Hot property

Sandra Krstović examines the troubled past and current prospects of the commercial real estate market.

Sandra Krstović examines the troubled past and current prospects of the commercial real estate market.

Mention bricks and mortar and most investors will cringe. But at the moment, as the economy is starting (if unevenly) to recover, commercial property in particular is looking healthy. So what's going on with real estate?

Once upon a time...

Before taking a look at the market today, let's briefly take a step back in time. We can't blame investors for instinctively shying away from property as real estate can legitimately be accused of playing a large part in dragging the global economy into the financial crisis. The root cause of this economic whirlpool was the sub-prime mortgage market, that is, the home loans given to borrowers unlikely to be able to repay them. The creation of mortgage-backed securities from these loans appeared to allow banks to dispose of the risks associated with them and lend out their capital again. But when market confidence in these structured securities finally collapsed, many homeowners defaulted on their mortgages, leaving banks with the keys to worthless properties and the money markets in turmoil.

During the credit freeze, commercial property had its share of the blues too - the overhang of loans was massive, with 4 per cent of the sector's $3.2 trillion in debt outstanding. But this market still stood much stronger than the residential sector which had a much greater 15 per cent of its debt outstanding. And despite the crisis, some investors were still prepared to provide debt financing. One big name was the Bank of China, which took a significant stake in the American commercial real estate market.

The slow blossoming of new market confidence and improving business performance has led to a higher demand for commercial space and so better prospects for those who choose to invest in the commercial side of the property market. Vehicles by which investors can gain exposure to this market such as real estate investment trusts (REITs) are raising their dividends, especially in the health care and retail sector. Investors can now expect a return of 8 to 10 per cent per annum.

Cosmopolitan

Region-wise, investors are turning to emerging markets. South Korea is particularly attractive due to its strong and stable economy. And property here is vastly undervalued with prices 30 per cent lower than in other Asian cities, but still offering returns of 5.5 to 6 per cent. Investors are also turning towards Seoul because of a decline in the value of Tokyo real estate and the potential overheating of the Chinese economy as the government raises interest rates to combat rising inflation.

Eastern Europe is attracting investors too, with transactions growing by almost two thirds in the third quarter of last year. Prime office space here gives back almost 10 per cent on investments, compared to 6 per cent in Western Europe. As in other asset classes, the BRICs also provide attractive real estate options - Brazil in particular. Ernst & Young have rated Brazil's commercial property sector highly for 2011. Thanks to its strong economy and easy credit, investment is pouring in to the South American nation, primarily in the hotel sector due to the upcoming 2014 FIFA World Cup and the 2016 Olympics.

Back in Europe, London is getting its fair share of investment too, leading to some distinctive new structures breaking its predominantly Georgian and Victorian skyline. The Shard of Glass - which will be a 72-storey high building in Southwark with offices, restaurants and a hotel - is scheduled to be completed in 2012. It is also due to get some equally fancy companions soon, with the Heron Tower, the "Cheese Grater" and the "Walkie-Talkie" all progressing from the drawing board to bricks and mortar.

They may not be as glamorous as the City's latest skyscrapers but, thanks to America's ageing population, nursing homes are definitely in fashion in the commercial real estate world, evidenced by the 46 private equity buyouts in this sector since 2005. Outlet centres have also caught the eye of investment firms. Shoppers are still generally staying away from swanky department stores, leading to a growing demand for discounted designer wear. As a result, there are 40 outlet centres currently on the drawing board in the US alone and, since their locations outside city centres make their costs lower, they're an attractive option for investors.

Banks are now going big on commercial real estate too. Deutsche Bank is heavily committed to the Cosmopolitan hotel and casino complex in Las Vegas, having ended up with the project on its hands when the original sponsors defaulted. Analysts however, are sceptical, saying that this is a huge undertaking for one bank alone, estimating that it will take Deutsche Bank fifteen years to recoup its initial investment. But BNP Paribas is also getting in on the act with its purchase of a 430,000 square foot office development in King's Cross. Even Morgan Stanley is buying in to the sector, despite huge real estate losses during the financial crisis. On a recent spree it acquired a 60,000 square foot shopping centre in California's Inland Empire. Known as one of Wall Street's biggest commercial property investors, it is looking for high-return opportunities and is bringing some properties in deep trouble back to life, with recent ventures into German retail property and Japanese office space.

Hand-holding

But investors are still cautious. Ventures now tend to be more calculated than pre-crisis. Even though commercial property transactions have doubled in volume since 2009 with a monthly average of $6.4 billion, activity is still a long way from the $35 billion peak monthly rate at the height of the pre-2007 boom. As commercial property markets move hand in hand with consumer demand, it is likely to be some time before they fully recover to these levels.

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