The demand-supply balance is far healthier than it was in the 1990s, but it is clear the credit crunch is no short-term blip. The question is how long before it begins to affect the fundamentals of real estate? Richard Lowe reports

As the credit crunch continues to show no sign of abating, one thing has become clear in recent months: the current global financial crisis is no short-term blip. We are now almost 12 months into the financial crisis ignited by the sub-prime meltdown in the US and some of the early predictions that debt markets and transactions volumes would have returned to normal by now look awkwardly naïve.
"There is no doubt that, when we first started to see the signs of the volatility of the markets back in the summer, there was a general view that things would be over and done with," recalls Mark Baillie, head of real estate (Europe and North America) at Macquarie Bank. "I remember speaking to people who said it would be over by the fourth quarter, then the first quarter of this year, then the second quarter… that was probably a factor of having such a long period of stability. People thought this was going to be a bit of a blip in the overall trend we had all been enjoying since the last big correction in the real estate markets, which was 15 years ago."
As the problem has looked to be more prolonged than initial expectations, economists, investment bankers, fund managers and investors alike have reassessed their views as to the severity and persistence of the situation - and the implications this has for global real estate markets.
A sentiment that has gained ground since the start of the credit crisis and been prevalent at numerous conferences in recent months is summed up in the oft-repeated line: "this is a banking crisis, not a real estate crisis." Indeed, unlike the last significant downturn in real estate markets, fundamentals are much healthier. Not least, a stronger supply-demand equilibrium exists across Europe. From this point of view, real estate itself does not seem to be to blame for the change in outlook.
"It is the first time the real estate market is suffering as a consequence of the capital markets rather than the real estate sector causing the crisis in the capital market," says Ian Marcus, managing director and chairman of real estate investment banking at Credit Suisse.
However,  there is a danger in hanging on to this notion as a way of exonerating the real estate industry from responsibility for the situation it is finding itself in. Indeed, Marcus warns against treating the global banking system and property markets as parallel universes, because "there is such inter-connectivity" between them.
Marcus explains how fundamental real estate is to the lending process. In contrast to common estimates that real estate loans make up 10-12% of banks' lending business, he suggests the figure should be nearer 90%.
"When you lend to a business or an individual you take a security - you take a mortgage on his house or a mortgage on his factory," he says. "When you think how fundamental real estate is to the lending process it is absolutely core. It is not just lending to property companies or developers. So, I don't think you can decouple the two."
And unfortunately, Marcus believes the situation for both is going to get worse before it gets better. In fact, he says the environment has deteriorated
significantly since the start of 2008 when the real estate industry hoped it would be a patchy liquidity issue that most banks would work their way through.
"My own personal view is that we could be looking at a two- to three-year horizon before we see any significant upswing in the market," he says soberly. The central issue to this bleak outlook is the danger that the credit crunch is persisting for so long that it will actually begin to damage the fundamentals - the demand-supply equilibrium - of real estate, which is the very thing the industry has been holding on to as its saving grace in these times of turmoil.
"We can live with the fact that values have fallen and yields have moved out - we understand why that is," Marcus says. "We can live with the fact that there is less availability of credit and banks can live with the idea that their LTV [loan-to-value] covenants have been breached in some form. What banks cannot cope with and will really begin to suffer over is if the cash flow servicing that debt comes under pressure and that gets back to occupational demand.
"It is still patchy, but there is increasing evidence that occupier demand across all sectors is coming under some degree of pressure and that will affect cash flow. It will affect interest cover and it will affect the ability of borrowers to service that debt and that is when banks will get nervous. That is the issue we should focus on."
Marcus believes this has the potential to transform what has been seen as strictly an investment market issue into an issue of the broader macro-economy. "There is no point in anyone in this market being a doomsday prophet," he adds. "But what I am trying to do is recognise that the banks have more pain to come, which does have a significant impact on an industry that is reliant on capital."
Simon Redman, head of business development at Invesco Real Estate, agrees that the key risk for banks would be a situation where income drops in leveraged portfolios and borrowers are unable to service the debt on the assets. Even if LTVs are breached, significant distress is unlikely unless the property values are lower than the debt and/or borrowers walk away, he says, although income coverage remains key. "The real problem is when you start being unable to cover your interest payments."
For this to happen, however, Redman believ es there would have to be a "big economic meltdown", where significant numbers of businesses default and are unable to pay rent. Fortunately, it is difficult to imagine this can really occur, he adds.
"From an investment perspective, the likelihood of a rent default happening is actually very low. You may get fewer new lettings and a bit more supply, but it takes an awful lot to impact the core income from real estate investments."
