WORKING CAPITAL

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WC-3 INTRODUCTION WHATIS“WORKINGCAPITAL”?

WC-4 OVERVIEW SPECULATIVECOMMERCIALPROPERTYDEVELOPMENT

WC-5 MONEYANDFINANCIALMARKETS THENATUREOFMONEYINGENERAL

WC-7 RISK WHATISRISK? RISKSENSITIVENESSOFOBLIGATIONS RISKSANDMITIGATIONS

WC-8 THEDEVELOPER’SSIXRISKSANDMITIGATIONSWC-9 FINANCIALPRODUCTS WHYAREFINANCIALPRODUCTSDEVELOPED? INTERESTRATESWAP

WC-10 NONRECOURSELOAN BOND COMMERCIALMORTGAGEBACKEDSECURITIES(CMBS) AKASECURITISATION

WC-11 REALESTATEINVESTMENTTRUST(REIT) FINANCIALPRODUCTS/FUNDINGMETHODS

WC-1� CONTEXT GOVERNMENT,DEVELOPERS,FINANCIERS,MARKETS

WC-13 AHYPOTHESIS

WC-14 DEVELOPMENTCASESTUDIES: TRADITIONALANDEMERGINGMODELS THEUKPROPERTYMARKET SUCCESSFULTRADITIONALMODEL:BANKSIDE1�3 UNSUCCESSFULTRADITIONALMODEL: CANARYWHARF1987-199�

WC-17 SUCCESSFULEMERGINGMODEL:BROADGATE

WC-�0 CASHFLOWDIAGRAM DETAILSOFISSUEDNOTE

WC-�1 TRANSACTIONACHIEVEMENTS TRANSACTIONECONOMICS

WC-�� CONCLUSION

WC-�3 BIBLIOGRAPHY

TABLE OF CONTENTS

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WHATIS“WORKINGCAPITAL”?Workingcapitalisafinancialtermwhichreferstothefundsbusinessesusetocovertheirshort-termday-to-dayexpenses.Acompany’samountofworkingcapitalisgenerallycalculatedascurrentassetsminuscurrentliabilities.However,thisinvestigationcoversabroaderrangeofissuesrelatedtomoney,financeandcapitalmarkets.Werealizethateventhetermsusedthusfarcanbealienatingandintimidatingtomanyreaders,sowewilldefinethemfirst.Additionaltermsnotdefinedinthetextwillbeaddressedintheglossaryofthisbook.

Assets: anythingofvalueownedbyacompanyorindividual(includesmoneyandthings).Capital: anyliquid(exchangeable)mediumormechanismthatrepresentswealth.Current: shortterm;disposableorpayablewithinoneyear.Debts: moneyowedtosomeoneelse;loans,liabilities.Finance: theresourcesandactivitiesassociatedwithprovidingfundsforcapital.Funds: financialresourcesandassetsintheformofmoney.Liabilities: anythingowedtosomeoneelse;debts,loans.Liquid: havinganadequateamountofcashorassetsthatcanbequicklyconvertedtocash.Markets: systemswhichfacilitatetheexchangeofgoodsandservices;i.e.exchanges,etc.Money: atokencommonlyusedtostoreandexchangevalue;usuallycreatedbygovernment.Securities: paperorelectronicassetsrepresentingaclaimonsomethingofvalue.

Ourdiscussionmakesfrequentreferenceto“financialproducts”or“financialinstruments,”bothofwhichdescribemethodsofmanaging,organizingandexchanging(ortrading)assets,capitalandliabilities.Somehavebeeninuseforalongtime,whileothersarequitenew.Thesefinancialproducts,whichwillbedefinedlater,include:Bonds;CMBS(CommercialMortgageBackedSecurities);Equity;HedgeFunds;InterestRateSwap;NonRecourseLoan;PropertyDerivatives;REITs;andSecuritisation.

INTRODUCTION

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SPECULATIVECOMMERCIALPROPERTYDEVELOPMENTSinceWorldWarIItherehavebeenfivereconfigurationsoftheUKspeculativecommercialpropertydevelopment,includingtwomajorboom/bustcycles.Witheachiteration,theactorsinvolvedadjustedtheirprocessesandrelationships,attemptingtoreduceexposuretoriskwhilesecuringaccesstocapitalflowsnecessaryforcontinueddevelopment(Isaac,�003.pp.7-11).Overthesameperiod,thefinalbuiltproducthasrespondedtotechnologicaldevelopments,governmentpolicies,thechangingnatureofwork,aestheticanddesigntrends,financingstructures,andmore.Thepurposeofthischapteristoexplaintheroleofcapital,finance,financialmarkets,andfinancialinstrumentsintheproductionofspeculativeofficespace.Ourprimarythesisisthatutilizationofrecentinnovativefinancialproductswillallowdeveloperstomanageassetsandcapitalflowsmoreeffectively,reducingtheirexposuretoriskandallowingthemtobridgedownturnsintherealestatecyclewithgreaterresiliency.Eventually,thiscouldleadtogreaterstabilityintheindustry,mitigatingtheeffectsoftraditionaldemandandsupplycyclesandallowingforasteadierstreamofproduction.Changesofthisnaturewouldallowmoreproactiveandstrategicbusinessplanningfortheprovisionofofficespace,ratherthanthepresentmodeofcrisis-orientedreactivedecision-makingandrushtobuildassociatedwithboom/bustcycles.

Criticshavearguedthatratherthanpromotingstability,thenewfinancialproductsinducegreatermarketvolatility.Whileitistruethatthesecuritiesmarketsmaybemorevolatileintermsoffrequentrapidfluctuations,theevidenceofthepastthreeglobalfinancialcrisesindicatesadecreasinglikeli-hoodthatacrisisinoneregionwillspreadtoothers(Sassen,�003).Infact,micro-volatilityisviewedasnecessaryandbeneficialintermsofmaintainingmacro-stability,assomenewfinancialproducts(hedgefunds)benefitfromsmall,frequentmarketmovements.Automaticcontrolsalsocontributetooverallstability,thoughfinancialsystemsarestillvulnerabletohumanerror.

Ourresearchhasraisedseveralquestionsthatremainunanswered.Theseconcerntherelationshipbetweenthespaces–bothpublic(exterior)andprivate(interior)–createdbythespeculativeofficedevelopmentprocess;theeconomic,environmentalandsocialsustainabilityofsuchdevelopment;andtheroleofinnovativenewfinancialinstrumentsincreatingaglobalpropertymarket.Insomeproceduralrespects,today’sspeculativepropertydevelopmentbearsresemblancetothatundertaken�00yearsagobythelikesofJohnNash.Themostsignificantdifferencesarethenumberofdirectandindirectactors,andthemassivescaleofdevelopment,whetherconsideredlocallyorglobally.Inouranalysisofthefinancialprocessesinvolvedinproductionofspeculativeofficespace,wehaveobservedananalogousdynamictothedissociationdescribedbysocialscientistsreferringtoindustrialcapitalism.Manylevelsofintermediationseparateactors,bothfromothersimilaractorsandthoseindifferentroles:developers,architects,contractors,agents,tenants,workers,visitors,neighbours,andowners.Securitisationandpropertyderivatives,inparticular,allowfor“liquification”ofrealestateassets,whichcannowbeeasilytradedinfinancialmarkets.Thismeansthatasinglebuildingcanhavemultipleunrelated(fragmentary)ownerswithnoconnectiontoplaceatanyscale–fromblocktocontinent.Conversely,propertyderivativesarenowbeingdiscussedwhichcouldconcentrateonverynarrowgeographicareasandtherebyreasserttheimportanceofplace.Ineithercase,investorinterestispurelyinassetperformanceandfinancialreturns.Thisphenomenoncansubjectsecuritisedandsimilarlyliquefiedpropertiestobothtenantand(possiblyconflicting)investordemands.

