The protracted turnaround of the United Kingdom's commercialproperty market was given an adrenaline shot in the form of aninflux of foreign capital to London. While this is good in theshort term for the UK, the rest of the country languishes andcontinues to feel downward pressure on its values. With all eyes,and capital, fixed on the UK's dominant metropolis, themuch-anticipated distressed asset market has yet to trulymaterialize.

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According to DTZ's "Global Occupancy Costs: Office 2010" report,London's West End regained its mantle in the first quarter as themost expensive location in the world to occupy office space. Retailis also thriving in this area, thanks to an influx of Europeantourists drawn by the advantageous euro-to-pound exchange rate.Although this rise in value is good for the UK in general, itcreates a larger looming issue for those secondary marketproperties.

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"There is a polarization between primary and secondary markets,' explains Rupert Dodson, head of valuation for Cushman &Wakefield in London: "Outside of London, there is great concernabout rental growth. Plus, the drivers of employment, job growthand consumer spending still look pretty poor." He says that theprimary factor, as in many of the US markets, is that investors arerisk averse.

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Oliver Gilmartin of the Royal Institute of Chartered Surveyorspoints out, "In Central London's office market, there has been animprovement in rental prospects through a combination of increasedlease-ups and a choked-off supply chain." The lack of new productin the pipeline, he adds, has created the perception that rentswill escalate over the next 12 months, which has persuaded peopleto buy in London.

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The UK's relative economic resilience-compared to itsneighbors-has also been a selling point for investors. As issueswith Spain, Italy and Greece persist, the pound remains separatefrom those countries' financial vicissitudes.

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"Although the UK has a very deep deficit, there aren'tnecessarily concerns about a mismanagement of inflationarypressure, ' points out Real Capital Analytics global economist SamChandan. Right now, the euro-to-pound exchange is attractingforeign investors from Europe to London. Non European money is alsofinding its way to London from the Korean Sovereign Wealth Fund andQatar.

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"These buyers are basically big investors that are looking toreposition their global portfolios, ' says Gilmartin. "Investorswant the large office box in London that they see as a good longterm investment. The secondary High Street-type property, which ishigh yielding, but also high risk, doesn't really fit thatmold."

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With foreign money buoying the London market, upward pricingpressure has created a distinct lack of distressed property in thecore sectors. Gilmartin explains that one of the key reasonsdistressed assets haven't really hit the market is that "the Bankof England has essentially bailed out the property sector byslashing rates to historic lows. This has meant that as long as youserviced your interest payments, debt service, in some cases, fellquite dramatically for commercial property landlords."

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But the outerlying areas are still in trouble, Gilmartinexplains, because of a pricing disconnect between Central Londonand the rest of the England. Still, this has not led to fire salesof troubled assets. Banks seem to have learned their lesson fromthe last downturn and are not foreclosing and divesting themselvesof distressed real estate.

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"It may be that banks were very reluctant in the UK to forecloseon property because it would obviously bring additional assets ontotheir balance sheets, which was ill-advised during the height ofthe credit crunch." Gilmartin observes.

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"Banks are sitting on significant portfolios of underwater loansand, prudently, have not been flooding the market with those."explains Dodson. "The market still anticipates there will be somesignificant shake out, but the banks are biding their time becauseotherwise they will be destroying the goose that's laying thegolden egg at the moment by flooding the market." making pricesfall again.

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However, Gilmartin sees another alternative as banks witness an8% to 10% yield in some of these commercial property sales comingout of London. "As banks' balance sheets become healthier, it couldbecome easier for them to start to foreclose on properties." hesays. This possibility would create a situation where thesefinancial institutions opportunistically begin foreclosing ontroubled assets to auction them off in a competitive market.

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The nationalization of the banks currently provides them asafety net to toy with such ideas, however, there may be a wrinklein that strategy. "There are new capital-adequacy rules coming in."Dodson points out. "They will require banks to hold a largerpercentage of capital on their balance sheets than they have in thepast. That may persuade some institutions to dump some property inorder to meet those requirements."

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Meanwhile, Gilmartin sees the recovery continuing over the nextsix months, though after that, things become a bit murkier. Aslonger- term interest rates start rising once the governmentstimulus dries up and taxpayers are completely drained by taxincreases, the recovery's momentum could be sapped of its potency,he explains. What's more, economic fundamentals, like job growth,are still lagging. And financing for local buyers remains scarce.This leaves local investors, who traditionally have beendebt-backed buyers, ostensibly out in the cold. The dominantinvestors, Gilmartin explains, "may just be the equity players,like the life or pension funds that don't really have to rely ondebt financing for their longer- term property investments."

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And then there is always the trouble with their neighboringisland, Ireland. Recently, the Irish government set up the NationalAsset Management Agency, effectively a government-run "bad bank."which purchases toxic Irish bank loans and exchanges them forgovernment bonds. This, in turn, is recapitalizing the country'sbanks and jump starting the Irish economy.

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"[The Irish] could end up with a very significant portfolio ofassets and many of them are worth less than their original value."Dodson explains. "There could be well in excess of €50 billion(US$66.8 billion) worth of property ending up on the governmentbooks." There is concern that the Irish government might flood theUK market with these assets and damage the UK economy, he says.

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The English government is trying to bargain with the Irishgovernment to hedge against this scenario, but the results remainto be seen. The eventual disposition of distressed properties,however, is inevitable. And Gilmartin notes that, as interest ratesrise, loans that have been extended may find trouble renegotiatingand head to the market as distressed properties. Chandan notes thatEngland, unlike the US, suffers from "primacy." where all othermarkets are necessarily subservient to London. Despite this issue,the benefits will slowly spread outward as investors seek higherrisk and returns. For now, distressed investors will have to waitout pre-election jitters and the current London boom.


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