u.k. economic & commercial real estate market...

www.quadrantrea.com

ATLANTA DUBLIN LONDON SYDNEY

Quadrant Real Estate Advisors LLC

U.K. Economic & Commercial Real Estate Market Commentary 3rd Quarter 2014

Kurt Wright, CFA Chief Executive Officer

+1 (1) 770 752 6713 [email protected]

Richard Sauerman Head of Global Research

+1 (1) 770 410 3716 [email protected]

mailto:[email protected]


U.K. ECONOMIC & MARKET COMMENTARY 3rd Quarter 2014

Quadrant Real Estate Advisors LLC 1 www.quadrantrea.com

Table of Contents

Executive Summary…………………………………………………………………………………………………………………….. ....2

State of the U.K. Economy………………………………………………………………………………………………………….. ....3

U.K. Commercial Real Estate Market Fundamentals…………………………………………………………………… .…6

U.K. Commercial Real Estate Debt Market……………..…………………………………………………………………… ..10

Contacts……………………………………………………………………………………………………………………………………… ..12

Important Disclosures………………………………………………………………………………………………………………… ..12

About Quadrant Real Estate Advisors

Quadrant Real Estate Advisors LLC (“Quadrant”) is a United States SEC registered investment

adviser and Australian Securities and Investments Commission (ASIC) Foreign Registered

Corporation (ABN 39 123 863 963). QREA Europe LLP ("QREA") is a subsidiary of Quadrant. QREA

Europe LLP (registration number 610613) is authorized and registered by the Financial Conduct

Authority (“FCA”). Quadrant has approximately $5.9 billion of commercial and multifamily real

estate investment under management on behalf of institutional investors. Clients include

insurance companies, pension funds, sovereign wealth management funds, and high net worth

investors.

Since 1993 Quadrant’s senior management has worked together as a team providing the firm’s

clients with access to both privately placed and publicly traded U.S. commercial real estate debt

and equity investments through commingled funds and single client accounts. In addition to

experience, senior management controls 100% of the firm, thereby providing true alignment of

interests and accountability.

The firm’s executive leadership includes Kurt Wright, Chief Executive Officer; Michael Wood,

Executive Vice President; Thomas Mattinson, Executive Vice President; and Walter Huggins,

Executive Vice President.



Executive Summary

The U.K. economy continues to exhibit strength relative to much of continental Europe.

Year-over-year real Gross Domestic Product (“GDP”) growth in the U.K. was relatively flat quarter-

over-quarter at 3.0% in the third quarter of 2014.

Quadrant expects GDP growth to continue to pace near 3.0% into 2015.

Total employment increased by 112,000 jobs in the third quarter, and the unemployment rate

dropped 30 bps (revised) sequentially to 6.0%.

The Bank of England Bank Rate remained unchanged at 0.50% during the quarter.

Key Economic Indicators

Source: Bloomberg, Capital Economics, Office for National Statistics

Economic momentum and low benchmark interest rates continued driving positive investor

sentiment, which further supported improvement of commercial real estate (“CRE”) fundamentals.

Strengthening CRE fundamentals have spread well-beyond Greater London, and the 2015 U.K. CRE

outlook is generally favourable throughout much of the country.

CRE debt availability remained somewhat fragmented outside of prime markets.

The Bank of England reported that aggregate net new property lending by banks and building

societies was negative £1.8 billion in the third quarter.

As a result, CRE debt (including development lending) as a percentage of outstanding bank debt

contracted 20 bps sequentially to 8.5%.

Lending demand remains disproportionately focused on properties in prime markets, but the

spread between loans on comparable assets in prime versus secondary locations is narrowing.

The capital availability gap that, for several years, resulted from falling bank originations volume has

also narrowed quickly as non-bank lenders have added liquidity to the market.

However, some borrowers continue to face maturing debt that is not refinancable at banks’ current

senior mortgage underwriting standards. As such, borrower demand for stretch senior and

mezzanine debt remains elevated. Lenders have achieved favourable relative value by lending up

to a 70-to-85% loan-to-value range.

Lender competition is high, so spreads and underwritten IRRs on all debt types secured by U.K.

properties continue trending down.

However, certain U.K. commercial real estate debt investments continue to offer higher risk-

adjusted returns relative to U.S. equivalents.