OnefinalnotewithrespecttoBankside1�3:LandSecuritiesisatraditionalandconservativedeveloper.Theirstrategyistobuild,operateandholdtheirpropertiesforlongperiodsoftime.TheinnovativefinancialproductswedescribedonotplayasbigaroleinLandSecurities’strategyastheydoforBritishLandorHammerson(theirdomesticcompetitors),orfordevelopersinNorthAmerica,Australia,andpartsofAsia.However,REITsarebeingintroducedintheUKeffectivein�007andweexpectthesewillplayanincreasingroleintheUKmarket.Additionally,sinceLondonisaglobalfinancialcentre,LandSecuritiesisoperatinginthecontextofaglobalpropertymarket.Theunprecedentedliquidityandmobilityofcapitalmeansthatglobalcitiesmustremaincompetitivewithotherlocationsaroundtheworld,andthiscompetitivenessextendstotheofficespaceonoffer.LandSecuritiesarethereforeaffectedbythesenewfinancialproductseventhoughtheydonotmakeuseofthem.

The production of office space usually lags behind economic cycles.

OVERVIEW

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THENATUREOFMONEYINGENERALMoneyisanysetofassetsusedtobuygoodsandservices:amediumofexchangeofferingbuyersandsellersamutuallyrecognizedmeansofpayment.Moneyisalsoastoreofvalue:itcanbereliablysaved,storedandpredictablyusedonceretrieved.

Moneyusagehastwoaspects:ontheonehand,thosewithsurplusseekwaystoincreaseitsvalue;ontheotherhandarethoselookingtofundvariousprojects.Banksandsimilarinstitutionshavebeenthetraditionalintermediaries,abletomeetthedemandsofbothsides.Apartyseekingmoney,nothavinganadequatesupplytomeettheirneeds(borrower),mustpayaprovider(lender)foritstemporaryuse.Thiscostiscalledinterestandreflectstheriskthattheborrowermightnotpaybackthelender(default),plusaratethatthelenderexpectstoobtainbymakingmoneyavailableintheborrowers’marketplace.Moneyisprovidedatdifferentratesfordifferentprojectsandborrowers.Thedifferenceinrates(thereforetheamountofmoneyavailable)isareflectionofthelender’ssensitivityto,andappetitefor,risk.

Thebiggestmoneylendersarebankswhichreceivedepositsfromindividuals.Bankscanbeborrowerswhentheyseektoraiseadditionalmoneytolendtotheirclients.Theavailabilityofmoneytocommercialbanksiscontrolledbyastate’scentralbank.Ifratesarehigh,thereislessdemandsincenotmanypartieswanttoincurhighcosts.Likewiselowratesincreasedemand.

Anotherwayforcompaniestoraisemoneyistosellpartialrightsovertheirassetstoinvestorsintheformofcertificates(stocks,equitiesorshares).Theshareowner(orshareholder)canselltheirsharesthroughadesignatedstockexchangewherethosesharesareregistered,ortheycansellthemtoathirdpartyatanagreedprice.Sometimesacompanyalsochoosestobuybacksharesfrominvestors.Althoughcompaniesdon’tneedtopayinteresttoshareholders,theydodisburseaportionoftheirprofitsintheformofdividends.

Ownersofmoneywhohavemorethantheyrequirecaneithersafelyconservetheirsurplusorputittoworkearningmoremoney.Theformercanbeachievedbydepositingfundsinabankandthelatterbyinvestinginfinancialinstrumentssuchasshares.Investingmoneywiththeexpectationofhighprofitscanberewardingbutrisky,andinvestorsgenerallywishtominimizetheirrisks.Investors’desirestomaximizegains—throughatolerableexposuretorisk—whileatthesametimeminimizinglossesresultingfromsuchexposurehascatalysedthedevelopmentofavarietyofrisk-distributingfinancialproducts.

MONEY AND FINANCIAL MARKETS

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THECAPITALMARKETS:INDIVIDUALS&INSTITUTIONSCapitalmarketsare“places”(sometimesexistinginpurelyelectronicform)whereactorswantingtoprofitbylendingmoneyandactorswishingtoborrowatareasonablecostcometogether.Becausecompaniesseekingtoraisemoneyinthemarketsmustpubliclydisclosetheirbusinessoperationsinordertogaininvestorconfidence,theeasiestwaytoraisemoneyisstilltoborrowfrombanks.However,banksgenerallyproviderelativelysmallloanscomparedwiththehugesumsmadeavailablebyinvestorsthroughthecapitalmarkets.Historically,capitalmarketshaveexperiencedcontinuedgrowth.Thisgrowthhasrecentlybeenleadbyinflowsofinvestmentfrompensionfunds,hedgefunds,privateequity,etc.,allofwhichhavevaryingappetitesforrisk.

Althoughthemarketsaren’tnecessarilyembodiedphysically,andalthoughtheiroperationisfartoocomplextobedirectedbyconsciousintervention,itcanbeinterestingtoconsider

“themarkets”asanactorinourscenario.Inabroadsense,thecapitalmarketshavethe“objectives”ofhighyieldandacceptableriskopportunities,andofimprovingtheinvestmentatmosphere.Theyhavetraditionallybeenconstrainedbygovernmentintervention,althoughglobalisationismakingthisincreasinglydifficult.Theyarealsosomewhatconstrainedbytheirverynature,whichisinherentlycyclicalandpronetofluctuation.Asalreadystated,itisunlikelythatthemarketscouldconsciouslyemployanystrategies.Instead,wecansaythattheyarereactiveanddifficulttocontrol.

MONEYANDTHEDEVELOPERToassemblethesubstantialfundsrequiredtobuildlarge-scalespeculativeofficeprojects,developersmustcombineborrowedmoney(constructionloans)withtheirownmoney(workingcapital).Constructionloans,whichareshort-termandgenerallyprovidedbybanks,incurinterestandmustbepaidbackuponcompletionofeachproject.However,duringthelongconstructionphase,largedevelopmentprojectsdonotgenerateanyincomeforthedeveloper.Whileinthisphase,developerswouldbenefitfromhavingaccesstomoneyfreeoftheshort-termconstraintsassociatedwithbankloans.Thisiswhydevelopersturntothecapitalmarketsandemployvariousfinancialproductsandinstrumentstoraisemoney.

THEMARKETENVIRONMENT

Actors and dynamics of the market environment.

