The commercial market correction in the UK (compiled by Garmans Limited 2008)

The commercial market in the UK revolves through the axis of International finance, the main issue that has surfaced in the current market is a result of an excess of funds in our system over the previous three years. It developed into a two level liquidity problem. Primarily being the banking system.

The banking system suffered as the off balance sheet securitised vehicles became abundant to the detriment of traditional lending through the banking system. These off balance sheet securitised vehicles were born through separately structured companies that independently packaged loans and sold shares of these companies to investors. As the risk of default on the loans was spread more widely, as opposed to the banks owning the risk. This in turn caused the product to be discredited. It was anticipated that because banks no longer owned the risk the standards of credit were now lower than ever before. This had a knock on effect to the management decisions of the banks and they concentrated more on fees that they accumulated through granting loans, and developing structured vehicles.

Banks took on incentivised departments to organise and facilitate the sale of the final product. It was branded as the “originate to distribute” model. The onus was taken from credit quality and more focus was given to on selling the packaged product.  Thus bad and good loans were fused and dealt into the hands of investors. As a result obtaining non-recourse loans at high loan to value ratios became difficult. This resulted in a significant decrease in property yields as the cost of borrowing increased and in turn the commercial market realised a negative cash flow.

The rental values continued growth was a recovery vehicle in the circumstances where property was sold at profit and the loan repaid. To sell at a profit commonly required an external investor in conjunction with excessive loan finance and unavoidably there was a requirement for a market correction. As a short term result there is now a necessity for more equity to be invested as in the short term banks have partially withdrawn from the market. The banks are now forced to be more selective to whom they lend as capital becomes limited. In the medium term banks will capitalise on investors with solid track records.

The future will be for securitisation products to distribute risk in the financial system. As this new product is relatively young its risks may lead to excess. However over time it will be an accepted way of doing business. Which in turn will lead to greater quality controls that are highly transparent. The excess liquidity has also grown into an explosion of open ended funds; the funds were developed to portray a false liquidity for investors, to invest without suffering the knock on effects of illiquidity inherent in the asset class.

Due to the impossibility to create instant market liquidity without disruption to the market place, investors may redeem a short term notice. The fund will be forced to sell the properties to meet these redemptions. Forced sellers intrinsically depress prices to achieve easy exits. This affects long term investors in open ended funds that were set to weather the difficult periods. Long term investors will then withdraw or may be liable to be prejudiced by the short term principles. The problem faced by long term investors is magnified by the valuation process. In the commercial market an excess liquidity placed external pressure on valuers to create growing prices on portfolios, resulting in valuations being unrealistic. As a result open ended funds are now being forced to sell to raise liquidity.

The first to go was the holdings of listed property shares, being most liquid. This depressed the property shares by up to 50%. Since the start of 2008 these shares have moved up again, albeit not at the same previous highs. This would indicate the open ended funds have come full circle on the sale programme, thereby negating the burden of forced selling. Many open ended funds decided to suspend redemptions and in doing so reducing the need for emergency selling.

The market as a result is now more orderly. This has not extinguished the ongoing necessity to raise cash by selling. A general motion adopted across the board was to be over pessimistic to deter redemption. This year should therefore be an increasingly attractive year for long and short term investors.