Kurt Wright, CFA

Chief Executive Officer

+1 (1) 770 752 6713

[email protected]

Richard Sauerman

Head of Global Research

+1 (1) 770 410 3716

[email protected]

www.quadrantrea.com


Kurt Wright, CFA

Chief Executive Officer

+1 (1) 770 752 6713

[email protected]

Richard Sauerman

Head of Global Research

+1 (1) 770 410 3716

[email protected]

www.quadrantrea.com


-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%2

00

1

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

3Q

20

14

20

15

F

20

16

F

Real GDP YoY Growth Unemployment Rate Headline CPI 10-Yr Gilt Yield







State of the U.K. Economy

Gross Domestic Product (“GDP”)

The Office for National Statistics’ (“ONS”) revised estimate of year-over-year real GDP growth was

3.0% in the third quarter of 2014 – slightly down from 3.2% (revised) in the second quarter.

Production output and construction output grew at faster clips than the previous quarter while the

service sector drove the 20 bps deceleration in year-over-year GDP growth.

Quadrant expects GDP growth to continue to pace near 3.0% into 2015.

Real Gross Domestic Product Growth (GBP-denominated)

Source: Bloomberg, Office for National Statistics

Employment

Total employment increased by 112,000 jobs in the third quarter.

Among people aged 16-to-64, 73.0% were employed as of September 2014, which was 10 bps

higher than the prior quarter. The level continued to inch toward the 73.1% record that was last

notched in February 2005.

The unemployment rate dropped 30 bps (revised) quarter-over-quarter to 6.0%.

Total Employment and Unemployment Rate

Source: Bloomberg, Office for National Statistics

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

22,500.000

23,500.000

24,500.000

25,500.000

26,500.000

27,500.000

28,500.000

29,500.000

30,500.000

31,500.000

Total Employment Unemployment Rate



Inflation

The Consumer Price Index (“CPI”) decreased 67 bps during the quarter to 1.2% (year-over-year).

CPI is forecasted to average below 2.0% through 2016.

Consumer Outlook

The GfK U.K. Consumer Confidence Indicator ended the fourth quarter at -1, down 2 points

sequentially but up 9 points year-over-year.

Nominal retail sales (excluding automobile fuel) increased 0.4% sequentially and 2.9% year-over-

year. The textiles/clothing/footwear category lagged as warmer weather reduced seasonal spend.

Consumer Confidence and Nominal Retail Sales

Source: Bloomberg, GfK, Office for National Statistics

Inflation-adjusted per capita retail sales in the third quarter were £1,019.91 (in December 1991

GBP). The metric has consistently averaged near £1,018-to-1,020 (revised) during 2014.

The level remained 15.0% below the first quarter 2008 pre-recessionary reading of £1,199.49.

Reaching the pre-recessionary level would result in an additional £85.9 billion of retail sales

annually (adjusted back to September 2014 GBP).

Inflation-Adjusted Per Capita Retail Sales

Source: Bloomberg, Office for National Statistics, Quadrant Real Estate Advisors

Note: Retail sales represent Retail Sales (excluding automobile fuel). Quadrant has adjusted Retail Sales to reflect per capita Retail Sales in December 1991 GBP.

-40.0-35.0-30.0-25.0-20.0-15.0-10.0-5.00.05.010.015.0

0.000

20.000

40.000

60.000

80.000

100.000

120.000

Retail Sales (ex-auto fuel) GfK U.K. Consumer Confidence Indicator

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

800.00

850.00

900.00

950.00

1,000.00

1,050.00

1,100.00

1,150.00

1,200.00

1,250.00

Inflation-adj. Per Capita Retail Sales Rolling 5yr Avg. of Adj. Retail Sales Cumulative CPI



Interest Rates

The Bank of England Bank Rate remained unchanged at 0.50% during the third quarter.

Despite labour market improvement and fairly strong GDP growth, the Monetary Policy Committee

(save two dissenting members) remained committed to maintaining the low Bank Rate to combat

low inflation.

Government bond yields fell quarter-over-quarter. The yield on the ten-year gilt declined 24 bps

during the quarter to 2.43%.

Quadrant expects the ten-year gilt yield to average between 2.5% and 3.0% during 2015.

10-Year Gilt Yield and Bank Rate (20 Years)

Source: Bloomberg

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

10-Year Gilt Yield BofE Bank Rate



U.K. Commercial Real Estate Market Fundamentals

Private Equity Performance & Pricing

The following chart shows CRE private equity performance in the U.S. and the U.K. over the past 25

years. The light blue line shows GBP-denominated U.K. performance. The dark blue and red lines

highlight USD-denominated U.K. and U.S. performance, respectively.