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WHATISRISK?Riskisapartofeverydaylife.Allhumanactivitiesinvolvesomedegreeofrisk,whetherseenasthepossibilityofincurringdamageinaparticularcontextorjustthenotionthattheremaybeotherchoiceswecouldhavemadethatmighthaveproducedmoredesirableoutcomesthanthechoicesweactuallymade.Peoplemakedecisionsabouttakingoravoidingriskswhentheydojustaboutanything;avoidingriskusuallymeansgivinguptheoutcomeofaparticularactivity,whereaspeoplemaychoosetoengageinthatactivityiftheriskisacceptabletothem.Thisistheideabehindtheaphorism“nothingventured,nothinggained.”However,evenwhenacceptingexposuretorisk,thereareseveralstrategiestoreducethelikelihoodand/orseverityofdamage.Therewillusuallybesomeonewillingtotakeanygivenriskiftherewardissufficient.

Developmentsinstatisticsandfinancehaveenabledthecreationofnewproductsthatprovidemonetarycompensationforcostsincurredduetorisk-relateddamage,thusallowingmorepeopletomanagemoretypesofrisk.Bankruptcy,however,maystillbeunavoidableincertaincasesbecauseofthecomplexmultipleindependentandinterdependentinternalandexternalfactorsinvolved.Fewpeoplewouldthereforewanttoundertakeriskundersuchcircumstances.Nevertheless,theconceptsoffinancehaveincreasinglybeenappliedtoriskmanagementinareasthathavehistoricallyposedthreatsofinsolvency.Derivativesareonesuchapplicationnowbeingusedinareasfromfinancingtovariousphenomenaofdailylife(suchasweather,etc.).Evergreaternumbersofpeopleandinstitutionsarebroadeningtheirexposuretoriskinaquestforhighermonetarycompensation.Theyusederivativestomitigate,ratherthansimplyaccept,theimpactofrisks.Sincetheadventoffinancialderivatives,riskscannowbeallocatedinexchangeformonetarycompensation.

RISKSENSITIVENESSOFOBLIGATIONS

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Different types of debt have different sensitivities to risk, which determines how easily accessible they are.

There are six risks faced by developers, each with one or more mitigation strategies.

RISKSANDMITIGATIONS

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THEDEVELOPER’SSIXRISKSANDMITIGATIONSTherearesixmaintypesofriskthathavetobenegotiatedwhenengaginginspeculativeofficedevelopment:business,interest,legislative,financial,liquidity,andinflation.Thedeveloperusesavarietyofstrategiestomitigatetheserisks.

Businessriskreferstotheeconomicenvironmentinthelocationsofdevelopment—recession,forexample.Thedevelopermustfirstandforemostmaintainfinancialstrengthinordertobridgeanyperiodsoflowdemand.Itwouldalsobeprudenttodiversifydevelopmentbothgeographicallyandbysector(i.e.office,retail,publicsector,etc.).Geographicandsectordiversificationwillalsoleadtodiversityoftenants,whicharelesslikelytobeequallyimpactedbyeconomicconditions.Choosingtherighttypesoftenantcouldalsomitigaterisk:ifthetenantsaregovernmentagencies,publicinstitutions,bluechipcompanies,etc.,theyaremorelikelytoremainstableoverlongperiodsoftime.InthecaseofLandSecurities,anotherimportantelementoftheirdiversificationstrategyispropertyoutsourcing,whichincludesmanagementandmaintenance.

Interestriskisthechancethatthecostofshort-termaccesstoborrowedmoneywillchange,withlowerinterestratesbeingsomewhatlessproblematicthanhigherones.TheBankofEnglandmightraiseorlowerinterestratesinresponsetooveralleconomicconditions,andbanksmighttightentheirmoneysupplybyraisinginterestratesinresponsetoapropertycrisis.Thedeveloper’straditionalresponsetolowerinterestratesisrefinancing.Tomakeloanpaymentsmorepredictable,developersuseinterestswaptransactionstoexchangevariable-interestratesforfixedrates.Tosecuremorereliablefundsthatarelesssensitivetointerestfluctuations,developersissuebonds.Landsecuritieshaspursuedastrategyofmassivecapitalaccumulation.Thissomewhatobviatestheirrequirementtoborrowmoney,aswasthecasewiththedevelopmentofBankside1�3(ofcourse,theydidn’thavetopurchasetheland,sotheinitialcapitalrequirementswereconsiderablylowerthanformoreconventionaldevelopments).

Legislativeriskisbasicallythepossibilitythatthegovernment—fromlocalauthoritiestonationalstates—mightenactlawswhichplaceconstraintsonsomeaspectofthedeveloper’scurrentoperations.IntheUKmarket,forexample,thismightbearestrictionofupward-onlyrentreviews.Thedeveloper’sresponsetothispossibilityistolobbylegislators.LandSecuritiesisoneofthelargest30companieslistedontheFTSE.Theyareimportantplayersinthenationaleconomyandhavecultivatedareputationasahigh-qualitydeveloperinterestedinlong-termvalueandregeneration.

Financialriskisthechancethatthedeveloperwillfailtoobtainadequateincometocovertheirdebtservice,perhapsbecausetheyhaven’tfoundtenantsforabuilding.Thedeveloperconstantlyreviewstheirportfolio,makingsuretheyareofferingtheproductstheircustomersreallywant(ortheiragentsarewillingtosell).Theyalsoemployassetandliabilitymanagement(ALM)techniquestoexercisemorecontrolovertheircapitalflows.InthecaseofBankside1,LandSecuritiesfacedlittlefinancialrisk,havingpre-letandsubsequentlysoldtoIPC,asubsidiaryofTimeWarner.ThiswillcertainlyincreasetheattractivenessofBankside�&3tofuturetenants.

Liquidityriskisthedifficultyindisposingofanasset(i.e.sellingabuilding).Theeasiestwaytomitigatethisriskisthroughastrategicdecision,suchasLandSecurities’saleofBanksideOnetoIPC/TimeInc.Othermitigationsofliquidityriskinvolvetheuseofinnovativefinancialproductslikepropertyderivativesandsecuritisation(CMBS),liquifyingpropertyandmakingiteasiertoownandexchange.LandSecuritieshasyettoengageinoneofthesetypesoftransactions.However,HammersonandBritishLand,theirlargestdomesticrivals,dosoregularly.ThesecuritisationofBroadgateEstatesbyBritishlandisthesubjectofacasestudyinthischapter.

Thelastriskisinflation,whichcandilutethevalueofrentalincomeandresultinthedeveloper’sfailuretomeettheirrequiredyield.Thisriskcanbemitigatedthroughleaseclauseswhichstipulatethatrentscanbeperiodicallyadjustedforinflation.

Bank loans as a percentage of total liabilities for 3 UK property developers.

Equity/Debt ratio for three UK property developers over the past two decades.

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Formostcompanies,raisingfundsisoneofthemostimportantoperationsfortheirdaytodaybusiness.Exceptforafewcompanies,mostdon’thaveenoughcashtoruntheiroperationsandthereforeneedtorelyonexternalfinancialresourcessuchasbankborrowing.Loweringfinancingcostshasbeenacrucialissueintermsofsecuringsustainableprofitability.Externalborrowingpresentsahighdegreeofrisk,asthecostofthistypeoffinancingisnotalwaysstable:unpredictablerisesinthecostoffinancingmaysignificantlyimpactcompanies’financialconditions.

