The sub-prime crisis from a Spanish perspective (Grosvenor) The Baltic real estate market (Re&Solution)

Journal of European Real Estate Research

ISSN: 1753-9269

Article publication date: 18 July 2008



(2008), "The sub-prime crisis from a Spanish perspective (Grosvenor) The Baltic real estate market (Re&Solution)", Journal of European Real Estate Research, Vol. 1 No. 2.



Emerald Group Publishing Limited

Copyright © 2008, Emerald Group Publishing Limited

The sub-prime crisis from a Spanish perspective (Grosvenor) The Baltic real estate market (Re&Solution)

Article Type: European Market Briefing Showcase From: Journal of European Real Estate Research, Volume 1, Issue 2

In this section (European Market Briefing Showcase), we will be re-presenting some of the best research available on the European Market. In this issue we are fortunate to be able to re-present two such pieces of work.The first is a paper from Grosvenor Research in the UK entitled “The sub-prime crisis from a Spanish perspective”. This is just one of a plethora of Research Papers available from Grosvenor UK at their research link at www.grosvenor.comThe second paper is from Re&Solution, in alliance with Jones Lang LaSalle entitled “The Property Markets in the Baltic States”. This is represents one of regular series of reviews available from Re&Solution at their research link at

Global outlook

World overview

Growth. Despite a relatively positive GDP performance in the US in Q2 (1.9 percent) the evidence of a marked slowdown across the OECD is now overwhelming. In the US we expect growth to slow again as the impact of the tax stimulus wanes and rising unemployment hits consumer spending. Although the Eurozone is not subject to the same imbalances as the US and UK, consumer and business confidence is dropping sharply and GDP probably shrank in Q2. Of all developed economies, the UK looks in most trouble: inflation is eating away at consumers’ budgets, house price falls are eroding consumers’ wealth and the important financial services sector is shrinking rapidly. The Japanese economy has stalled, as weaker exports have put manufacturing into recession. Only in the emerging markets is growth still robust: China posted 10.1 percent y-o-y growth (20.1 percent in nominal terms) in Q2 and India is growing at 9 percent. We expect emerging markets to start to slow in 2009.

Inflation. Inflation remains above target virtually everywhere. In the US CPI growth is at 5 percent (implied target 2 percent), in the Eurozone it is 4.1 percent (target lower than 2 percent) and in the UK it is at 3.8 percent (target around 2 percent). In Japan inflation of 2 percent is at a decade high. Emerging markets, due to the greater weight given to food in the inflation indices, have a worse problem. China’s implied inflation is nearly 10 percent and India’s actual inflation is nearly 12 percent. However, due to the scale of the economic slowdown now in place it is likely that inflation in the OECD is close to peaking.

Policy. Although rate cuts are not yet on the agenda across the OECD, there is a growing sense amongst policy makers that recession is a bigger problem than inflation. That the Fed held US rates steady in August and indicated that it was in no rush to raise is evidence of this, as is the UK MPCs’ decision to keep rates steady. A substantial OECD output gap will have opened up by end 2008, which should leave the way clear for a slow decline in rates (except in the US). However, policy tightening will continue in emerging markets leaving them vulnerable to a sharper than expected slowdown (Table I).

A year on: the sub-prime crisis from a Spanish perspective

A year ago the “sub-prime” crisis hit the markets. It started in the US, where many thought it may have been contained. In the short-term it was mainly a liquidity issue but as time has passed, and asset values, real estate in particular, have fallen it has increasingly become a solvency problem, with a number of banks going under and more to follow. What some thought might be history within the year is now a signal cause of a global economic slowdown which is considerably more severe than expected. Furthermore, the banking crisis did move outside of US borders, crossing the Atlantic to the UK and Europe. Initially many thought only a few directly exposed German banks might suffer but the crisis has been more wide spread. Here we consider how Spanish banks have fared and the implications for the real estate sector.

In Spain the banking crisis has been smaller than in the US, with Spanish banks posting good results in 2007. However, growing uncertainties, such as, the long awaited residential price correction combined with the liquidity crisis will make banks far more exposed in 2008. Not surprisingly with increasing risks to profits bank share prices have fallen (Figure 1). This despite the fact bank performance in Spain is boosted by the high concentration of the sector, which distorts competition and produces more generous margins. In Spain, the Big Five – Banco Santander, BBVA, Banco Popular, Caja Madrid and La Caixa account for 42 percent of total market share.