Through the third quarter of 2014, the IPD Total Return Property Index (adjusted to USD) remained

8.6% below its third quarter 2007 high.

U.K. and U.S. CRE Private Equity Total Returns (25 Years; USD)

Source: IPD, Bank of America Merrill Lynch, NCREIF, Bloomberg, Quadrant Real Estate Advisors

Property Investment Yields (Cap Rates)

Property Sector June 2014 September 2014

OFFICE

London – West End 3.75% 3.75%

London – City 4.50% 4.50%

M25 / South East 5.50% 5.25%

Major Regional Cities 5.25% 5.25%

Strong Secondary 5.50% 5.50%

Secondary 7.00%+ 7.00%+

RETAIL

High Street Retail – Prime 4.50% 4.50%

High Street Retail – Strong Secondary 6.00% 6.00%

High Street Retail – Secondary 10.00%+ 10.00%

Shopping Centres – Prime 5.75% 5.50%

Shopping Centres – Strong Secondary 6.75% 6.50%

Shopping Centres – Secondary 8.75% 8.50%

Bulky Goods Parks – Prime 5.75% 5.50%

Bulky Goods Parks – Secondary 6.50% 6.25%

INDUSTRIAL / WAREHOUSE

Distribution – Prime 5.50% 5.25%

Distribution – Secondary 7.00% 6.50%

Estate – Prime 5.50% 5.25%

Estate – Secondary 8.00%+ 7.25% Source: CBRE, Knight Frank, Savills, Quadrant Real Estate Advisors

Note: “Strong Secondary” refers to metro areas of major regional cities, and “Secondary” refers to outlying markets.

-100.00%

0.00%

100.00%

200.00%

300.00%

400.00%

500.00%

600.00%

700.00%

800.00%

IPD UK TR Property Index (GBP) IPD UK TR Property Index (USD) NCREIF US Property Index TR (USD)



As the table shows, the spread between prime and secondary property yields remained wide.

However, the spread continued to narrow during the quarter as economic improvement further

expanded into secondary markets and supported stronger commercial property fundamentals.

Fundamentally sound properties located in strong secondary markets and value-add opportunities

in prime/strong secondary markets offer the most favourable relative value.

Private Equity Transaction Volume

The following chart shows Quadrant’s estimates of U.K. commercial property private equity

transaction volume (limited to properties >5,000 sf in size).

Private Equity Transaction Volume – 3rd Quarter 2014

Source: EGi, Quadrant Real Estate Advisors

Spatial Supply

Seasonally-adjusted private commercial/industrial construction output volume contracted 2.5%

sequentially in the third quarter of 2014 after decreasing 1.8% (revised) in the prior quarter.

Construction volume also decreased 3.1% during the twelve month period through September

2014 versus an average year-over-year increase of 1.0% over the preceding four quarters.

The following chart shows private construction output volume (left axis) and quarterly percentage

change (right axis). As the chart indicates, construction volume remained historically low.

Private Commercial/Industrial Construction Output (£MM; % Change)

Source: Office for National Statistics, Quadrant Real Estate Advisors

However, development activity is forecasted to improve toward 2016-to-2017 according to the

Royal Institute of British Architects’ September 2014 Future Trends Survey. Respondents indicated

Total Volume (£MM) Total Square Footage

(millions)

Property Sector Q3 2014 Q2 2014 Q3 2014 Q2 2014

OFFICE 4,963.4 6,100.4 15.6 11.4

RETAIL 2,802.1 2,273.6 10.2 9.4

INDUSTRIAL / WAREHOUSE 696.6 1,141.6 14.1 45.0

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

0.0

2,000.0

4,000.0

6,000.0

8,000.0

10,000.0

12,000.0

% Change (R) Volume (L)



that they expect an increase in architectural workload from the commercial property sector, which

could manifest in more CRE development starts in the next 12-to-24 months.

The September survey’s commercial sector index value was +19 (the baseline of 0 indicates no

anticipation of workload change).

New development is still expected to be primarily located in London, major regional cities, and

strong secondary markets.

Weaker secondary markets will continue to exhibit net contraction of spatial supply as obsolete

retail and industrial stock is demolished and development remains muted.