Sourcesoffinancehavetraditionallybeenlimitedtobanksorsimilarintermediaryinstitutionsthatprofitbyreceivingdepositsandthenprovidingloanstotheirclients.Whencompaniesrequirelargeamountsofmoneynoteasilysourcedfromcommercialbanks,theyturndirectlytothecapitalmarketstoraisefunds.Inrecentyears,accessibilitytocapitalmarketshasbeeneasedbydevelopmentsinfinancialtechnologiesanddiversificationinfundingproviders.Today’scompanieshavemorediversifiedfundingsourcesthanthoseofthepast.

Thisdiversificationinfundingsources,however,hasmadecompaniessensitivetomarketfluctuationsandsomehowfinanciallyfragile.Agreaterdegreeofriskisnowembeddedincorporatefinance.Companiesthereforedesiredtominimizetheirexposuretorisk,andincollaborationwithfinancialinstitutions,havedevelopedandimplementednewriskmanagementproducts.Theprincipleofthemostinnovativeproductsistotransferrisktothosedesiringsomeexposureatreasonablecostandwiththepotentialforhigherthanaveragereturns.

INTERESTRATESWAPInterestrateswapsareaformoffinancialderivative.Normally,bankloansareprovidedatfloatingrates.Agenerictypeofthistransactioninvolvestheborrowerexchanging(swapping)theirfloatingrateforafixedratetobettermanagecashflowandtoavoidhigherpaymentsresultingfromratehikes.Higherinterestcanbeimposedbybanksinresponsetodeteriorationofacompany’sfinancialconditionorapoorgeneraleconomicenvironment.

FINANCIAL PRODUCTS

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NONRECOURSELOANAtypeofloanstructuredsuchthatthelenderisonlyentitledtorepaymentfromprofitsgeneratedbythespecificprojectfundedbythatparticularloan.Thistypeofloandoesnotentitlethelendertoanyclaimovertheborrower’sotherassets.

BONDAbondisafixed-interestdebtinstrumentissuedbyaninstitutionseekingtoraisearelativelylargeamountofmoneyforacertainperiodatfixedcost.Bondspaytheirholdersafixedamountoveraspecifiedinterval(month,year,etc.)untilamaturitydate,whenthefacevaluecanberedeemedfromtheissuer.

COMMERCIALMORTGAGEBACKEDSECURITIES(CMBS)AKASECURITISATIONACMBSisaninvestmentinstrumentthatrepresentsownershipofaninterest(i.e.shares)inamortgageorgroupofaggregatedmortgages.Thesesecuritiesareissuedbyatypeofcompany(usuallyapapercompany)whichisgenerallyestablishedsolelytoconductthiskindoftransactionandisbackedbythevalueofitsownedassets(i.e.buildings).TherentalincomefromtenantsispayabletotheholdersofCMBS.

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REALESTATEINVESTMENTTRUST(REIT)AREITisacorporationortrustthatusesthepooledcapitalofmanyinvestorstopurchaseandmanageincomepropertyand/ormortgageloansoranyothertypesofproductsrelatedtoproperty.REITsaretradableonmajorexchangesjustlikestocks.Theyaregrantedspecialtaxconsiderations,whichmakesthemmoreattractivetosomeinvestors.REITsofferseveralbenefitsoveractuallyowningproperties.First,REITsharesarehighlyliquid,unliketraditionalrealestate.Second,REITsenablepartialownershipofnon-residentialproperties,suchashotels,malls,andothercommercialorindustrialproperties.Thisallowsmoreinvestorstoparticipateinthesepropertymarkets.REITspayyieldsintheformofdividends.

FINANCIALPRODUCTS/FUNDINGMETHODS

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GOVERNMENT,DEVELOPERS,FINANCIERS,MARKETSOfrelevancetothecapitalmarkets,therearetwomainandtwosecondaryactorsinvolvedinthefundamentalprocessesofspeculativeofficedevelopment.Themainactorsarethegovernmentanddevelopers,andthesecondaryactorsarefinanciersandratingagencies.

Thegovernmentwants:(“sustainable”)economicgrowth;agoodbusiness,socialandnaturalenvironment;equitable(re)distributionofwealthandjustice;andinfrastructureinvestment.Thegovernmentisconstrainedby:globalcompetition,pressureforderegulation;tradegrouppressure;budgetconstraints;urbanproblems;andratingagencies,whichcanaffectthecostandavailabilityofmoney.Toovercomeconstraintsandachieveobjectives,thegovernmentuses:publicrelations;politicalpressureonothergovernmentalbodies(i.e.regional,national,etc.);incentives;policy;regulationsandlegislation;andinfrastructuredeployment.

Developerswant:profitandincome;investorconfidenceandcommunitycredibility;favourablelegislationandpolicies;growthopportunities;andegogratification.Intheirwayare:governmentintervention,taxation,poorpublicopinion,requirementforcorporateresponsibility,marketpressures,lowdemand,labourmarkets,andcompetitors.Toovercometheseobstaclesthey:usecreativefinancingandpublicrelations;maintaingoodrelationshipswithinfluentialactors;andnegotiateskilfullywithgovernments.

Financiersintermediatebetweenmarketsandpartiesraisingcapital(governments,developers,etc.).Theyseekriches,aswellasprotectionfromandfavourabletreatmentbygovernments.Marketvalueisoflessinterestthanmicro-volatilityandmacro-stabilitysolongastransactionsarebeingmade.Constraintsare:governmentintervention,marketregulation,taxation,andpublicopinion(exaltedbysome,demonisedbyothers).Highlycreativeandinnovativeinachievingtheirgoals,theyaretheinventorsandproducersofthenewfinancialproductsandinstrumentsdiscussedinthischapter.Theyusepublicrelations,closerelationshipswithinfluentialactors,andpressureongovernments,businesses,etc.tosupporttheiractivities.

Ratingagenciesarethemostneutralyetinfluentialofalltheactors.Theirinterestisinmaintainingagoodreputationbysupplyingaccurate,objective,andreliableinformationaboutlocalandnationalgovernments,banks,companies,sectors,andanythingelseimpactinginvestmentdecisions.Ratingschangescanhaveasignificantimpactonthedeveloper’scostofmoneyandthereforeaccesstocapital,liquidityandsolvency.

CONTEXT

Actors and dynamics of speculative economic growth and development

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Developershaveimprovedtheirresiliencyinthefaceofunexpectedpropertydemandcyclefluctuationsbyimplementingassetandliabilitymanagement(ALM)strategies.Chiefamongthesestrategieshasbeenthediversificationoffundingsources.Thetraditionalmethodsforachievingthisdiversificationhaveinvolvedanappropriatecombinationofshorttermloans,longtermfundsraisedbybondissuance,andequityfinance.Recentproductinnovationsinthefinanceindustryhaveaddedtodevelopers’fundingdiversificationrepertoire,andnowincludepropertyderivativesandsecuritisation(CMBS).

