Don’t count on those new debt funds to close the financing gap

Germany holds no truck with the “upward-only“ rent revision rule, so beloved of landlords – and indeed lenders - in markets such as the UK and Ireland. Part of the attraction of investing in London office property has traditionally been the landlord-friendly regime and the benevolent approach taken by lending institutions to financing assets, where rents have traditionally gone only in one direction.

The pernicious rule fails to offer any respite to retailers or office tenants who find themselves in wildly different economic circumstances since signing their lease agreement, or where lease values have seriously declined. The Irish, at least, have put a stop to this practice for new lease agreements, but it has been at the root of the downfall of many a business in Ireland and the UK over the past five years.

In Germany and other European markets, pragmatism would never have countenanced such a one-way bargain. Instead, these markets prefer shorterterm office leases with no rent-review clause, but options to extend the term, subject to agreeing rent and other conditions. This sounds eminently sensible, although it can present problems when trying to get a bank loan or refinance existing obligations. Given the prospects for German office rent levels, however, the dilemma for investors looks as if it is about to get a lot worse.

Despite the current industry fascination with alternative sources of financing to compensate for the retreat of traditional lenders, the truth is that the financing gap is barely being closed by the arrival of debt funds and other exotic providers of loan capital. Firstly, they represent a very small segment of the industry. Secondly they have, if anything, the same risk profile and demand the same returns as traditional lenders, while restricting their scope of interest to those very same ‘core’ properties

which the remaining banks are likely prepared to finance in any case.

Hence the widespread belief in certain banking quarters in Germany that ‘there is no credit crunch’, and finance is readily available. Of course it is, in abundance, for the handful of properties that everyone wants to own. Just don’t expect debt funds, insurance companies, or occupational pension funds to get their hands dirty by financing a third-rate property in need of a serious makeover in downtown Mümmlingen-Grumbach. It’s not going to happen.

Debt funds have largely failed, so far, to deliver on the promises they’ve made to their investors. To deliver higher returns, they’ll have to take higher risks. At least there are plenty of those.

REFIRE has long waved a stick at those real estate brokers (i.e. practically all of them) who are obsessed with ‘peak rents’, as if these tell any meaningful story as to what’s going on in German cities. We have little difficulty believing that the peak rent in Frankfurt’s most prestigious office tower has nudged up by €1.00 to €38.00 (per sq.m. per month), but all that this tells us is that the senior partner in some law firm decides he wants the best view in town – and darned if some client isn’t going to pay for it.. It tells us little about what’s happening in the 95% of office properties that absorb the bulk of investor funding.

Market research firm BulwienGesa’s Office Rental Index covers 125 German cities and has tracked the market for longer than anyone can remember. Its all-markets index shows a cumulative change after 20 years of MINUS 14%, while the last two years - which saw near-record levels of investment activity - saw rents rising by only 1.6% in total. All told, a pretty paltry performance.

Jones Lang LaSalle predict rents rising by 3% at most for the ENTIRE next three years in Germany’s Big 7 cities – where demand is at its highest. Those are figures grudgingly coming from a broker firm, who can notoriously find a silver lining in even the gloomiest of scenarios. We’re entering a period where landlords are sitting down with tenants who signed their ten-year lease agreements in the heady days of 2005-2007, to discuss their longer-term plans. A lot of them are not liking what they hear.

Office properties outside the primest of business districts have been disproportionately hit by the new-found aversion by bankers to funding less-than -blue-chip propositions. Dodgy locations or single-tenant occupancies with pending rent reviews spell anathema to financiers – and tenants will use this knowledge to demand hefty rent reductions. It’s already happening, and the smarter heads in the market appear to be adjusting to a future of static or falling office rents. They are right to do so. Asset managers are balefully concluding that jumping through hoops to keep their tenants happy and willing to extend at the same – or slightly less – rent than they’re currently paying, is a better strategy than risking even higher vacancy rates when the contract expires in two years time.

All this will have a detrimental effect on valuations, whichever way it’s sliced and diced. Anecdotal evidence from professional investors, though, still suggests that, for many offering properties to prospective buyers, the pfennig simply hasn’t dropped as to how fantasy-fuelled their price expectations are.

But it will. And when it does, there’ll be little succour to be found from the new debt funds or insurers - who didn’t enter this game to end up with their arms up to their elbows in buckets of gypsum and conformal coating materials. No sirree. That’s another business, called opportunistic investing, and - well, we’re here to help. You’ve got 50% vacancy? Refinancing coming up? Where did you say it was located? Please, do come in.