happens, banks will demand that borrowers reduces their loan so the percentage returns to where it was at the start.  This can cause problems for owners and at times lead to them losing their properties.  This is better explained by way of an example.  An investor buys a high street shop with a flat above for £250,000.  He doesn’t have £250,000 so needs to borrow money from a bank.  The bank gets a valuation which comes out at £230,000.  The bank then agrees to lend the investor 70% of the lower of the cost or value which equates to £161,000 (70% of £230,000).  The investor now has to find £89,000 in order to buy the property (£250,000 – £161,000).  The investor actually has to find more than £89,000 but to keep things simple these additional costs have not been included (they include stamp duty, legal fees, agent’s fees, valuation fees, fees to the bank to borrow the money, mortgage broker’s fees and survey fees).  The country goes into recession and commercial property values start to fall.  The bank demands that the owner has a valuation which concludes that the value of the property has fallen by 20% and is now worth £184,000 (20% less than £230,000).  The bank tells the investor that their loan of £161,000 is now 87.5% of the value of their property so they must give the bank £32,200 to reduce their loan from £161,000 to £128,800 (as £128,800 is 70% of £184,000).  If the investor manages to find another £32,200, they will have invested a total amount of £121,200 of their money in the property (the original £89,000 plus the additional £32,200).  As their property is now only worth £184,000, the money they have invested represents 66% of the value of their property.  If the investor cannot find the additional £32,200, the bank will repossess the property and if the bank cannot sell the property for more than £161,000 (the amount they originally lent), the investor will lose the £89,000 of cash they put in when they bought it.

  4. Revaluations

     

    As soon as interest rates start to rise, and there are signs that commercial property values are starting to fall, lenders will ask borrowers to get up-to-date valuations on their properties.  These are known as revaluations, which borrowers have to pay for, and enable banks to demand money from borrowers to prevent loan-to-value breaches (as described above).

    When lenders, borrowers and valuers soon start to see that property values are falling, buyers start offering less and sellers start reducing their prices.  This ‘ripple’ affect quickly starts to reduce prices across all sectors and all parts of the country.

    Some properties can fall as much as 50% during a recession which can have devastating consequences on property owners.

  5. Lack of confidence

     

    One of the most intangible economic ‘drivers’ which affects markets, especially the commercial property market, is confidence.  As soon as confidence starts to wane, values start to fall.

    Rising interest rates create a lot of uncertainty.  People are uncertain about how much rates will rise, how long it will be before they start to fall and how the rises will affect the economy and the markets in which they do business.

    When there is uncertainty, which leads to a lack of confidence, to begin with people do one of two things.  They either do nothing and wait or they panic and sell.  Some have to sell as they have no choice.  The ones who decide to sell early on are usually the ones who suffer the least.  The longer an investor waits, the more their property will fall in value and the harder it will be to sell.  If a investor waits too long, and if they are able to sell, they may only get a price which clears their loan.  If this happens, they will lose all of their equity.  Therefore timing is crucial and recognising values are about to fall is of paramount importance.

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