Spatial Demand

The Royal Institution of Chartered Surveyors (“RICS”) Commercial Property Market Survey indicated

that 44% of U.K. surveyors reported rising occupier demand in the third quarter (versus 38% in the

prior quarter).

The result was the second highest level in the survey’s history; eclipsed only by the first quarter

of 2014’s 52% reading.

Furthermore, the survey indicated that demand accelerated in all three primary property sectors,

though industrial demand growth outpaced office and retail growth.

The share of survey respondents expecting rental rate growth hit a record high of 38% (versus 33%,

the previous record, in the prior quarter).

Overall, third quarter demand further reflected the favourable economic outlook and supported

the notion that commercial property market fundamentals continued to improve beyond prime

population centers.

Availability & Rental Rate Growth

Broadly, rental rate growth strengthened as economic expansion drove competition amongst

occupiers. Competition will downwardly pressure availability and drive positive net absorption.

Furthermore, although property investors benefitted from a rapidly improving lending environment

(please refer to the next section of this report for further discussion), financing for new

development remained limited.

The lack of debt capital to fund new construction may serve as a near-term drag on supply

growth and, thus, availability.

Although favourable availability and rental rate fundamentals are evident in London, major regional

cities, and strong secondary markets; in less robust secondary markets, fundamentals continue to

favor occupiers over landlords. Challenges are particularly evident among retail and older industrial

stock in secondary markets.

U.K. CRE Rental Rate Growth by Property Sector

Source: Capital Economics

Rental Growth (forecasts in gray) Rental Growth (forecasts in gray) Property Sector 2013 2014 2015 2016 2017

Office 3.2% 7.1% 6.2% 4.8% 3.0%

Retail -0.4% 1.1% 2.1% 2.6% 2.3%

Industrial/Warehouse 0.7% 2.6% 3.6% 3.0% 2.7%



Summary U.K. CRE Market Outlook

The table below summarizes Quadrant’s outlook for U.K. CRE market fundamentals. The outlook

for office and industrial properties in strong secondary markets is particularly favourable on a

relative basis.

Quadrant’s 2015 U.K. Commercial Real Estate Market Outlook

Source: Quadrant Real Estate Advisors

Yields (Cap Rates)

Market Type

Rent Growth

Availability Net

Absorption Prime

Quality Non-prime

Quality O

ffic

e

Prime

Strong Secondary

Secondary

Reta

il

Prime

Strong Secondary

Secondary

Indus

tria

l/W

H

Prime

Strong Secondary

Secondary



U.K. Commercial Real Estate Debt Market

Private Debt Market Overview

The capital availability gap that had resulted from banks and building societies limiting new CRE

debt originations has quickly attracted non-bank portfolio lenders.

The migration of the lender base over time is exhibited in the chart below (data through mid-year

2014 due to non-bank lender data availability).

U.K. Commercial Real Estate Debt Oustanding by Lender Type

Source: De Montfort University

The Bank of England reported that aggregate net new lending to property (including development)

by banks and building societies was negative £1.8 billion in the third quarter of 2014.

As a result, CRE debt (including development lending) as a percentage of outstanding bank debt

contracted 20 bps sequentially to 8.5%.

The third quarter marked the 11th consecutive quarter of decline.

Property loans accounted for nearly 12% of bank debt at its peak in 2009.

Declining bank CRE debt holdings (both nominally and in percentage terms), therefore, provided

greater supply of property loans for the increasing number of non-bank lenders with capital to

invest in U.K. CRE debt.

Leveraged equity investors’ significant appetite for CRE assets further supported supply for debt

investors as such equity investors sought acquisition financing.

Given that 33.5% of maturing senior mortgages exhibit 70%+ loan-to-value ratios and 11.5% have

interest coverage ratios below 1.0x, existing borrowers also fueled stretch senior and subordinate

debt supply for the non-bank lending market (as of mid-end 2014).

Coupled with the demand for peak loan proceeds to fund acquisitions, this provides further LTV-

fueled debt supply, which favors debt investors with higher credit risk tolerance.

To achieve market efficiency and equilibrium, this elevated LTV supply is dependent on sufficient

demand from non-bank lenders/investors with an appetite for the assumption of stretch senior

(generally up to 85% LTV), transitional, or subordinate credit risk.

