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PROPERTY - Painful Purge

  02/07/10 16:48, by Len, Categories: Financial Management, Investment Management, Property Investment

Source: Article by Ian Fife of the Financial Mail

The property market slump is over. Developers and owners are distressed, banks are worried and impatient, and investors are sitting on the sidelines. Now comes the property cleanout, before the slow, fragile recovery.

Ian Fife tracks the winners, losers and opportunities in this new upswing.

First came the property bust. Now comes the sequel:

Property crashes, the exposure of dodgy deals and banks searching for a way to limit their losses. This real estate Little Armageddon is a normal punctuation mark at the end of one cycle and the beginning of another.

Banks have already provisionally written off (impaired) R132bn of the money they have lent. At least R25bn of that is against their property lending, according to an FM industry source. Much of this R25bn will show up as deeply discounted prices as the banks sell their bad properties to cash-rich developers and investors. Says one banker: "At the end of the day anything more than zero is good."

The properties up for grabs include Immobili, the retail portfolio of the property-developing Theodosiou brothers, who are opposing liquidation. They owe Absa about R1,28bn but the properties are unlikely to be worth more than R600m. Absa says they are worth more. Others are:

* The Philkin portfolio of Johannesburg developments, which owes R600m to Standard Bank, but has drawn only R100m at auction;

* The King development portfolio of shopping centres, owing R500m but whose auction value is estimated at R55m; and

* The Rita Krok family trust developments - Hartenbos Landgoed in Mossel Bay and Le Grande golf course and The Hills development in Pretoria - with R400m exposure.

What's happening is that residential and commercial owners are finally able to measure the distance to where they would be out of trouble. But they can also see it is too far and they won't make it. They capitulate and their properties join the auction lists.

Also, suppliers tire of their debtors' endless excuses for not paying and liquidate them. But most of the distressed sales and auctions will come from the banks, which are turning their attention to building market share again, rather than nursing struggling borrowers.

The cleanout is healthy. The market is purging itself of weak participants and toxic detritus. Property wealth is being transferred to the rich, experienced and prudent. It will continue to be a painful process for the unlucky and overoptimistic, particularly the hundreds of new commercial and residential property developers and investors who sprang up in the six-year boom, which ended in 2008 when global markets crashed.

The big five - Investec, Standard, Nedbank, Absa, and FirstRand - don't want to reveal the breakdown of their bad commercial property loans or the percentage they expect will be written off.

In the past, they would clear the decks by repossessing properties. But this time is different, says Lyndon Kan, Absa head of commercial property finance. "They were much less regulated then and had smaller reputations," he says.

"And we are now more aware of the consequences of foreclosure on asset values. We have a large nonperforming book but we haven't taken ownership of one property yet."

Kan says banks work closely with their distressed customers by restructuring loans to help them through the cycle. "Where clients are willing to work with us, we find a way to make the property perform again," he says. "It all comes down to managing the equity and available cash flow in the property."

He adds: "Many of our clients have built up large equity in their properties as their values rose over the boom, so we use that to work out until the cash flow is positive."

Nedbank commercial property finance chief Frank Berkeley plays down the level of bad loans. Based on a R2bn list of 24 bad properties prepared by one liquidator for the FM, Nedbank seems to have come out of the recession more lightly than its peers, with only the King portfolio on it. "It's the only one we have," Berkeley says. "Our nonperforming loans as a percentage of our book are far lower than in 2001, when interest rates were nearly 25%. And we certainly have a lot less to be sold."

In about six months it is likely to be a different picture, particularly in residential, leisure and small investment property.

Industry sources speculate that Investec could have as many as 27 large residential and golf and gated estates that are in trouble. But Investec Property CEO Sam Hackner says it is in low single figures.

However, the view that leisure property is the hardest hit is "on the money", says Pam Golding Properties CEO Andrew Golding. " Most leisure property owners are not distressed and the primary market will hold its own this year. But we're already seeing that distressed owners of coastal properties, who were refusing low offers late last year, are now beginning to accept them." He says the pressure from the institutions will build up during the year. His company has been called by lending institutions to advise them on pricing and the market outlook for leisure property.

Some big names are among the casualties. PG Glass's Ronnie Lubner and Softline CEO Ivan Epstein have reportedly had to plough in a further R75m to the R500m they and Anglo Irish co-developer David Nagle invested in a residential development on Houghton golf course. The money has been used to redesign the course and build a new clubhouse rather than finish the half-built development.

The family trust of Rita Krok (businessman Solly Krok's wife) was apparently talked into several developments by a relative but, despite the family's history of shrewd investments, they don't have experience in township development. The projects are in liquidation.

