Where are all the soup kitchens?
UK Real Estate : 12 months of observation
Since September 2008, following the collapse of Lehman Brothers and with it the financial markets, we have
been analysing the UK real estate markets and seeking to understand where is there distress, in which sectors
and markets and why.
The market should in theory have been distressed, not least because of the overhang of debt. The total volume
of outstanding UK Commercial Real Estate (CRE) debt reached £247bn at the end of 2007, comprising
outstanding debt on bank balance sheets and the value of outstanding commercial mortgage‐backed
securitisations (CMBS). The total disclosed problem loan portfolios of Lloyds and RBS that were provisionally
designated for the Treasury’s Asset Protection Scheme were £300bn.
Since 2007, CRE lenders were said to have had an increasing number of non‐performing or defaulted loans in
their portfolio against office, retail and leisure property assets in the UK and Europe. £43bn of loans against
commercial property matured in 2009 with another £10bn in 2010. We believed that none of this debt could
be ‘refinanced’, and that there would be a flood of defaulted assets rushed into the market.
Any yet, this didn’t happen, so our question is, where are all the soup kitchens?
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Zaggora is a private investment partnership of outstanding individuals from the principal real estate
investment and banking universe (JP Morgan, Knight Frank, Union Bancaire Privee, The Ability Group) raising
capital to acquire UK and European assets at distressed prices across real estate asset classes.
Questions & Answers
What is it that financial institutions will do with distressed assets?
‐ Banks are going to carefully manage, rather than fire‐sell, assets. Notable sales of loan or asset
portfolios include the $6bn loan book sale by Merill Lynch to Lonestar in October 2008, the sale of a
£4bn loan book by Barclays with a £3.6bn staple financing and more recently the sale of a £1bn
portfolio by Anglo Irish to private investors. These more recent sales, are outliers.
‐ Instead, banks – under protection from the Asset Protection Scheme (UK), NAMA (Ireland),
TARP/TALF (US) – are managing their distressed real and loan assets. For instance, RBS has created an
off‐balance sheet company called West Register to manage its real estate assets and Lloyds Banking
Group has formed a team of 800 people in BSU (Business Support Unit).
Banks have reconciled themselves to self‐managing a lot of their assets for three key reasons.
1 They believe that the market (January – August 09) would not offer them anything more than 40‐
50p on the £1 for assets. This is following a cascade of PE, private investor interest in ‘bidding’ banks
below market value for assets.
2 The belief that, over time, markets will recover and they will be able to exit at face value or less of a
discount to fire selling today.
3 Banks have learnt from the mistakes of the last recession (1990/3) when many, most notably
Barclays, panicked and defaulted borrowers in the largest enforcement of security packages in the UK.
This left the banks with thousands of real estate assets that continued to fall in value because of
What is it that is attractive and interesting to investors?
Investors are concerned about growth, inflation, underlying economic strength as well as systematic
imbalances. At the same time, they recognise there is an opportunity to acquire UK real estate assets because;
1 GBP is below long term trend against most major currencies but notably USD and EURO
2 Interest rates are historically low
3 The UK is politically stable and has a large, transparent, real estate market
4 Lease structures are the longest in the world (20/25 years) and are landlord friendly
5 Cash and treasuries offer low returns, increasing the opportunity cost of holding risk free assets
6 Equity markets may well have out‐run corporate earnings and real economy performance
7 There must be distressed sellers and assets at cheap prices
However, transaction volumes have been thin and there has been a distinct lack of liquidity in the open market
for prime and secondary location assets and across sectors (office, retail). This lack of liquidity has been caused
because existing investors do not wish to sell into a falling market and there is no pressure for them to do so
since banks have clearly decided to focus on assets which are no longer able to service interest. Assets and
borrowers which are in breach of covenant (such as LTV, ISCR) or due for maturity in 2010/11/12 have been
ignored by lenders. Instead they have focused on those assets not servicing interest.
The opportunity to acquire assets in the open market after a 25%‐30% drop in values (Savills, Moodys, IPD) has
been recognised by many investors and a series of new investment vehicles have been established. PE firms
are also believed to have £20‐30bn to spend on real estate assets from funds raised in 2006/7 (Datalink).
However, the lack of sufficient supply of available assets has meant that those assets which have been sold,
have received more interest that normal and have traded at better than asking prices.
Notwithstanding this, there was a flurry of ‘distressed’ sales in Q1 09 from fund investors such as ING and large
listed such as British land facing covenant breaches on debt facilities and redemption requests. But these came
to an end in Q2 as a sense of stability returned to the market.
Investors have also been attempting to access off‐market opportunities. However, many overseas investors
into the UK do not have the relationships within the market with principal owners of assets to be able to
source and structure deals. Secondly, those investors approaching banks with distressed assets have all sought
– almost exclusively – to bid at 30%‐50% of loan or asset value on the basis that it is ‘distressed’. The banks will
simply not trade at these levels, for the reasons mentioned above.
