The many constraints to the flow of capital means investors must reappraise their expectations. Andy Rofe reports

The past 12 months have witnessed a huge withdrawal of global capital, particularly from the US and Asia, and an even more marked decline in cross-border investment activity in commercial real estate, which has fallen by nearly 60% to US$82bn (€58bn) in 2008 relative to the year before. This decline is not surprising given that the US has been the largest exporter of capital. What are the causes of this withdrawal and will it continue?
Survey results recently published by INREV on capital raising provide a few useful indicators. While the amount of capital raised into funds witnessed a fall of almost 50% from 2007 to 2008, what is perhaps more instructive is that of the capital raised in the four years from 2005, €27.6bn has not been drawn and remains uninvested. This level of ‘captive' capital dwarfs the amount anticipated to be raised into funds in 2009, which is anticipated to be only €6.1bn, and is equivalent to over two years of the volume of capital raised in a more normal financial environment.

This represents a significant source of capital which normally would be expected to be directed at correcting markets. There are several large caveats to the availability of this capital which are exercising the investment community, which drive to the heart of the current constraints inhibiting the market: first, the denominator effect globally and the requirement for cash in other business areas; second, return expectations predicated on the previous availability of debt in highly geared structures, which are either no longer available or not desired by investors due to their altering risk aversion; third, the need to focus capital on repairing or trying to repair broken capital structures.

The onus on investment managers is not only to communicate and guide investors through the current challenges, but also to provide coherent solutions for tackling the issues faced in a time of instability and change within the investment management community. Trusted and established relationships between investors and investment managers are key to this process. (See figure 1).

What will be the drivers to restore market equilibrium and unlock either new or captive capital? The global fiscal stimulus combined with quantitative easing has provided a significant boost to global economies, potentially putting a floor on the recession and, in theory, making the cost of debt cheaper, which should stimulate economic growth. In the UK, this appeared to be working with 10-year bond yields decreasing, although the recent S&P re-rating and the sheer volume of public debt have largely reversed this movement. On a positive note, liquidity has clearly improved and would indicate a return to modest growth by the end of this year - the TED spread (the risk premium of lending among commercial banks relative to the risk free rate, see figure 2) provides a good indication for economic growth 6-9 months ahead. The huge spreads from October are manifested as negative GDP today but the improvements recorded now point to optimism.

Will this potential capital and perceived optimism drive future capital flows and a sustained recovery? Sadly, probably not. There are still big issues facing the banking sector and investors, not least the non-availability of debt in the system, which is likely to continue and will weaken any recovery. The banks are not passing on the full benefit of lower borrowing costs (as depicted in the recent falls in three-month LIBOR) to customers or investors. Syndication of large loans is now no longer possible; banks are focusing on generating returns on existing refinancing business through increased fees and margins, and increasingly directed towards their domestic markets as government intervention in the banking system makes cross-border loans more challenging.

As significant as the potential upside of available uninvested capital is the polar force of the sheer scale of commercial real estate debt coming up for refinancing, which is absorbing much of the UK banks' capacity to provide finance on new business. And in Europe an estimated €3-6bn of CMBS needs to be refinanced over the next couple of years, which will lead to reduced liquidity. In the US, the two largest holders of real estate debt are the banks (45%) and CMBS (21%). The total commercial mortgage debt market in the US totals US$3.5trn.

While it is likely that the issues associated with dealing with this will apply an effective brake to market development. The rising pressure on balance sheets can also result in opportunities emerging as loans approach maturity and the closing of the CMBS market adds refinancing risk to maturing CMBS loans.

This leads me back to owners of real estate who are now or will be over-leveraged, with broken capital structures; either where declining property values no longer support borrowing levels and/or declining revenue no longer covers debt repayments. There will be opportunities to recapitalise or to buy the assets in distressed situations. There has not been much evidence of this in the markets to date; there have been pockets of activity but no consistent theme, largely due to the banks being required to be inward rather than outward facing in terms of the issues they are prioritising. However, there is the potential over the next 12-18 months for more opportunities of this nature to surface and for them in turn to provide a compelling reason for the capital to return.

Cross-border activity, which has recently fallen back so dramatically, ironically could be the driver for increased capital flows due to the diversity of market recovery. The UK is a good example: given the sheer speed and violence of the market correction, there is now attraction to the correcting markets. If you add to that the weakness of the UK currency, the investor who can arbitrage the currency on top of seizing the opportunities that exist within the markets due to availability of equity will be making handsome returns. German investors are leading the way in terms of recent activity as they seek to secure quality assets at attractive prices in a thin market.

The capital market is very tight and will continue to provide a low leverage environment for the foreseeable future. Investors obliged to deal with the lack of available financing and concurrent refinancing requirements should be reappraising their return expectations so investment managers can actually invest some of the uncommitted capital without fear of underperforming. This is particularly relevant in an operating environment over the next few years where the prospect of capital growth to power returns is reduced. Additionally, some of the committed but undrawn capital should be able to be used to sensibly replace leverage; there is evidence of this happening, but generally only under duress.

There are cautious signs of optimism and there will be opportunities from the fallout of the process of global de-leveraging that will feed the market for some time to come.