Recent months have illustrated the unpredictability of the real estate investment markets. William Hill tells Richard Lowe how Schroder Property dealt with the turmoil of 2007-08 in the UK and is now looking to take advantage of the recovery when it comes

Less than two years ago, talk in the UK was of soft landings versus hard landings. It was clear that the boom years were coming to an end and a correction was due. William Hill, CEO at Schroder Property, the real estate arm of the British-based global asset management company Schroders, was predicting a "bumpy landing" - not overly pessimistic but certainly erring on the side of caution. But Hill, along with every industry figure not in possession of a crystal ball, had no way of anticipating what the 24 months that followed would hold.

There were: the sub-prime debacle; the ensuing credit crunch; the drying up of transactions; the redemptions from open-ended funds; valuers forced to base valuations on market sentiment; and IPD total returns seeing the severest correction ever. These developments were not visible on the horizon in early 2007, let alone what followed: major financial institutions falling or being bailed out; governments around the world concerting their efforts to prevent global financial meltdown; talk of a US downturn and debates about decoupling being quickly supplanted by the real prospect of a global recession.

Nevertheless, in early 2007 Hill was expecting a bumpy landing. This he attributes to the "massive weight of money" that had begun to pursue property, driven by overly "generous terms on debt" and creating an unsustainable asset-price bubble. It was certainly going to be different to the previous downturn that Hill experienced firsthand, between 1989 and 1991, which was the result of overbuilding and a speculative development-led boom.

It wasn't until the summer of 2007, when the credit crunch first reared its head, that the nature of the downturn changed and Schroder Property found itself facing some difficult challenges. "There was real fear and panic in the air in real estate terms. The start of the credit crunch was the moment that spooked the markets completely," he remembers.
One of the ways out was through the numerous open-ended property funds in the UK. Retail funds were hit the hardest by redemptions, but institutional funds, such as the Schroder Exempt Property Unit Trust (SEPUT), were also affected. However, unlike their retail counterparts, institutional funds did not have the luxury of holding significant amounts of cash to aid redemptions.

"The institutional funds, which were holding less cash, were obviously under more pressure," Hill says. "They didn't have that cash buffer, because, believe it or not, the money was coming into the retail funds in volumes still during 2007." SEPUT received a block of redemption requests in September 2007. With very little liquidity in the market and facing a correction, it was not the ideal time to sell assets. Investors were warned that they might not get their cash back before the three-month deadline that operates under normal market conditions.

Hill explains that Schroders was successful in matching half of the redemptions by December 2007, with the remainder being delivered by the following March. "We were successful in selling about £200m (€252m) of property in the UK between the summer of 2007 through to March. That was a big decision and a big call and we got that right," he says."Running a property business in the autumn of last year was very uncomfortable, very difficult and very challenging. If you ran open-ended funds you were really tested on your ability to operate those funds according to the label on the tin. As an industry, I think we made a reasonable job of it. Some were better than others."

In August, Schroders warned investors that wished to redeem from SEPUT that they could be charged as much as 25% during the current downturn, so as to protect the interests of remaining investors. This appears to have been an appropriate move, since the worst of the correction in the UK looks to have passed. Hill claims that current redemptions - at the time of this interview in October 2008 - are now "very small". He says: "Most institutional investors have taken the view that the market has come off so much there is no point but to ride the cycle. If we do have redemptions, the price at which we let people out will reflect the price of obtaining liquidity in a market that is completely dysfunctional. That means they are taking a big hit so, generally speaking, people are taking a longer-term view."

Hill doesn't believe the recent debacle undermines the open-ended fund model, rather the recent events have been extremely difficult for fund managers; on the whole, they have dealt with these challenges relatively well. "In the UK we do have a very deep, liquid market in normal conditions," he says. "I don't think anyone feels particularly proud of the situation, in terms of having to implement deferrals. But the industry has, so far, just about held it together."

With the worst of the episode - we hope - now in the past, Hill admits that the issue of managing redemptions has been superseded by other concerns. One, which will also be a concern for real estate investors all over the world, is the level of debt in existing portfolios.

"We are seeing values fall away, so what are our loan-to-value covenants? How are we matching up against the criteria we have in our loan agreements," he says. Hill believes Schroder Property is somewhat ahead of the game: "We haven't had to renegotiate any facilities. We are all well within where we want to be. We were de-gearing our funds in 2007 anyway, so that was helpful."

A less immediate issue, but one that has the potential to become more significant, is the ultimate effect the fallout of the credit crunch will have on the real global economy. People can no longer cling to the view that the current crisis is a purely financial one and not a real estate one; the demand-supply balance may be much stronger today than it was at the start of the 1990s, but for how long?