ThedeploymentofnewfinancialinstrumentswhichallowALMtobemorefinelycontrolledhasnotonlyincreaseddevelopers’resiliency,buthasalsoreturnedgreatershareholdervalue.Thishasenhanceddevelopmentcompanies’attractivenesstoinvestors,resultinginincreasedcapitalflowstothepropertydevelopmentmarket.

Thisnewcapitalrepresentsadiversificationofrisk,becauseitispartiallybroughtinthroughCMBSandREITs—bothvehiclesforgreaternumbersofsmallerinvestors.Eventually,thediversificationofriskcouldresultingreaterstabilitybothinthemarketsandintheproductionofspeculativeofficespace.

A HYPOTHESIS

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THEUKPROPERTYMARKETInordertoestablishabasisforourresearch,itwasnecessarytounderstandthecharacteristicsoftheBritishcommercialpropertymarket.IntheUK,theinstitutionalcategoryleaseisgenerallybetween15and�5years,normallyaccompaniedbyarentappraisal

—usuallyupward-only—everyfiveyears.LeaselengthsintheUKareconsiderablylongerthanthoseontheEuropeancontinent.Rentsarebasedontheopenmarketvalue,whichhasgenerallytendedtoincreaseovertime.ThisdenotesasecureinvestmentclimateintheUKwithsignificantaddedvalueinLondon’spropertymarket.

LONDON’SWORLDCOMPETITIVENESS;KEYFACTORSCONTRIBUTINGTOTHEHIGHDEMANDFOROFFICESPACEItspoliticalstability,goodairtransportfacilitiesandadvancedtelecommunication,aswellasitsuniquepositionintheworld’stimezonesallowingittodobusinesswiththeFarEastandNorthAmericaonthesamedaywitheasyaccesstotheirmajorfinancialcentres,hasgreatlyadvantagedLondon’sestablishmentasaworldfinancialcentre.Londonhasalsoleverageditsgoodreputation,itsworldwidelegacyofcontactsachievedthroughpoliticalandcommonwealthlinksmaintainedinthepost-warera,andthecommonuseoftheEnglishlanguageinbankingandfinance,toencouragelargenumbersofglobalforeignbanks,securityhousesandinsurancecompaniestoestablishoperationswithinitsborders.Morerecently,the1979removalofexchangecontrolsandthe198�StockExchangederegulationencouragedLondon-basedfinancierstoseekbusinessopportunitiesinoverseasmarketsandalsocreatedfavourableconditionsforforeigncapitaltobeinvestedintheUK.AstheLondonmarketbecomesmorefavourabletoforeigncapitalinvestment,producerservicefirms,globalheadquartersandforeignsubsidiariesareallcompetingforlimitedspace,creatingademandwhichwillresultinfurtherinvestmentinofficedevelopment.

SUCCESSFULTRADITIONALMODEL:BANKSIDE1�3Acrossindustries,therehasbeenamyththatexpandingthesizeofacompany’sbalancesheetbyincreasingassetsandliabilitiesisevidenceofgrowth.Forthepropertydevelopmentindustry,itseemedespeciallyplausiblesinceundergoodeconomicconditions,themorebuildingsthedeveloperbuilds,themorerentalincomeisexpected.Eventhoughbeliefinthismythhasleadsomedeveloperstoinsolvencyduringperiodsofrecession,theirfailurestendedtobeblamedonpoormanagementorbadluck,andthemythremainedintact.

Today’s“shareholder’seconomy”hasemphasizedefficientcapitalutilizationasakeyprincipleforsuccessfulbusinessoperation,asitisasurerindicatorofacompany’sfiscalhealth.Profitabilitymeasuredbyseveralkeyratiosisregardedasfarmoreimportanttoinvestorsthanearningsalone.Developerswhosebusinessgrowthisstillattachedtoassetgrowthmustbemorestrategic—acquiringsitesincompetitivelocationsatreasonablecostsandthenbuildingattractiveofficefacilities—inordertomeetinvestorexpectationsundertighterconstraints.

UNSUCCESSFULTRADITIONALMODEL:CANARYWHARF1987-199�Duetotherealestatemarket’scyclicalnature,officedevelopershavealwaysfacedtheriskofsufferingcriticalfinanciallosses,whichintheworstcasesleadtobankruptcy.Thishashappenedwhenlowdemandhasforceddeveloperstocompeteforlettings,leadingtoreducedrentalprices.Thespeculativedevelopertakestheriskofbuildingofficespacewithoutpre-letting,whichmeansthatinill-fatedcases,hecouldwindupproducingempty

Bankside 1, the Blue Fin Building developed by Land Securities and sold to IPC (a division of Time, Inc.).

The developer’s simplified balance sheet is made up of assets (A), debt (D) and equities (E). To begin construction (C), the developer takes out a loan (L), thereby increasing the size of the balance sheet — and the business. When the building is finished (F), the developer finds an occupant (O) and the building becomes yet another of the developer’s assets.

DEVELOPMENT CASE STUDIES:TRADITIONAL AND EMERGING MODELS

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officespacewithnotenants.Thedeveloperwouldnotbeabletocollectanyrentandwouldthereforehavedifficultyservicinghisbankdebt.Prolongedvacancieswilleventuallyleadthedeveloperintobankruptcy,withlenderstakingovertheinsolventcompany’spropertytoliquefyitASAPinanefforttorecoupsomeoftheirmoney.Duringeconomicdownturns,companiesrelyingonaccesstoshorttermcreditwouldfeelthestrainasbankstightenedthemoneysupplybyraisinginterestrates.AlthoughtodayCanaryWharfisrenownedasasuccessfulworldclassbusinesscentre,ourresearchisconcernedwiththeperiodbetween1987and199�,whenit’sCanadiandeveloperOlympiaandYorkwentbankrupt.

THEINITIATIVETheUK’sfirmlyestablishedbusinessdistrict,theCityofLondon,containingmanyhistoricbuildingswithobsoletefloorplans,limitedspaceandhighmaintenancecosts,hasbeentheonlyoptionformanyleadingglobalfinancialinstitutionssettlinginLondon.Consequently,theemergenceofadvancedofficelayout—largeopen-plantradingfloorswithhigherfloortoceilingheights,raisedfloorstoaccommodateextracablingtosupportthelatesttechnology,andlargeunitsthatcouldhouseoperationsunderoneroof—wasindispensabletokeepupwiththemoderncomplexfunctionsofmanyfirmsandtomaintainthecity’sstandingasaworldfinancialcentre.TheCity’sinabilitytomeetthedemandformodernspacewasduetolimitedopportunitiesforredevelopmentgivenUKplanninglawsregardinghistoricbuildings,aswellasthemultiplicityofsiteownership.Inthe1980s,anoptimisticclimateforthefinancialandbusinessservicesector,attributabletothefinancialderegulationundertakenbytheThatchergovernment,wasestablishedinLondon.Thevisionfornewofficedevelopmentdidnotcomefromdevelopers,butfrompotentialtenantsseekingenhancedofficespaceinLondon.Initially,anAmericanbankerandthechairmanofMorganStanleyforesawthepotentialoftheCanaryWharfsiteandjoinedwithG.WareTravelstead,aTexas-baseddeveloperinproposingaonemillionsq.m.Officecomplexin198�.Thatschemewaswithdrawnduetoitsdeficiencyinfunding.In1987theCanadiandevelopersOlympia&York,ownedbytheReichmannbrothers,tookoverthescheme.Fromthebeginning,CanaryWharfwasenvisionedasacompetitiveclass-Aofficedevelopmentwhichwoulddeliverexcellentattributesandgoodvalue.

