THE UDECOTT OFFICE PROJECT
Medium-term consequence
Published Thursday 10th July, 2008
Udecott has confirmed to me that the 900,000 sq ft of
offices in the
International Waterfront Project are not allocated to any ministry or
state agency. The implication is that that space is going to be offered
for rent on the market; it would be interesting to see on what terms.
On June 26 this
column set out the first charges, detailing what we see as being wrong
about the Udecott situation. This week, we continue to set out points
for information on these events.
The Business
Guardian’s last two editorials contained alarming information as to the
safety of the Ministry of Education Tower being constructed on St
Vincent Street. The contractor, Shanghai Construction Group, issued a
rebuttal on June 24 and we await some official attempt to clear the air
from Udecott. The builder’s work in a properly-contracted construction
project is insured by a performance bond and the insurers of that
project must surely be having some concerns, since claims arising from
poor construction are likely to accrue to their account.
This week we
examine a little-known consequence of the major state-sponsored office
projects in our capital. In a previous column we raised the question of
the State “crowding-out” private sector participants from their historic
role as developers of office space in our capital. The sheer volume and
quality of the state-sponsored office projects will not only threaten
the income of those landlords who now rent offices to the State, they
will also compete against those who have built high-class offices to
rent.
Apart from the
adjustments which the first set of landlords will be forced to make,
there is also the relevant question of whether there is enough sustained
demand for high-quality offices for all those investors to survive. The
market for office space in our capital is likely to undergo significant
shifts in which the sudden and massive increase in supply will prompt a
decline in rental levels. At this point there is little that can be done
to avoid the consequences of that series of public projects, so the only
question is the manner in which the decline will take place. Can we
manage the change?
Those who finished
their buildings when costs were lower and have not borrowed heavily will
be in a better position to accept lower rents. Those who have just
completed expensive construction or who have borrowed heavily on their
properties, will be less able to adjust. All told, we seem to be heading
into a grim game in which the newcomers will be penalised and prudent
lenders would have to take a fresh look at the assets in their books.
In relation to the
lenders’ assets, we should explain that loans are shown as assets in the
accounts of financial institutions. In the case of loans made using
property as collateral, the loan is secured by the value of the property
and that is of significance here, as shown in the sidebar.
A further and
final point, in addition to the State “crowding-out” the private sector
by leaving the office space they now rent to occupy their own space,
there is another issue for concern. Udecott has confirmed to me that the
900,000 sq ft of offices in the International Waterfront Project are not
allocated to any ministry or state agency.
The implication is
that that space is going to be offered for rent on the market; it would
be interesting to see on what terms. We are reliably informed that
office space in other new State buildings is also being offered to
private tenants.
The State is not
only building to get pride of ownership, it is entering the market as a
major landlord at a time when it will be declining.
The issue of
impaired assets
If, for example, a
bank lent a client US$20 million to build a 20,000 sq ft office with a
present value of say $30 million and a present monthly rent of $13 per
sq ft, the loan-to-value ratio is “safe” at two-thirds. The picture
changes dramatically if those rent levels were to decline to say $11.00
per sq ft since the monthly income derived from the building would fall
from $260,000 to $220,000. That is a decline of about 15 per cent and it
would be reasonable to infer that capital values would also decline.
If the capital
value fell in tandem with the decline in rents, it would be $25.5
million after losing 15 per cent of its value and the loan-to-value
ratio would now exceed 78 per cent.
But the reality is
more serious since the capital value of that office building would not
decline in tandem with the fall in rent. If office rentals were to
decline, it would be necessary for the market to adjust its assumptions
about that type of investment.
All other things
being equal—the continuing high cost of the ingredients of finance,
well-located land and quality construction—the declining revenue will
dictate that office investments be ‘discounted’ to reflect their longer
“payback period.”
In the
circumstances being outlined in this example, there would be a downward
adjustment in the value the market places on the income stream from
offices. The effect would be to reduce the value of the building in this
example to, say, $23.0 million, in which case the loan-to-value ratio
would be almost 87 per cent.
It is important to
point out that we are describing a decline of only $2 per sq ft—a mere
15 per cent—and its possible impact. The point is that while it is
common for banks to lend 90 per cent on the value of an owner-occupied
home, it is virtually unheard of that those ratios are advanced on
commercial projects. It is beyond the scope of this column to explore
that rationale, but this is the reality within which we operate. If the
loan-to-value ratios shifted in the manner outlined, the results could
be serious even for conscientious borrowers who never missed a payment.
The prudent lender in those circumstances would view those loans as
“impaired assets,” since the security against which the loan was
advanced is now viewed as inadequate.
Even if the
borrower were meeting payments to the bank, they could be faced with a
demand to put up more assets so as to bring the bank’s loan-to-value
ratio into an acceptable range.
Afra Raymond is a
director of Raymond & Pierre Limited. Feedback can be directed to afrar@wow.net.
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