Thus, there is distress, but you have to find it and the market has become very much an ‘insiders game’. This is
because banks do not want to openly advertise the number of problem loans and assets they really have and
borrowers who are in default or under‐water do not wish to be seen to be in difficulty.
Which asset classes and markets offer best long term value growth on a risk adjusted basis?
We have also spent the last 12 months analysing and understanding various asset classes varying from
commercial office, retail, hotels, student accommodation, healthcare and residential property.
Residential Property – No Distress
Initially there was a lot of excitement in Q4 08/Q1 09 about acquiring central London distressed residential
assets. However, given that over half of UK mortgages are on a variable rate basis, the reduction of the base
rate to 0.5% has meant that most borrowers have seen a fall of 90% in their monthly mortgage payment. This
has led to an increase in supply of properties being made available to let as the arbitrage between mortgage
and rental are now larger than ever. However, this is mainly for existing owners/investors as buy‐to‐let
mortgages have significantly reduced as a mortgage product.
Thus, in residential, there is no real distress. We know historically that there is a clear correlation between
unemployment rates and average residential home values so that home values do not ever really bottom until
unemployment peaks. Unemployment is expected to peak in the UK in 2011 and we expect home values to
bottom at the same time. This indicates there may be a further 10‐15% drop in values on a nationwide basis.
Commercial Office – Some distress
The UK commercial office market has seen a significant weakening of the classic fundamentals of occupancy,
rental rates and covenant strength. There has also been a lack of available financing for new acquisitions (or at
least on terms that make investing less attractive). In particular, rental rates in the city of London have
dropped for Prime space from £65 to £45. Other city centre markets, such as Manchester, Birmingham, West‐
End, have seen similar falls. Vacancy rates have increased by 5‐7% in most markets to an average of 10%
However, supply of assets for acquisition has been thin. This is because there has been little distress caused by
banks accelerating loans or funds forced into marketing through redemptions. Many office properties
financed in 2006‐7 will now be over‐leveraged and over‐rented but with facilities not maturing until
2011/2012, sponsors and banks are not looking to sell as long as tenants continue paying rents (which by and
large they are).
From our perspective, there is a strong equity story to commercial office assets within the M25 as we believe
the equity story for London far more than that in the regional office market. London contributes 32% to UK
GDP and has done for decades. We do not believe this will change, although the weakening of the financial
service sector may result (temporarily) in a fall of this contribution. Tenant demand will always be highest in
London but the investment market in the regions may offer more rapid growth as the market shifts towards
the safety of London.
Student Accommodation & Healthcare – No Distress (yet)
These two sectors have attracted a lot more investor interest in recent years. The long term demographic
imbalance in the UK (ageing population) is increasing the demand for care rooms as well as the growth in the
student population for dorm rooms. The model adopted by most healthcare operators (Bupa, Spire, Four
Seasons) and student accommodation operators (United) is to grant 20‐30 year RPI leases to property owners.
This attractive, long term income stream with bond‐like characteristics, has drawn interest from many financial
investors as well as property companies. This, plus the demographic trend, provided a compelling investment
As a result, prices – like most real estate asset classes – in 2006/7 became unsustainable with some
transactions trading at a 4.5% yield (Southern Cross). Since then, yields have significantly shifted outward as
the value of these assets has dropped. Now, healthcare assets on long leases are available at 7‐8% yields with
student accommodation trading at 6.5% ‐ 7%.
Compared to 2006/7 prices, these may appear to be distressed, but there is no ‘distress’ in the sector.
Again, investors are increasingly chasing these types of assets as they are ‘defensive’ and in many ways
counter cyclical. However, the difficulty in financing new transactions has reduced the ability and willingness
to pay higher prices. Like office assets, there is no real distress as banks are not forcing borrowers to re‐
capitalise or sell assets. This will have to come with refinancing dates in 2010/11. None of the major
healthcare or student operators have experienced any difficulties and therefore continue to pay their rent to
owners who are in turn able to service their bank debt.
Retail – Much Distress
The retail sector has felt a lot of distress since Q3 2008. The fall in consumer spending coupled with rising
unemployment has resulted in a squeeze on revenue for all retailers in the UK at the high to mid range of the
market with discount retailers benefiting from a flight to value by consumers. Tesco have continued to
increase their revenue (£260bn) and net profit (£2.8bn) as consumer shop for value at lower prices. This
knock‐on effect for landlords has been an increase in vacancy rates as many tenants have collapsed as well as
falling rental levels across the UK. Secondary retail shopping centres, in out of town locations, have seen yields
widen from 5.5%‐6% in 2007 to 9‐10% in 2009.