THESITEASPECT/CANARYWHARFINTHE1980SUntilthelate19�0s,TheLondonDocklandshadbeenathrivingdistrictfortradeandshipping.However,rapiddeclinebeganwiththeintroductionofcontainerization,withmostshippingactivitymovingtonewcontainerportssuchasTilbury’s.LocatedwithinLondonDocklandsunderjurisdictionoftheLondonDocklandsDevelopmentCorporation(LDDC),createdbythelocalGovernmentPlanningandLandAct1980,therewereneitherstructuralplanningprinciplesnoranykindofpublicscrutinyofthedevelopmentprocess.TheIsleofDogsbecameanEnterpriseZoneofferingtaxallowances.Hence,thesitebecamefavouredforinvestmentasthegovernmentofferedtaxallowances,attractivesubsidiesandincentivestobothprivateinvestorsandprivatedevelopersinordertorevivethedomesticeconomy.TheCanaryWharfsitewassubjecttolessrestrictivebuildingregulationsandlowerlandpricesthanthoseintheCityofLondon.Asaresult,developersrushedtoconstructbuildingswithintheIsleofDogsdistrictinordertobenefitfromitsfinancialandplanningincentivesbeforetheyexpired.

POLITICALCLIMATETheConservativepoliticianMargaretThatcherbecameprimeministeroftheUKin1979andbeganintroducingfree-marketpoliciesintoBritain.Withhighunemploymentininnercitiesandoverallrecession,theThatchergovernmentenactedpoliciesofeconomicderegulationandprivatizationofstate-runindustries.In1981theConservativeGovernmentformedtheLondonDocklandsDevelopmentCorporation(LDDC)torevivethethenfailingeconomyoftheDocklanddistrict.In198�,theIsleofDogswasdeclaredanEnterpriseZonewhichofferedtaxallowancesforinvestorsanddevelopersforatenyearperiod.InMarch1998,theLDDCcloseditsbureauandhandedoveritsjobtotheLondonBoroughsofNewham,SouthwarkandTowerHamlets.

The Canada Place tower at Canary Wharf. This project was a catalyst for the failure of Olympia & York, the most aggressive property developer of its day.

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THEDEVELOPEROlympiaandYorkDevelopments(O&Y),oncethemostprestigiousinternationalpropertydevelopmentfirms,wasaprivateToronto-basedcompanyownedbytheReichmannfamily.O&Yestablisheditsreputationasamajorinternationalpropertydeveloperduringthe1980sthroughthesuccessofFirstCanadianPlaceinTorontoandtheWorldFinancialCentreinNewYorkCity.ThecompanytookagambleonCanaryWharf,theworld’slargestofficedevelopmentat83acres(33�,000sq.m.),inthelate1980s.In199�,Olympia&YorkCanaryWharfLtd.wentintoadministration.

PROJECTTIMELINE

CAUSESOFFAILURESincerealestateisalongtermbusiness,developersareoftenvulnerabletoriskduringthecourseoftheirdevelopment.Asaclassicalcase,OlympiaandYorkfailedbecausetheydidnotreachtheirpredictedmarketdemand.Asaclosely(andprivately)heldenigmaticdeveloper,theywereover-confidentintheirperformanceduetotheirscaleandlargeextentoffinancialindependence.Olympia&York’sprojecteddevelopmentwastobeconstructedinphasesoveraperiodoftenyears,wherehalfofthefinancingwouldbeprovidedbythedeveloperandtheotherhalfwouldbeaccumulatedfrombankloans.ThefirstphaseoftheconstructionwhichincludedtheCanadaSquarewastobecrucialforthedeveloper,sinceitssuccessfulleasingwouldguaranteetheabilitytoraisefurtherfinancingforthesubsequentphases.Thecompanyhadindeedconsideredthepossibilityofafewminorpropertyrecessionsduringthetenyeardevelopmentperiod.Nevertheless,Britain’sworstrecessionsincethe1930s,theaccompanyingslumpinLondon’sofficemarketfrom1989to1994,andthefurthercomplicatingfactorofBlackMonday’sdramaticfallinequitypricesinOctoberof1987,didnotencourageanypotentialclientstomovetheirfirmsfromtheCity.

TheunenthusiasticmarketresponsetoCanaryWharfwasfurtherexacerbatedbythelackofcommitmentfromtheUKConservativegovernmentwhichhadinitiallyofferedassuranceoftheirsupportinfundingtheinfrastructure.Atthestart,thegovernmenthadconsideredmovingtheDepartmentofEnvironmentheadquarterstotheCanaryWharfestate,whichwouldhavebeenamajorvoteofconfidenceforthesite.Furthermore,transportconnectionswerenotinplaceduetoO&Y’sdelayoftheir$�9millionJubileeLineextensionpayment.Thegovernmentalsowithdrewfinancialsupportfortheonce-promisedinfrastructurewhentheyrealizedO&Ywouldbeincapableofcoveringitsshareofobligations.

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In1991,thefirstphasewascompletedandthefirsttenantsmovedin.However,confidenceinfuturedevelopmentwasaffectedbythepooroutcomeintheirfirstphaselease,leadinginvestorstobemorecautiousinfundingfuturephases.MeanwhiletheCity,actingincompetitionwithCanaryWharf,hadalreadylooseneditsbuildingrestrictionsonofficespace,spurringasignificantincreaseinofficedevelopmentswithintheCitydistrict.Subsequently,asBritainenteredarecessionandBritishfirmswereunwillingtorelocatefromthetraditionalfinancialcentre,theofficespaceatCanaryWharfremainedlargelyempty.Consequently,OlympiaandYorkhadtoconfrontlargevacancyrateandgreatlydecreasedtheirrentalprice.Thesurplussupplyofofficesinthemarketoccurredinthecontextofmacroeconomicrecessionduringtheearly1990s,takingthepropertymarketintofurtherdecline.Despitethecollapseinpropertyvaluecausedbyoversupply,Olympia&YorkcontinuedtoinvestinCanaryWharfwithgreatexposuretorisk.

TheReichmannfamilyinvested$500millionofitsfamilymoneyinordertoachieveliquidity,buttheirendeavourtorescueCanaryWharffrombankruptcyfailed,aselevenbankswithapproximately£550millioninloanstotheprojectrefusedtoextendtheirloans,leavingthecompanywithmassivedebt.Furthermore,thecollapseinpropertyvaluecausedbytherealestatedownturnleadtoasituationinwhichOlympia&York’sliabilitiesexceededtheircompanyassets.O&Yhadactuallyattemptedtodiversifyitsbusinessduringthemidtolate1980s.IttookoverAbitibi-Price,theworld’slargestpaper&newsprintproducer,bypurchasing8�%ofitsshares,andalsoacquiredGulfCanada,alargeoilandGasCompany,witha75%stake.Inbothinvestmentstheyfaced1991lossesof$�4.5�and$53.55millionrespectively.AsO&Y’smajorshareholder,theReichmannfamilysacrificedhugeassetswhichdeclinedfrom$�.89billioninJanuary1991to$4.�8billioninMay199�,a3�%lossover17months.InMarch199�,PaulReichmannhadtoleavehisposition,andsubsequentlyinMaythecompanyannounceditsbankruptcy,owingover�0billiondollars.

