The case for property as a diversification from equities will be strengthened - one of several consequences the shortage of debt capital will have on real estate investment, which are considered here by Mark Callender

In the past 12 months the performance of UK commercial property has revived, with annual total returns improving to 23.9% in June 2010 (source IPD Monthly Index). The stabilisation of the economy in mid-2009 has encouraged overseas investors and UK institutions to return to the investment market and this renewed interest has put downward pressure on property yields and supported a partial recovery in capital values.

Moreover, fears that the recession would cause open market rental values to collapse have proved to be overly pessimistic and the latest forecasts now suggest that rental values will settle later this year at a level roughly 10% below their peak in mid-2008. Although tenant demand for space is still hesitant, particularly outside London, rental values have been supported by the relatively low level of new building over the past few years.

However, while the UK commercial property market is currently recuperating, it is still some way off from being restored to full health. One major concern is the large amount of debt that was borrowed before the global financial crisis and that still needs to be serviced and repaid.

The latest Commercial Property Lending Report from De Montfort University, published in May 2010, underlines the scale of the task. According to the study, the total amount of outstanding debt on UK commercial property rose from £90bn (€109bn) at the end of 2002 to £228bn at the end of 2009. In addition, the UK CMBS (commercial mortgage backed securities) market simultaneously sprang into life and the amount of outstanding CMBS jumped from roughly £12bn to £50bn over the same period.

In theory that increase in gearing would not be a problem if capital values and rental incomes had been stable over the intervening period and if borrowers had no difficulty in renewing loans at the end of their term. However, in part because of the increase in debt, capital values were actually very volatile, rising by almost 50% between the end of 2002 and mid-2007, but then falling by 44% over the following two years through to mid-2009.

While those property investors that took out loans between 2003-05 were not too badly affected by the subsequent downturn, many borrowers that took out loans in 2006-07, just before the market peaked, have been left owning properties that are worth significantly less than the debt secured against them. Even after the recent rally, capital values at the end of June 2010 were still 36% below their 2007 peak.

Furthermore, although the total rental income on property portfolios held up remarkably well through the recession, thanks to the upward-only rent review clause in existing leases, the average masks wide variations across individual portfolios. IPD data reveal that the rental income on prime and good-quality secondary portfolios rose by between 1-5% in 2009.

By contrast, portfolios composed of poorer-quality secondary and tertiary properties with short leases typically suffered falls in rental income of between 5-10% in 2009. This drop in rental income has meant that many investors in secondary and tertiary properties are now struggling to pay the interest on their loans.

The combination of volatile capital values and falling portfolio incomes has led to a surge in bad loans. According to the De Montfort survey the value of UK commercial property loans in default jumped from £0.8bn to £19.3bn over the same period, equating to a default rate of 8.5%. On top of that, a further £28.3bn of loans were in breach of at least one of their banking covenants. In total, therefore, over a fifth of UK commercial property loans by value were under stress at the end of 2009. (Note these figures do not include CMBS.)

Neither is this problem unique to the UK. While there are no publicly available data, CBRE estimates that the total value of commercial property loans outstanding in Europe ex-UK was roughly €640bn at the end of 2009. In broad terms, that equates to average gearing of 25%, although that average masks significant variations across individual countries, with anecdotal evidence pointing to higher levels of borrowing in central Europe, Germany and Spain than in France and the Nordic region. The vast majority of that debt is probably reasonably secure given that capital values in most European markets have fallen from peak to trough by between 20-25% and the average loan to value ratio when most loans were originated was between 60-70%.

However, CBRE has identified a rump of €115bn of loans, equal to 15-20% of the total, which have high loan to value ratios and which were made at the peak of the market against relatively poor-quality properties, particularly in Germany. It is this set of loans where most defaults will probably be concentrated.

Following the global financial crisis (or at least its most intense phase), European property lenders split into two main camps. In the first camp are those banks that have been over-whelmed by their losses either on commercial property, or on other types of lending and have either been nationalised, or are dependent on some form of state aid to continue in business. Examples include Anglo Irish Bank, Hypo Real Estate (Germany), ING (Netherlands), Royal Bank of Scotland (UK) and the Spanish regional savings banks. In general these banks are closed for new property lending.

In the second camp are those banks that are still actively lending on European commercial property. Examples include Barclays (UK), EuroHypo (Germany), HSBC (UK), Nordea (Sweden), Santander (Spain) and Société Générale (France). While these banks have also typically suffered an increase in defaults on their property loans, their balance sheets have been able to take the strain.