Although competition amongst such lenders is high, opportunities to exploit attractive risk-

adjusted pricing are expected to ensue in the near-term.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Other Non-Bank Lenders

Insurance Companies

North American Banks

Other Intl Banks

German Banks

U.K. Banks/Building Societies



Private Debt Market Pricing Summary

The following table presents Quadrant’s summary of current market lending terms across debt

types based on a generic Grade A office asset with reasonable tenant, rent roll, and sponsorship

characteristics.

Benchmark Interest Rates

Typical Terms

Senior Mortgage Senior Mortgage – Transitional

Senior Mortgage – Stretch

Mezzanine Debt

Security 1st

lien on collateral 1st

lien on collateral 1st

lien on collateral 1

st lien on borrower equity;

possibly 2nd lien on collateral

Tenor 3-to-10 years; possibly with

extension options 3-to-7 years; possibly with



extension options

Amortization Amortizing, partial I/O, or

full term I/O Amortizing, partial I/O, or

full term I/O Amortizing, partial I/O, or

full term I/O Full term I/O

Payment Frequency

Quarterly Quarterly Quarterly Quarterly

Occupancy ~85%+ Underwritten to <80% at some point during term

~85%+ ~85%+

Reserves TI/LC, may be waived Upfront interest; TI/LC, may

be waived TI/LC and/or interest, may

be waived TI/LC and/or interest, may

be waived

Recourse No No No No

Coupon Type Fixed or Floating Fixed or Floating Fixed or Floating Fixed or Floating

Benchmark Rate

Floating: 3-month LIBOR Fixed: GBP gilt swap curve




Current Market Margin/Spread

Prime: 75-to-200 bps Secondary: 150-to-350 bps

200-to-375+ bps; current pay component

Prime: 125-to-325 bps Secondary: 250-to-435 bps

Prime: 325-to-500 bps Secondary: 400-to-800+ bps

Origination Fee 50-to-100 bps 75-to-150 bps 50-to-125 bps 75-to-150 bps

Extension Fee 25-to-50 bps per extension 25-to-50 bps per extension 25-to-50 bps per extension 25-to-50 bps per extension

Exit Fee/Lookback

None 0-to-150+ bps None None

Underwritten IRR

Prime: 2.0-to-4.0%+ Secondary: 3.0-to-5.0%+




Stabilized Loan-to-Value

Up to 65% Up to 80% 65-to-85% 65-to-85%

Minimum DSCR 1.30x Deal specific; may be highly

varied 1.10x 1.10x

Financial Covenant(s)*

DSCR: 1.30x Debt Yield: >/=9%

LTV: </=LTV at origination Original LTV+5%: 100% cash

flow sweep Original LTV+10%: Default

Generally, covenants are based on timeline hurdles

pertaining to income, construction/ capital

improvements, leasing/re-leasing, etc.


If 7.5-to-8%: 50% cash flow sweep

If <7.5%: 100% cash flow sweep


If 7.5-to-8%: 50% cash flow sweep

If <7.5%: 100% cash flow sweep

Prepayment Structured or Gilt + ~50 bps

Lockout: 0-to-3 years Structured or Gilt + ~50 bps



Lockout: 0-to-3 years

Source: Quadrant Real Estate Advisors

*Generally, loan documents provide borrowers a ~20 day forbearance period in which to cure financial covenant breaches.

Benchmark June 2014 September 2014

3-month LIBOR 0.55% 0.57%

3-year GBP Gilt Swap 1.70% 1.58%




Source: Bloomberg



Contacts

U.K. & Europe:

Caleb Kyle

Senior Vice President

+44 (0) 20 7396 5502

[email protected]

United States:

Thomas Mattinson

Executive Vice President

+1 (1) 770 752 6714

[email protected]

Australia:

Michael Wood

Executive Vice President

+61 (0) 2 9917 8300

[email protected]

Important Disclosures

This report is for informational purposes only and does not constitute, form, nor should be

construed as an offer to sell or a solicitation of an offer to buy investments or any fund and does

not constitute any commitment or recommendation on the part of Quadrant Real Estate Advisors.

An investment offering will be made only through a confidential private offering memorandum

subject at all time to revision and completion.

The information contained herein is derived from various sources which Quadrant believes but

does not guarantee to be accurate as of the date hereof. Neither Quadrant nor any of its affiliates

nor any other person makes any representation or warranty, express or implied, as to the accuracy

or completeness of the information contained in this newsletter and nothing contained herein shall

be relied upon or construed as a promise or reorientation of past or future performance.




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