The required asset management for multi‐let assets has also caused a problem for many lenders as borrowers
literally hand back the keys for assets to banks which are now over‐rented and under‐tenanted. This presents
an opportunity to acquire quality assets in good locations for distressed prices from lenders as well as forced
sellers. The assets require asset management but there is much value to be gained by doing this over the next
Banks are also increasingly concerned about having to manage multi‐let shopping centres given their limited
resources and lack of familiarity/speciality for retail assets.
Hotels – Much Distress
Since Q3 2008, hotel performance in terms of occupancy, revenue per available room (RevPAR), average daily
rate (ADR) have fallen significantly outside of central London by as much as 20%. Within central London,
occupancy levels have fallen by 10% but RevPAR has been managed to show a fall of just 5%.
Given the nature of hotels, in that tenants pay (or not) the rent daily, income available for debt service falls on
a weekly basis. This has left many hotel owners unable to service interest to lenders. Lenders are terrified
because hotels require more asset management than any other real estate class and few of the banks have
developed teams for hotel assets. As a result, there is much distress in the sector for assets managed by
operators such as Hilton, Marriot, Radisson and others.
From experience, we know that the hotel operators also require management. Under‐managed assets fail to
achieve robust operating margins and many are trading at sub 20% (EBITDA/Revenue) as costs have not been
flexed in line with a fall in revenue. As a result, many assets are actively in default after being over‐leveraged
by borrowers in 2005‐7.
Much like retail, we believe there to be a very strong story for a growth in the value of hotel assets over the
next 3‐5 years in the UK. Especially given that in 2012 London will host the Olympics.
Why is there not more distress?
The total volume of outstanding UK Commercial Real Estate (CRE) debt reached £247bn at the end of 2007,
comprising outstanding debt on bank balance sheets and the value of outstanding commercial mortgage‐
backed securitisations (CMBS). The total disclosed problem loan portfolios of Lloyds and RBS that were
provisionally designated from the Treasury’s Asset Protection Scheme were £300bn.
Since 2007, CRE lenders were said to have had an increasing number of non‐performing or defaulted loans in
their portfolio against office, retail and leisure property assets in the UK and Europe. And without wonder. The
collapse of the global credit market in September 2008 has caused a weakening of the covenants of both
borrowers and tenants and a fall in the value of property assets as investment yields have widened and as
trading assets have seen margins squeezed.
As a result of the write downs that many banks were forced to take in 2008 and 2009, regulatory capital was
impaired as financial institutions had to provision for the losses by setting capital aside – also reducing balance
sheet capacity for new lending. Governments swooned and the banks received billions in what has to be one
of the greatest debt for equity swaps of all time. We believed that none of this debt could be ‘refinanced’, and
that there would be a flood of defaulted assets rushed into the market by banks such as RBS desperate to
clean up their books....and yet, far from their slogan of ‘Make it Happen’, it ‘Didn’t Happen’.
The positive growth in the global economy since 2000 had meant that commercial real estate lenders have had
historically low incidences of arrears and defaults.
The UK real estate market owes the banks £280bn...
Aggregated value of outstanding commercial real estate debt (£bn)
Source: De Montford University Lending Survey
‐30 99 00 01 02 03 04 05 06 07 08
...with the largest volume of outstanding CMBS loans in the UK...
40 Outstanding CMBS in Europe (£bn)
30 Source: De Montford University Lending Survey / Fitch Ratings
UK Multi ‐ national Germany Netherlands Italy France Other
....but the default risk is still concentrated in these banks rather than the MBS holders
2010 2011 2012 2013 2014
CMBS loans Regular loans
Given the scale of the distress, the widespread lack of experience in managing distressed or defaulted loans
within the banks and above all the cushion of receiving billions in taxpayer money, banks are under no
incentive or government pressure to dispose of distressed assets or loans. In fact, they are being encouraged
by central government to lend more than they were and have been provided with the liquidity to refinance the
Specifically, banks are holding onto troubled loans and refinancing them for several reasons;
1. They believe that the market would not offer them anything more than a significantly discounted
price for the assets. This is following a cascade of PE, private investor interest in ‘bidding’ banks
below market value.
Perhaps it was Philip Green who best demonstrated this by hoping on a plane to Iceland after the
widespread default and offered ‘peanuts’ for several large Icelandic owned companies.
2. The belief that, over time, markets will recover and they will be able to exit at face value or less
of a discount to fire selling today. Economic growth and market recovery will see them through.
3. Banks have learnt from the mistakes of the last recession (1990/3) when many, most notably
Barclays, panicked and defaulted borrowers. This left the banks with thousands of real estate
assets that continued to fall in value because of under‐management and fire‐selling.