Figure 1 Spanish bank's share prices

Another factor supportive of Spanish banks is the highly dynamic credit cycle over the past few years, which has further driven bank profits. The Spanish banking system is known for charging borrowers more and giving savers less, compared to both Italian and British banks. The average margin is around 2 percent across the Spanish banking sector, similar to Italy but higher than in Britain (1.61 percent), France (0.98 percent) and Germany (0.77 percent).

Also, the main Spanish banks are very well capitalised because they rely heavily on retained profits for their capital base expansion, plus the Spanish government forces them to make a high level of provision against losses. The coverage ratio of non performing loans is above 200 percent compared with an average of 60 percent for other European banks. The ratio of doubtful loans to gross loans only stood at 1.2 percent in 2007 compared with levels reaching 3–6 percent in the Core Euro zone countries.

All that said, the liquidity crisis in Spain was triggered by much the same factors as in the US, rising interest rates and falling property prices. A reduction in credit availability following tighter financial conditions, plus the deteriorating economic background, will act negatively on banking activity, eroding total loan volumes and eroding margins.

One area where Spanish banks are slightly more exposed than their continental European peers is their use of securitisation to gains funds. Spain has been behind the UK, but ahead against other EU countries, in terms of securitization with residential mortgage backed securities reaching €42 billion compared with the UK at €180 billion. Banks are now forced to refinance themselves on the “expensive” interbank loan market given the lack of the asset securitization, as well as the freeze of interbank transactions related to covered bonds.

So how’s this impacting on real estate? Residential prices are falling, construction volumes and property transactions have decreased, with outward yield shifts in both the office and retail markets. This slowdown is a direct result of reduced credit availability (Figure 2). The volumes of mortgages as well as loans to the property sector are decreasing so real estate in Spain will suffer more substantially than originally thought.

Figure 2 U-turn in real estate loans

The downturn in the property market, plus the lower repayment capacity of borrowers will lead to an increase in defaults as well as a lowering of recovery rates. Despite this bleak picture the impact of a multiplication of defaults on the balance sheets and profitability of the institutions will be limited for the following reasons, the requirements of the Bank of Spain, regarding statistical coverage of credit risk, should guarantee a safety buffer against bad loans and losses related to depreciation of mortgage loans would not be solely carried by Spanish institutions (Spanish banks “export” close to 30 percent of the counterparty risks linked to mortgage loans).

Our judgement is that the downturn in the economy and the severe downturn in real estate markets will impact on Spanish banks’ profitability and appetite to lend. This in turn will lead to a deeper correction in real estate prices than previously thought. However, the highly regulated and somewhat “overprotected” banking system should be robust enough to survive intact.

The property markets in the Baltic states have not been immune from international pressures but show great promise for investors

The property investment markets in the Baltic states of Lithuania, Latvia and Estonia, are characterised at present, on the one hand, by a combination of a general economic slowdown and the obvious impact of the credit crunch and, on the other, by a remarkable supply of new investment opportunities. International real estate investors’ attitudes towards the Baltic states have been tempered by the somewhat vague macroeconomic background and by higher credit costs. One positive for investors is that local property owners are having to look at selling their assets so that they can find the resources to complete projects that are underway or to start new ones.

Depending on the type and quality of investment, net yields were affected by 25-100 basis points during the second half of 2007 and by a further 25-50 basis points during the first quarter of 2008. The fallout from the credit crunch has had implications for property pricing and for the spectrum of potential buyers. The Baltic states are no exception; therefore, highly leveraged buyers are out of the game, while unleveraged or low leverage buyers are poised to reap the benefits.

Scandinavian investors, who have dominated the market in recent years, have now been joined by institutional investors from Germany, Netherlands, the United Kingdom and the United States.

A supply boom

Although the pricing and quality of investment opportunities in the Baltic states is as attractive as it has ever been, the uncertainty displayed by international investors has proved a barrier to the completion of transactions:

  • “We are still nervous about buying in Lithuania right now … ”

  • “Unfortunately, we are constrained from investing into Lithuania at the current moment due to the high currency risk … ”

  • “We have made a decision to put our Baltic investments on hold for the time being … ”

  • “Unfortunately, our new fund, which we have recently opened, restricts our investment in the Baltic States. We are also still very cautious about entering the market at this time … ”

These are some comments from investors that best describe their current view toward investments in the Baltic States. We are often asked to elaborate on our view concerning the general economic situation – for example, the risk of currency depreciation, conditions of financing, margins and loan-to-value ratios, market maturity, and projected oversupply in the office sector.

It is not that easy to give accurate answers to these questions, whether or not now is the right time to invest in the Baltic region, but we can give a convincing “yes” when talking about the variety of open investment opportunities and their quality. Nevertheless, the answer is not that persuasive when it comes to commenting on obtaining attractive financing terms and conditions and the general prospects for economic development in the Baltic states.