The City of London office market is a good place to look, because it can be seen as a potential microcosm of what is happening on a wider global scale. Although some investors are beginning to see value since it has repriced and yields have moved out, as one of the world's top financial centres there are concerns over the occupational market's vulnerability to the effects of the credit crunch. But Redman says, if you look back to the bear market of the 1990s, the City office market saw a large fall in rents, yet default levels remained extremely low. "For those people who owned assets, if you ignored the value side, the income was unaffected," he says.
John Slade, co-chairman of capital markets and head of direct investment at DTZ, states that experts predict redundancies in the City of London and other financial capitals around the world to be in the region of 30% of the levels seen after September 11, 2001 and during the 2002-03 period.
"Most businesses, particularly in London, are working at overcapacity in the space they had prior to the credit crunch," he says. "There has actually been a paucity of offloading of first-class space by anybody as yet. There has been a lot of talk about how the central city markets - not just London - will be hit. But everyone was working at such overcapacity in their space that I think there is some slack the market can take up."

Slade admits that, if there was a very deep recession and this caused a much larger volume of redundancies, "everyone would start to get worried". But he believes the signs, at least for the UK, are that this is not an immediate danger.
He is much more optimistic about the outlook for real estate than he was last August, now the property markets have been through pain in terms of repricing and a fall in transaction volumes.
"To be blunt, I was pretty worried about the state of the markets and the fact we weren't going to have the liquidity," he reveals. "Despite the fact there is probably more depressing economic news coming through, the property markets have probably been through the worst of the inactivity. Property was hit extremely hard, in terms of the lack of activity and repricing. All that happened probably between July/August last year and February/March this year."
"So, there has been a lot of pain, but I think the levels of liquidity or activity are showing signs they may be about to pick up, particularly in some of the continental European markets. I would expect during the last quarter of this year the level of transactions to increase, albeit an adjusted level lower than historical highs. I don't think the fundamentals have changed. I think pricing has changed."
Mark Bailie of Macquarie Bank is also optimistic for the outlook for real estate markets. He admits that, if the credit crunch does have a significant impact on economies, "it will obviously affect the demand for real estate". But he also believes property is in a better state to cope with such a development.
"Is it going to be as bad as it was in the early 1990s? That is the question that all the global markets are trying to make their minds up about at the moment," he says. "But whatever the outcome, real estate is going to fare significantly better than it did in the early 1990s, due to the structural changes that have taken place in the industry since that point in time."
These structural changes include increased information and transparency, and a greater global liquidity. "In the early 1990s you had a lot of oversupply, because there was a lot of speculative development. You might have pockets of that, but if you look globally there is a relatively good equilibrium of supply and demand," he says.
These points have been made before, but Baillie also suggests that the growth in the listed real estate sector has brought about less volatility in the direct market - with the exception of the UK where valuers have repriced assets on the basis of market sentiment. "There has been a continued volatility in the capital markets, but we have still not seen any credible evidence of significant change in the valuations of the physical markets," he says. Baillie believes the listed markets have borne the brunt of the increase in investor pessimism.
"In days gone by, when people took a negative view on real estate and wanted to allocate away, they had to sell direct assets. In the early 1990s, there were a fair amount of fire-sale disposals and this had a snowball effect on overall levels," he says. "If you look on a broad global scale, we have yet to see any significant emergence of distressed selling. Certainly there are pockets of it, but it is not taking on the same level of global phenomena, partly because there is a lot more liquidity in the markets these days that has been allocated to real estate and can actually move relatively quickly globally to mitigate any arbitrages."
However, Jonathan Thompson, head of real estate at KMPG, believes the credit crunch has yet to affect real estate directly. Until now it has affected property markets because it has "caused all investors to stop and think" about the fundamentals of the asset class and question whether it is in fact over-valued on those fundamentals.
"The really interesting question is what is going to happen from here," he says. "I suspect the credit crunch is going to come in. I think it has still to work its way through in terms of its effect on pricing. That is only going to happen when people either have to start repaying debt or renegotiating, the banks start forcing some sales because they need extra liquidity."
Thompson believes this is the view of the stock market, as evidenced by the repricing of property securities, and also the derivatives market, which offers a forward-looking indicator of the direct market (for the UK, at least).
"If you look at the quoted equities, their pricing would indicate they are expecting a further fall. If you look at the derivatives
market, it is predicting a further fall. And if you look at what respected property analysts are saying, they are predicting a further fall - and a further fall in the direct market across Europe, not just the UK. So, my feeling is that the future pricing is going to be affected much more by the credit crisis."