Another potential residential development collapse would be Pinnacle Point, the listed property developer whose 12 major golf and other developments are billions in debt to banks. Projects include a golf estate in Nigeria and one in the Seychelles. Pinnacle Point had until January 31 to satisfy Absa, its 40% shareholder, that it actually owned its Lagos golf estate, but the parties have been silent on the matter. This indicates that the proof has not come but that Absa and Pinnacle are still trying to salvage the company.

Then there's the V&A Waterfront in Cape Town. Its owners, UK-based London & Regional Ltd and Dubai World, have done no development beyond extending the residential units since paying Transnet Pension Fund R7,2bn for it in 2007, and borrowing most of the money from SA banks. Their soothing responses to queries about V&A's health are sounding increasingly hollow as the property shows typical signs of deep cost-cutting (for instance, lifts and parking booms not working, and limited maintenance on escalators).

The failed property owners and their banks have learnt an important truth too late. "Developing a property is like wrestling a big crocodile," says Hackner. "The profit's in the tail. You have to fight your way from the front to get your hands on it. It always takes longer and more cash than people think."

Though the market has turned, its fragility and very slow return to a firm recovery means the cleanout is likely to take longer than it did in 2001. Then, with interest rates at 23,5%, the market crashed suddenly and recovered quickly.

This is more like 1985, when the recovery began to take off only late in 1987. And like 1987, far more properties will sink into distress in 2010 than during the 2001 crash.

The biggest projects won't be put up for auction. There's too much money at stake for the banks. And projects like the Houghton development that have investors with deep pockets will eventually go ahead. But much of the original developers' equity could be written off.

If the V&A Waterfront's current owners can't inject more money into it, they will have to make way for another partner. They are unlikely to be liquidated because the write-offs will be too big for the banks.

A decade or more ago, the large property developments such as golf estates would have been auctioned off. But Basel 2 (the international standard on how much capital banks must have to underpin their lending) and new management practices mentioned by Absa's Kan have changed that.

Banks must now write off tier-one assets - the core capital of the banks, made up of shareholders' equity, retained earnings and some 10-year bonds - when their security is auctioned off. For every R1 in assets a bank has, it can lend R10. So if the bank writes off R1bn, it has R10bn less to lend. Impairments have the same effect.

But if they are nonperforming loans, they are put into less onerous Basel 2 "buckets" that don't reduce the banks' lending power as much as tier-one write-offs and impairments.

Banks are devising creative strategies to deal with these problems. They swap the debt for shares in projects, create special purpose vehicles in which they have shares to hold distressed properties, and enter joint ventures with successful developers. The more money they are owed, the more likely they are to avoid auctions.

Even distressed individual residential properties have had this treatment. It's not only developments that are crashing.

Despite R2bn in impairments reported in Absa's recent six-month results, the bank's head of home loans, Luthando Vutula, describes his management of the recession since 2007 as "a great success". "Our strategy of helping our borrowers through the bad times rather than foreclosing and repossessing probably saved us R500m," he says.

Distressed borrowers were mainly given a lifeline of lower monthly payments to help them through the high interest rate period (when it reached 15,5% during 2008). As a result Absa has few residential repossessions, and with R500m more capital, it can lend R5bn more.

Standard Bank appears to have had a similar approach, while Nedbank and FNB have embraced a rapid sales policy in which part of their debt is written off after the sale and the rest is converted into an unsecured loan to the debtor.

Some residential crashes could reveal big amounts that banks have been exposed to, for instance in the case of residential buy-to-let promoter Treoc. (See "Risky business".)

It's a sign of how big the property market has grown that even R10bn in write-offs would be only 1% of the banks' mortgage exposure.

WHAT IT MEANS:
* Gradual property upswing has started
* So has unforgiving clean-out of bad deals

Waiting in the wings are an industry of scavengers to clean up the cadavers of failed property ventures and a few big white knights who could save them before they expire. Some of the scavengers will become SA's next big successes. (See "Smart money cleans up".) Well-established, cash-flush property investors, such as Eric Ellerine and Jonathan Beare, have also been waiting for this moment. So are the big listed property funds like Growthpoint, Redefine and Resilient. The banks say they are looking for partners like them - and for big profits.

"They will be looking to buy projects at about 60% of their current value in this depressed market," says Redefine CEO Marc Wainer. "The banks will still have to take big write-downs."

This is the best time for these investors: when the sellers know that they are selling well below the current market value but have to do it. This cleanout phase in the property cycle also exposes many dodgy deals that attracted tens of thousands of unsophisticated investors (see story on page 34).

SA's property market holds the promise of 10 years of a constant but sometimes volatile upturn. The quicker and more thorough the cleanout, the more likely it is that the promise will be met.

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