We do not seek to change investors’ strategies towards the Baltic States, and we cannot deny the general situation in the financial markets here; however, we aim to provide a local view and add some colour to the Baltic investment picture.

Evidence No. 1: Remarkable supply accelerated by a tighter credit policy for local developers. The Baltic region, along with the whole European continent, seems to be experiencing a remarkable supply of investment opportunities. Institutional investors claim that 2008 has started impressively in terms of investment products coming from the Baltic region. Increased costs of borrowing and a significantly tighter credit policy have induced developers to start considering alternative financing opportunities – for example, forward funding or disposing of assets.

Evidence No. 2: A higher quality of investment opportunities driven by an increased supply of assets held by the strongest developers, retail and logistics chains. The quality of investment products has improved substantially compared to, for example, 2006-2007. The largest shopping centre developers and retail chains have started selling their assets and the quality of investment opportunities has increased substantially. The biggest shopping centre, one of the largest logistics hubs, is for sale at present; the strongest retail chains are considering joint venture and sale-and-leaseback opportunities; the strongest developers are searching for development and financial partners.

It is important to emphasise that local developers learned a lot from their previous mistakes; they have adopted international standards in respect of both the technical grade and the lease structure of the assets. Long-term lease agreements, triple net rent and transparency of the sales process are evidence of competence and market maturity. The majority of projects that are underway completely fulfill the requirements of institutional investors.

Evidence No. 3: Adequate lot sizes. It is necessary to elaborate on another important issue concerning the latest market transformation. Inadequate lot sizes of available investment opportunities used to act as a market impediment for leading continental European investors, certainly in the past three to five years. Investment opportunities comprising lots of €5-15 million used to dominate the market, and this deterred the entry of the major funds. Most of the currently open investment opportunities are for more than €20 million, and two of the available propositions are for more than €100 million. These are likely to prove more attractive to leading institutional investors.

Evidence No. 4: Reasonable yield levels. Rapid yield compression has been the distinctive market feature of the Baltic property market since 2003. As the chart shows, yields in 2003-2004 were between 10 per cent and 12 per cent and dropped last year down to between 6.3 per cent and 7 per cent. Despite growing anxiety about overheating of the economy, the early months of 2007 were dominated by an investor optimism that was, for the most part, carried on from 2006. Investors showed an ever increasing interest in all types of deals across all property subsectors, sending prime yields even further down.

Large banks were the first to express their concerns over steep inflation, the growing current account deficit, the unnaturally low unemployment rate, overestimated market potential and yet extremely low investment yields, which apparently did not include a risk premium at all. Nevertheless, investors were still seized by optimistic inertia and continued to offer very low yields based on high expectations. Their activity was spurred by the change in loan issuing policies of most banks in the latter half of 2007.

The second half of 2007 was marked by a clear change of mood. Concerns regarding the economic health of the countries in the region turned into widespread forecasts of economic downturn. Local economic problems appeared even more menacing against the backdrop of global economic turmoil.

There is no doubt that three factors – the imbalanced macroeconomic stability of the Baltic region; the risk of economic overheating, resulting in a presumed “hard landing”; and both of these reinforced by the impact of the credit crunch – have combined to make a crucial impact both on developers’ returns and on investors’ net yield expectations. The issues mentioned above have certain implications regarding development of a yield curve.

The biggest and best assets and portfolios have experienced a quite insignificant impact on the yield level. High quality cashflow objects with long lease agreements and strong lessees have been affected by 25-50 basis points, while less attractive small properties (up to €20 million) or those with an unappealing lease structure situated in secondary locations have faced a net yield increase of some 75-150 basis points (Figure 3).

Figure 3

Growing up

The majority of local development market players in the Baltic states appear to have learned sufficiently from their previous mistakes and have gained valuable insight and advice from international investors and financial partners as well as from consultants and lawyers.

It is necessary to emphasise that local developers have to start realising that the time for making mistakes is already in the past. In seeking to obtain “western European” yields, a sufficiently structured product must be provided. Well structured lease agreements, professional property management, international architects, a high attention to the technical quality of the building; all these are becoming fundamental issues for every new large project, thus creating a larger supply of quality products for institutional investors.

Local markets have started providing the possibility of investing in prime regional properties, meeting the requirements of the major institutional investors; leading global funds have started to enter the markets in the Baltic states and this is forecast to increase further over the next two to three years. The Scandinavian capital that dominated previously is expected to be augmented especially by German and UK money, and this will be followed by major global banks and funding organisations.

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