4. They have no incentive to sell the assets or loans.
5. Low cost financing allows them to refinance loans cheaply, central banks are more than happy to
provide sufficient liquidity.
‘Extend & Pretend’
There is a widespread practice within the banks to ‘extend and pretend’ whereby they ‘roll‐over’ maturing
loans with new covenants and pretend that the loan is performing. This is made all the more allowable
because in the UK we have ‘upward‐only’ rents. This means that although the rental market has declined in
some parts of the UK by up to 30%, tenants continue to pay the same rent they agreed at the last review. This
sustains the continuation of rent from which the interest on the loan is paid. The loan may well be worth less
than the asset, since asset price yields have widened, but the interest is being serviced.
In the UK, far less of the loans advanced by banks against real estate assets were securitised compared to
other countries such as the US. Commercial Mortgage Backed Securities (CMBS) are bonds created after
splitting the risk of a whole into many pieces, before being sold to investors who took the risk the loan may
default for the price of the interest they received from the underlying loan.
As a result, when a default on a loan occurs, far more of the loans in the UK are still held on the books of the
bank, rather than with bond holders who bought the CMBS. This allows the bank to ‘extend and pretend’ as
above. In the case of defaulting CMBS, it is more difficult to resolve the default because there may be 1,000
holders of the CMBS who need to somehow get together and enforce their security over the asset.
In conclusion, the commercial mortgage bailout saga has left a market confused, bemused and humbled.
The great crash that we all expected, the fears over the un‐refinanceable debt mountain of banks such as RBS,
the flood of cheap, distressed assets into the market, didn’t happen. Real estate asset values have rebounded
from the lows of Q1 2009 according to the Investment Property Databank and the market seems to be looking
to growth once again. It seems as if the view of the banks to hold onto their loan assets, wait until the market
recovery and then redeem the full value is paying off. This way, they eventually realise a profit on the
difference between the written down value of the assets and the redeemed value as a profit which they will
keep, given that their tax losses were so big in 2008 and 2009.
Whilst the environment is of course still uncertain and it is probably far too soon to say, my guess is that the
Treasury will see a solid profit on its investment in the banks for the taxpayer, and a super one at that.
In short, it seems as if RBS did ‘Make it Happen’ after all.
Achieving Growth & Value
How can we capitalise on this dislocation and what are the opportunities?
Simply, by focussing on distressed asset classes and distressed banks.
We believe we have identified those sectors which are most distressed in the UK market and understood the
reasons why. We believe these sectors, based on these reasons, present the greatest value opportunity. We
also believe we have understood the banks and what they are doing to manage distressed and defaulted
assets. By marrying these two factors, we believe we have a compelling investment strategy.
Based on our conversations and active development of our ideas on real assets with Lloyds Banking Group,
Royal Bank Of Scotland and Eurohypo, we have developed a sustainable model that allows us to acquire assets
from them which are in distress. This model has been fully endorsed by these lenders as well as HM Treasury.
Institutions know that they cannot manage all of the defaulted assets, given there are so many and require
specialist management and knowledge. They therefore recognise they need specialist managers and if equity
can be contributed, there is a package which can be rolled out across the portfolio.
Specifically, this structure allows us to acquire distressed assets which require asset management by investing
10% of outstanding whole loan value as amortisation, reducing interest to the point at which it services
remaining debt, and increasing income to develop a strong equity return. (See Distressed Asset Model)
We believe the benefits of this approach can be summarised as being;
‐ Access to large, off‐market, deal flow on favourable terms from financial institutions
‐ Identification of attractive assets that require asset management to actively earn and manage upside
potential on an income rather than a value basis
‐ Achieving effective asset management by a team of experienced professionals and market spcialists
‐ To achieve 7‐8x leverage at the ‘bottom’ of the market and in a market which is only lending 4‐5x for
newly acquired assets
‐ To capture the Beta performance of the UK market
‐ To achieve 10‐20% running equity yields and net IRR of 20%+ over 5 years
Zaggora LLP is a limited liability partnership registered in England and Wales, registered number OC344767, with its registered office at 30 Old
Burlington Street, London, W1S 3NL. This memorandum was prepared by Zaggora LLP.
This document is for information purposes only and should not be construed as a solicitation or offer, or recommendation to acquire or dispose of
any investment in real estate assets or securities or any other transaction. Whilst all reasonable efforts have been made to obtain information
from sources believed to be reliable, no representations are made that the information or opinions contained in this term sheet are accurate or
reliable. Nothing in this document constitutes investment, legal, accounting or financial or other advice. Any investment decision should only be
made after consultation of professional advisers.
Zaggora LLP is not authorised or regulated by the Financial Services Authority and does not promote, give investment advice on or make
arrangements in financial instruments. This presentation does not constitute an offer to invest. Any and all opinions contained in this document
are those of Zaggora LLP.