Secondary markets set to really feel the squeeze as lenders withdraw

There is a very high likelihood that most of Europe will be in recession later this year and through 2013. That includes Germany, which has so far ridden high through the crisis – partly, of course, as a result of its European neighbours’ misfortunes, but also because of its successful ability to manufacture and sell high-end products to the major growth markets of China, India, Russia and Brazil.

On the surface of it, Germany should be able to withstand the initial effects of a collapsing Europe. Just recently, the unemployment rate fell to 6.6%, with 2.8 million people out of work – the lowest level in more than twenty years. Little in day-to-day German economic life is yet comparable to the anguish being suffered by large numbers in the euro- zone’s periphery countries. Germany’s showcase industries, such as the auto industry, have been breaking previous records in numbers of cars sold, particularly at the higher end of the market. Precision tools and machinery are being shipped out to emerging markets across the world, helped by the recent decline of the euro on world currency markets. For many, life is pretty good, but they are fearful that it might not stay that way.

Indeed, warning signals abound. Companies, even in booming industries, but whose products are sold almost exclusively in Europe, such as Opel cars, have not been sharing in the lucrative bonanza. Several thousand job cuts are imminent at its plants in Germany, and very likely entire factory closures. The Federal Employment Agency, which tracks all 176 of its local employment agencies throughout the country, is seeing a notable deterioration in the jobs situation kicking in from autumn onwards – about the normal 6-month time lag after orders begin to fall off. In the three months to April, German machine builders saw orders from the Chinese market fall 9% year-on-year. Figures for the next three months are expected to be worse.

In the short term, these developments will likely affect Germany’s real estate markets only marginally. Germany’s banks are shifting their lending to the residential markets, where competitive pressures are building up to gain or hold on to market share. While we’re probably not in bubble territory yet, several aggressive lenders are coming close to offering financing packages that are reminiscent of those good old ‘full-financing’ deals - that even in supposedly risk-averse Germany were becoming popular, before America’s sub-prime crisis sent foreign mortgage providers like GMAC RFC scarpering for cover. Newer providers are now creeping back with very similar products. Everyone wants a piece of the residential action.

The assumption that inflation is headed our way, along with low interest rates, a wide availability of finance and a perceived lack of investment alternatives, is fuelling this German housing boom. By contrast, a wall of commercial property re-financings, including billions in CMBS debt, is coming down the turnpike – and traditional lenders are in full retreat. The newly-launched FAP Barometer, which we report on in this issue, paints an overall positive picture of the financial climate for commercial property lending – which is good news – but acknowledges that conditions might be about to get a lot tighter, and more expensive. Big gaps are looming, and it’s not clear how quickly they can be filled from alternative sources.

The biggest problem is going to be in secondary markets, which are already suffering from the impact of declining investor confidence and transaction volumes. Naturally, prime yields in the very top commercial properties in Europe’s most stable and liquid cities are holding firm, propped up by sovereign wealth funds from Asia and the Middle East, as well as by very high net worth individuals. But these represent a small fraction of the market. The secondary markets are more likely to bear the brunt of real-world companies’ decisions to consolidate or trim their operations - and hence make them even riskier for potential investors.

That’s not all bad. Many US investors, in particular, are fine with risk, and are definitely interested in European distressed or opportunistic investments. But most reasonable secondary market opportunities don’t fall into this category – and may have to undergo a lot more downward mobility before that becomes the case. Frankfurt is a good example. Visitors to the city might be forgiven for thinking that Germany’s banking capital is booming, such is the density of cranes dragging new buildings out of the depths to join the city’s burgeoning skyline. But unfortunately most of it is displacement, not net new absorption – good for the construction industry, but it will leave the city’s office vacancy rate unchanged at an absurdly high level.

What it really means is this - no matter what happens as Europe’s financing markets evolve to embrace a wider range of financing sources – whether from insurers, pension funds or the new tailor-made debt funds – none of these players will be interested in getting down and dirty and financing anything other than the pick of the crop, while transition to new funding models is underway. This will take time. But in the meantime, plenty of decent properties in the second and third division are going to find the next few years very tough indeed.