In addition, the reopening of the Pfandbrief covered bond market with support from the European Central Bank has enabled some of these banks to raise new funding for commercial and residential mortgages.

At this stage it is unclear how long the work-out process will take, but it is unlikely to be completed in just one or two years. Most European banks cannot afford to embark on a large scale programme of repossessions and write-downs and provided interest payments are being met, they have generally preferred to extend loans and impose higher margins on borrowers in the hope that capital values will recover in a few more years and loans can then be repaid.

As a result of this Mr Micawber "something will turn up" approach there have been surprisingly few distressed sales in Europe, although the number could increase if higher profits on other activities give the banks more breathing space.

The main attraction now for those banks that are still making new property loans is that with fewer competitors they can simultaneously raise their fees and reduce their risks by only lending on prime and good-quality secondary standing investment properties.

The De Montfort survey found that the average margin on loans secured against prime offices doubled from 110 basis points in 2006 to 220 basis points in 2009. This has been echoed in the euro-zone where the property finance team at Schroders has seen margins jump from 60-70 basis points in 2007 to 130 basis points in Germany and around 200 basis points in Italy and the Netherlands.

Yet, while it is once again possible to obtain bank debt in Europe, the volume of new property lending is unlikely to get back to pre-crisis levels for the foreseeable future for two main reasons. First, there is the obvious point that although some banks have been recapitalised, the financial crisis has resulted in the permanent destruction of bank capital.

Second, regulations on new commercial property lending will be tightened. Although the Bank for International Settlements has not yet finalised the new Basel III set of capital adequacy ratios, it seems certain that the amount of their own equity that banks have set aside to for commercial property lending will be raised significantly.

The likelihood that new debt will be strictly rationed for the next three to five years has a number of implications for European commercial property markets. First, it suggests that insurance funds, pension funds and other equity-rich investors will probably be the dominant players over the next few years. Second, it follows given the strong preference of institutions for prime properties with long secure income streams that the gap between prime, secondary and tertiary property yields is unlikely to re-compress in the near-term.

A third consequence of the debt shortage is that there will be very little finance to fund new developments over the next few years. From the property investors' standpoint this is the silver lining of the global financial crisis, because it reduces the future risk of excessive development and over-supply. However, from the point of view of regenerating poor inner city areas, the shortage of development finance could be a serious hurdle, particularly at a time when governments will struggle to fill the gap and provide more support.

Another potential consequence of the general shortage of new bank debt in the economy as a whole could be an increase in company sale and leasebacks, as companies sell assets in order to raise capital. Last year there were a number of sales and leasebacks by European hypermarkets (eg, Casino, Kesko, Sainsbury, Tesco) and these properties were in strong demand from institutions looking for long leases and tenants with good covenants.

Finally, looking several years ahead, a further consequence of de-leveraging could be an improvement in the degree of diversification that property offers against equities. Historically, property has been a good diversifier of equity risk when capital values and total returns have been driven mainly by changes in rental values, such as in the 1980s, or the second half of the 1990s.

Changes in rental values in turn reflect the balance between tenant demand and new building and during these periods property's performance is closely tied to the current health of the "real economy". In short, property then behaves as a coincident indicator of the economic cycle. Conversely, equities tend to be a leading indicator, because their performance is largely driven by expectations of future profits.

By contrast, over the past seven years European property capital values and total returns have been driven principally by movements in property yields, rather than by changes in rents. Although property yields are heavily influenced by expectations for future rental growth and by prospects for other assets, they are also influenced by the amount of debt which investors can access.

The rapid growth in property lending was probably the main factor that drove down property yields and pushed up capital values across Europe between 2003 and 2007 and the credit crunch was a major factor behind the jump in property yields and collapse in capital values in 2008 and 2009. Through this period property behaved like a leading indicator of the economy and property total returns were highly correlated with equities.

While property yields are notoriously difficult to forecast, Schroder's view is that the European property yields will remain broadly stable over the next few years, provided that inflation stays low and there is no hike in bond yields. If this view is correct and rental values start to increase from 2011 onwards - the speed of recovery will vary considerably across local markets - then European property should once again behave as a coincident indicator of the economy and offer useful diversification against equities.

Mark Callender is head of property research at Schroder PIM