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U.K. CAPITAL FREEZES, BUT EUROPE REMAINS HOT

By Ryan Chittum

It's not only a U.S. phenomenon.

Across the pond, the Brits seem to have some capital market problems in common with their Yankee allies. Yes, it is extremely difficult to get a loan for retail real estate in the U.K. just now, what with financiers scrambling to preserve capital levels depleted by billions of pounds in losses.

But financing is still possible in the rest of Europe, especially for large investors that have long-term relationships with their bankers and lots of equity to invest. “You can really draw a distinctive line between the U.K. and the rest of continental Europe,” said Stuart Dawkins, a director of the European investment team at Los Angeles-based CB Richard Ellis. The U.K. “is far more directly linked to the U.S., and the credit crunch hit right away.”

Continental Europe, meanwhile, is doing considerably better. This is partly because the Continent boasts a more diverse set of lenders. “We had a pretty buoyant last two quarters of 2007,” said Jeremy Eddy, head of European retail investment on the Continent for Chicago-based Jones Lang LaSalle, of non-U.K. Europe. “And that has continued through the first month of 2008. We've seen some pretty aggressive deals go through with 2007 pricing.”

But even in Europe, as the loan size increases, financing becomes exponentially harder, even for the big boys. The credit crisis hit the U.S. in earnest in August, following the collapse of the subprime mortgage industry, which had begun to implode several months earlier. Banks, which had already been reining in lending, then yanked the money cart to a near halt as it became impossible to syndicate real estate debt, something that had allowed lenders to keep the cash spigots flowing as it kept the loans off the balance sheet.

In the U.K., which had seen capitalization rates plunge even further than the U.S., the low yields suddenly looked too low to lenders. “We had prime yields in central London office of sub-4 percent, and retail really wasn't that far behind,” Dawkins said. “This was too expensive for traditional investors. The major players were highly leveraged buyers, principally among them the Irish, who could borrow at advantageous euro rates. These guys can't get the financing anymore.”

Since then, retail cap rates have pushed up as much as 2 percent in the U.K. “For the first time, we've seen Continental investors looking at U.K. [real estate] stock because it's cheaper than the Continent,” Dawkins said.

Cap rates have not risen nearly as much in the rest of Europe, market watchers say. Prime center-city yields have seen little movement in continental Europe, while secondary yields have bumped up 25 to 50 basis points, Eddy says. The crimp on high-cost prime retail investments means few deals are being done in that area, making it difficult to discern movement there.

Still, all of Europe has been hit by the fear of securitization. Securitization totals in the first two months of the year were about € 16 billion ($25 billion), down from about € 65 billion in the first two months of 2007. That means big deals (about € 100 million and over, which banks would need to syndicate off their books) are much harder to finance.

But for the old-style real estate investors, this means the field is theirs again. “There are still players out there that have pre-existing debt facilities or are guys who don't have high debt levels that can borrow readily from their banks” at 50 to 60 percent loan-to-value, according to Eddy. But anything that approaches 70 percent or more than $100 million is difficult to finance.

Larger loans in capital markets in Britain or elsewhere in Europe are locked down, as they pretty much have been since the summer. “I haven't seen any [commercial-mortgage-backed securities] or any large borrowing since last June or July,” said Peter Lowy, managing director of Westfield Group. “And there's no sign of that changing anytime soon.”

Many analysts and investors expect even high-equity, small-cap lending to get much more difficult in Europe. “People are saying it's only a matter of time before it gets worse,” Dawkins said. “My own point of view is, it's a race against time.”

The equity side is seeing some interesting movement, though. “A couple of sovereign wealth funds are starting to look at real estate for equity investments, especially the [funds] from Middle Eastern and Nordic countries” Lowy said. “The other thing you see is movement from the German open- and closed-end fund business. They're actually getting money now, specifically in their nondomestic funds.”

In Germany investors have pushed up yields on fears that there may be too much supply in the market, but in other countries, cap rates are still falling in some instances. In France, a Marseilles shopping center recently sold at a 3.8 percent cap rate. REITs in the U.K. must revalue their holdings each quarter. Lowy says retail cap rates there have increased about 5 to 10 percent. Westfield's went from a 5.1 percent cap rate to 5.4 percent.

European commercial real estate transactions were up 2 percent last year (in dollars, though they were down 6 percent in local currency), to $327 billion, according to Jones Lang LaSalle. But 2007 was a tale of two halves for European real estate sales. The second half of the year saw transactions fall 14 percent from a year earlier, to about $158 billion, primarily because of the collapse of the U.K. sales market.

Most do not see the outlook clearing up anytime soon. Banks need to be recapitalized, and the debt and equity markets will both have to stabilize, observers say. One bright spot is the fundamentals of the business. Most of the European economies show solid growth. Kemper's Group, a German retail real estate advisory firm, predicts that German retail rents in center-city locations could rise more than 5 percent this year, double the 2007 rate.

After three years of financial engineers running the show, this means nuts-and-bolts real estate operators will have a chance to dominate the field. But the clouds have got to break for that to happen too, and for the foreseeable future, U.K. cap rates for retail property remain well below the cost of funds.