SUCCESSFULEMERGINGMODEL:BROADGATETheelevenbuildingsmakingupthefourBroadgateEstatesweresubjectsofthefirstmajorUKsecuritisationtransactionofofficebuildingsin1999.LearningfrompastfailuresintheUKcommercialpropertymarket,Britishdevelopershavebecomemoreresilientbymanagingtheamountofdebttheyemployintheirbusiness.Theystillrequiremuchcapitalduetogrowthinthescaleofdevelopment,yetthenatureofthetraditionaldemandandsupplycycleremainsunpredictable.Thankstoadvancesinfinancetechnology,developersarenowabletocontroltheirdebtthroughtheuseoffinancialproducts—suchasderivatives,tomitigateinterestfluctuationrisk—thatcanhavesignificantimpactdependingoncompanies’amountsofdebt.Developershavealsostrategicallyadjustedtheproportionofbankloans(shortandlongterm)andfundsraisedbydebtinstrumentssothattheycanbetternavigateunexpectedmarketturbulence.

The developer’s simplified balance sheet is made up of assets (A), debt (D) and equities (E). To begin construction (C), the developer takes out a loan (L), thereby increasing the size of the balance sheet. When the building is finished (F), the developer fails to find an occupant and the building remains empty (E). If the developer receives no rent for a long enough period of time, they will have to service their debt by liquefying some of their assets. This would result in a diminishing value of equities, and ultimately in insolvency if the interest on bank loans couldn’t be paid on time.

First Exchange House (Bishopsgate Project, Broadgate) London, England 1989

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BritishLandisonecompanythatactivelyadoptedfinancetechnologytomitigateriskwhileremainingmoreleveragedthanitscompetitors.AsoneoftheUK’smajordevelopers,withannualturnoverof£�19.9million(FY�005),thecompanyhasfocusedondevelopmentthroughacquisitionofstrategicsitesandprovisionofattractivecommercialfacilities,officebuildings,andretailspacesinmajorUKcities.Fromtheearly1990sthecompanygraduallyacquiredassetsaboveandaroundLiverpoolStreetstationintheCityofLondon,includingtheexBroadgateStationthatwasclosedin198�.Developmentonthe1�hectaresite,calledBroadgate,startedunderThatcherin1984andwasoneofthemajorprojectscompletedduringthaterain1991.ThedeveloperwasacollaborationbetweenRosehaughandStanhope,andBritishLand,firstinvolvedaspartofafundingconsortiumfor1FinsburyAvenue,apartofthesite.BritishLandgraduallypurchasedtheassetsinthesitethroughaperiodwhichsawthebankruptcyofRosehaughandStanhope,andcompletedthepurchaseoffinalportionofthesitein�003.Accordingtothelatestfinancials,thevalueofBroadgateEstatesis£�.974billionequivalentto�0%ofthecompany’sportfolio(FY�005).11buildingsinthesitehavebeenoccupiedmainlybymajorfinancialinstitutionssuchasLehmanBrothers,UBS,RoyalBankofScotland,etc.

EvenafterthedisastrouspropertymarketcrashleadingtoOlympiaandYork’sbankruptcyin199�,developers’modusoperandiforofficedevelopmentremainedthesameandthereforetherisktheycarriedremainedunchanged.Inaddition,aspensionfundsincreasedinvestmentintheoverallcapitalmarkets,theirconcernswithefficientcapitalutilizationandhighdividendsplacedheightenedemphasisonassetquality.Aswehavenotedinourcasestudyfortraditionalpropertydevelopment,ithasbeenconventionalwisdomthatanexpansioninthesizeofacompany’sbalancesheetachievedbyacquiringsitesandconstructingbuildingswouldbetheonlywayforthatcompanytosustainitsbusiness,eventhoughthisstrategywouldsimultaneouslyescalateriskofinsolvencyintheeventthatdemandinthemarketwasstagnant.Securitisation,afinanceinnovationdevelopedintheU.S.inthelate19�0s,presentedasolutiontothiscontradictorysituationbyenablingdeveloperstopursuecontinuousbusinessexpansionwhilemaintaininggoodassetquality.

Inasecuritisation,theincome-generatingassetisseparatedfromtheinitiatingcompany’sbalancesheettoavoidaffectingthecompany’ssolvency.Theassetisthenacquiredbyapapercompanyestablishedbytheinitiatingcompanysolelyforthatasset-specifictransaction.Thefunctionofthepapercompanyistoissuesecurities(CMBS)tobepurchasedbyinvestors.Thevalueofthesecuritiesisbackedbythevalueoftheassetandtheinvestorsreceiveincomegeneratedbythatasset(rent).Theproceedsreceivedbythepapercompanyfrominvestorsarethenpaidtotheinitiating(parent)company,whichwastheformerowneroftheasset.Throughenteringthistransaction,withsomeuniquefeaturesofUKpropertymarketcustom,thecompanycanachievetwoimprovementsintermsoffinance:reducingcostoffinanceandobtainingextraordinarilylongtermfinance.Theformerdirectlyimprovestheprofitabilityofthecompanywhilethelatterwillsatisfythecompany’slongtermfinancialneedswithstablemoney.Usuallythecostofraisingfundsisrelativetothelengthoftheperiodthatthefundsareemployed;thelongertheperiodthatthecompanyrequirestoborrow,thegreaterthecostthattheyneedtopay.Thecostisalsoaffectedbythefinancialconditionofthecompanyaswehavementionedearlier.Insecuritisation,thecostofmoneyraisedbythepapercompanyisbasedonthequalityofthetransferredasset.Thismeansthepapercompany’ssecuritiesarelikelytoreceiveahigherratingthanthoseoftheparentcompany,whichallowsthepapercompanytopaycheaperinterest.Thus,theparentcompanycanachievelowercostandlongertermfinancing,whichiscontradictorytotraditionalcommon-senseinfinance.

The developer’s simplified balance sheet is made up of assets, debt and equities (A, D & E). To begin construction (C), the developer takes out a loan (L), thereby increasing the size of the balance sheet. When the building is finished (F), the developer finds an occupant (O) for the building. The building (i.e. asset) is removed from the balance sheet through the process of securitization. The result is two legally separate companies.

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TRANSACTIONDIAGRAM

ORGANIGRAMOFBROADGATESECURITISATION

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BritishLand’ssecuritisationofBroadgatewasconductedasfollows:

1.Ownershipofthe11companies,eachholdingoneofthe11respectivebuildingsinBroadgateistransferredbyBritishLandtoasinglenewlycreatedpapercompany:BroadgatePropertyHoldingCompanyLtd(“BPHC”).

