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 afra@raymondandpierre.com.