Hill reveals that he is already seeing tenants under pressure. Although rent arrears are currently low, the first warning signs are starting to flash, with tenants starting to request monthly rents, for example."Are we going to go into a major recession and therefore are we going to see vacancies open up?" Hill asks. "If we do, I don't think it is going to be catastrophe in the same way it was in 1991, because we are starting from a point where supply is still relatively low at this stage of the cycle. But nevertheless one cannot avoid some of those pressures."

The greatest stress seems to be cropping up among retail tenants, but Hill stresses that any business that relies on bank funding and is having to renegotiate its credit lines is likely to be under pressure."We have a situation with one company in the warehousing area that used to be able to finance its Christmas stock in a particular way," he says. "It now cannot get that credit, so it has cash flow problems and we have to work with them to help them through that. It doesn't mean the business has gone bad, it's just they have cash flow difficulties."

Hill believes this is where landlords have to be pragmatic and help businesses through, although in some cases the problems facing some tenants may be terminal. "You have to make some big judgement calls as a manager/owner of a property as to which tenants you can support and which tenants are past support."Having said this and despite the apparent vulnerability to the redundancies forecast in the global finance industry, Hill is not overly pessimistic for the London City office market.

"It has to be vulnerable but if you look at City rents, as a headline number, they are actually, in a London context, quite cheap," he says. "Land values are low, so although the City is the market that is going to have the greatest job losses, I just feel we are not going to see a massive collapse."Instead, Hill expects to see some of the development pipeline come to a halt, which will temper supply. He also believes that rents will fall but vacancy rates will remain well above levels seen in the early 1990s. "I would be very surprised if we ended up in a complete market meltdown," he says.

In late 2007, Schroders was predicting that fair value would return to the UK real estate market in 2008, albeit not before the spring. However, with hindsight, even this sober forecast - which its is likely  that many in the industry agreed with at the time - now looks unduly optimistic."Things have deteriorated a lot more," Hill says. "I don't think anybody anticipated the collapse in availability of debt… As a consequence of all that debt falling away and the extent of the over-leverage that is in the system - values have fallen more than we thought."

When the recovery does come, Hill does not expect it is going to be a "dramatic" one. He says: "I think there will be a bounce, but we are going to be very beholden to the availability of debt. If the debt markets are not going to come back for two or three years, the recovery could take a little bit longer. But it will come. Particularly if we move into lower interest rates."Certainly, the raft of opportunity funds in the market hoping to raise capital are banking on recoveries in the UK real estate market and farther afield.

Schroder Property is hoping 2009 will be an important year for capital-raising, not just for its private equity-style UK opportunity fund, Columbus, but also for its open-ended UK vehicle being marketed to German investors.

Also on the cards is an opportunistic fund of funds product that would look to invest in "best ideas" across Europe and possibly even Asia."From a business perspective, I regard 2009 as a great opportunity for real estate, in terms of pulling together equity to reinvest into the market at these much lower levels," he says. "At those levels, if you raise equity and deploy it over maybe the second half of 2009 into 2010, I think it is quite an attractive base for investors to come back into the asset class. We certainly, as a business, are concentrating on raising equity in distressed recovery-type strategies."

In addition to the UK, Hill believes investors will tend to retreat to the core mature markets around the world, now that yields are moving out, away from riskier emerging markets. Money will focus on the likes of Germany and Japan rather than Romania, China or Vietnam.

"Those are all economies that are going to grow in the long term, but probably all have too much overbuilding," he says of the latter. "I just feel there is going to be a retrenchment away from the riskier markets where there is not a great deal of depth, where you are really reliant on the development business providing you with the stock."

Finally, it is clear that Schroders sees opportunities outside the traditional bricks and mortar sector, as evidenced by the launch of its agricultural land fund earlier this year.
"That is a very interesting new area," Hill says. "The drivers behind agricultural are very different to global finance. It is much more about demographics and trends in the world. As developing countries get richer, so their eating patterns change, so their demand for meat grows, so the demand for grain to feed the animals grows, and that puts an increasing load on the space that is in production.

"We think the long-term dynamics of a rising global population and changing patterns within that population are going to create significant demands for agricultural land. And if you layer on top of that climate change, and which areas of the world are going to be winners and which parts are going to be losers, there are some very interesting investment themes to be derived."

Schroders envisages the fund as mainstream institutional product deliverable through funds of funds. "We are looking at doing it through a UK investment trust, as well to access the retail market," he says. "But I think the real money should be through pension funds as part of their real estate allocation."
 

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