�.BroadgateFinancingPLC(“BFPLC”),anotherpapercompanywhichisalsoestablishedforthistransaction,issuessevenkindsofsecuritiesdifferentiatedbythedegreeofriskandmaturitydateofeachsecurity,whichtogetherdeterminethecouponrate(equaltointerestpayabletoborrowings).Eachnoteisratedbyaratingagency(i.e.Standard&Poor’s)whichreflectsonthequalityoftheassetandlengthofperioduntilthematuritydateofthesecurity.

3.MorganStanleyBroadgateFinancePLC(“MSBFPLC”),anotherpapercompanycreatedbyMorganStanley,thearrangerofthistransaction,undertookallthesecuritiesissuedbyBFPLCandissuedsecurities-backednotestoinvestors.TheproceedsofthesaleofthenoteswerepaidtoBFPLC.

4.BFPLCprovidesaloan,whichisfundedbytheproceedspaidbyMSBFPLC,toBPHC.Semi-annually,BPHCneedstopayBFPLCtheinterestwhichisessentiallytherentpaidbythetenantsof11buildings.Uponreceiptoftheinterest,BFPLCusesitfortheirpaymentofinteresttoMSBFPLC.MSBFPLCthenpaythecoupontotheholderofthenote.Inthisstructure,therentpaidbythetenantsisthesourceofthecoupon.

CASHFLOWDIAGRAM

Inthistransaction,BritishLandhasrealizedtwomajoraccomplishments:reductioninaveragefinancecostby14%to7.3%from8.4%;andextensionoftheaveragelifeofexistingdebtfrom19.8yearsto�3years.

DETAILSOFISSUEDNOTE

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TRANSACTIONECONOMICS

Afterenteringthetransaction,BritishLandrepaidtheirexistingdebtwiththefundsobtainedfromthistransactionandtheyachievedtheabove-mentionedaccomplishments.ThereductionofthefinancecostwasmadepossiblebythefactmorethanhalfofthesecuritiesobtainedhigherratingsthanthosegiventoBritishLand’sownbonds.Thehigherratingwasgivendueto1)qualityoftenantsinthebuildings:internationallyrenownedfinancialinstitutions,legalfirms,internationalorganizations,etc,eventhoughitispossiblethatanyoneofthemmightbecomeinsolvent(meaningthatthereisalwayssomedegreeofrisk)and�)thelegalremotenessofthetwopapercompaniesfromtheinitiatingcompany,meaningthatpaymentmadebyBHLCtoBFPLC,andthenfromBFPLCtoMSBFPLCwillnotbeaffectedbyanyinsolvencyexperiencedbyBritishLand.Thelongermaturitydatesofthesecuritiesareallowedbylongleasecontractsbetweentheownersandthetenants.Furthermore,theasset’squalityisenhancedbyitspremierofficelocationinLondon,asitcanbepredictedthattheownerwilleasilyfindnewatenantwhenanyexistingtenantterminatestheircontract.Forthesereasonsitisforeseeablethattheassetwillgenerateincomeovernextthreedecades.

UNSUCCESSFULEMERGINGMODEL:HYPOTHETICAL(&UBIQUITOUS)Fromthedeveloper’sperspective,owningavacantbuildingisalmostequivalenttolosingmoneysincehugeexpendituresmustbemadeforsiteacquisitionandconstructionovertheyearsittakestocompleteaproject.Inaddition,thedeveloperhadtocommenceofficedevelopmentinexpectationofmeetingdemandinevitablyinfluencedbyunpredictableeconomictrends.Inmostcases,bankruptcywouldresultfromadeveloper’sinaccuratepredictionofdemandincombinationwithaweakenedfinancialconditionpartlyresultingfrompastexpendituresforthedevelopmentproject.Therefore,findinggoodtenantsforabuildingisstillacriticalissuefordevelopers.

Innovationsinfinancesometimeschallengetheorthodoxyofcommon-sensebusinesspracticesinaparticularindustry.Thepropertyderivativerepresentsonesuchchallengeasitallowsthedevelopertoreceiveincomewithouthavingatenantintheirbuilding.Themechanismistotransfertheriskofvacancy—whichalsoincludesthepossibilityofreceivingrentoncethebuildingcapturesatenant—tothosewhowillingtotakesuchrisks.YetthefirstPropertyDerivativejustintroducedlastyearwasatailor-madetransactionandhenceremainsilliquidbecauseamarketforthistypeofinstrumenthasyettobeformed.However,anincreaseofinvestorsseekingpropertyincomethroughderivativesratherthanpurchasingpropertydirectlymayencouragetheformationofapropertyderivativesmarketandmayprovideasolutionfordeveloperswhoarefacingdifficultiesinattractingtenants.

TRANSACTIONACHIEVEMENTS

The developer’s simplified balance sheet is made up of assets, liabilities and equities (A, L & E). To begin construction (C), the developer takes out a loan (L), thereby increasing the size of the balance sheet. When the building is finished (F), the developer may fail to find a tenant, leaving the building vacant (V). The developer’s resilience in enduring the period of vacancy is enhanced by new funding sources and finance technologies which enable more effective ALM.

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SpeculativeofficedevelopmentinLondonhasbeencontinuouslyfuelledbytheCorporationofLondonandtheGreaterLondonAuthorityintheirdrivetomaintainLondon’sleadingpositionamongWorldCityleaguetable.ThemajorUKdevelopershaveengagedinspeculativeofficedevelopmentinthiscontext.

Traditionaldemandandsupplycyclesdrivenbyunpredictableeconomictrendsstillremainthemajorchallengefordevelopers.Inthepast,aswehaveobserved,theLondonpropertymarketcycleswallowedwhatwasoncetheworld’saggressivedeveloper.ThiscorrectioninresponsetounletspacetemporarilyhaltedspeculativeofficedevelopmentinLondon.

NewinstrumentsoffinancetechnologyenabledeveloperstoemployawiderarrayofALMstrategiestomaintainrobustbalancesheets.Thisrepresentsagreaterdegreeofcontrol,allowingdeveloperstoremainmoreresilientinthefaceofunexpectedmarketdownturnsthatdampendemandandincreasefinancialconstraints.

Resilientdevelopersoffermoreattractiveinvestmentopportunitiesbecausetheyreturngreatershareholdervalue.Investors’responsetobetterstabilityandreturnswillbringmorecapitalintothepropertymarket.Ascapitalflowsexpandandnewinvestorsenterthemarket,therewillbemoredemandforproductslikeCMBSandREITs—bothproductsthatallowgreaternumbersofsmallerinvestorstoparticipateandtherebydiversifyrisk.Theoutcomeofexpandeduseoftheseproductswilltheoreticallybegreaterstabilityintheproductionofspeculativeofficespace.

AnotheroutcomeofhavingmoreinvestorsinamarketwheretheuseofCMBS,REITsandnewerpropertyderivativesisprevalentwillbeownershipofindividualbuildingsbymultipleunrelated(fragmentary)non-occupierswithlittleornonon-financialconnectionthebuilding’sactuallocation.

CONCLUSION

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