The credit crunch and the Spanish property market

The credit crunch is going to take its toll on the Spanish property business. One high profile developer, Llanera (till recently sponsors of Charlton Athletic) has already gone under, but we ain’t seen nothing yet. Every day you hear another expert say everything is fine, all is well, prices won’t fall, this is just a return to normality, a soft landing , indeed a privilege and pleasure to experience, but it sounds increasingly panicky to me. I’m expecting significant price falls in quite a few areas, and some big casualties in the next year as companies with high overheads and/or high gearing run out of cash. Plenty of developers will be fine, but plenty won’t. Expect a fair number of half-finished building sites to litter the coast for a few years yet.

Why my pessimism? Consider this:

The Spanish construction boom, now ending, was so monstrous there’s just no way it could ever end sweetly, even without the credit crunch. Several years of 800,000 housing starts per annum, 18.5% of GDP going to housing / construction, pouring 66% more cement than Germany (whose economy is 3 times larger), and building 25% of all new homes in the EU last year, means the Spanish economy has become a real estate junkie. The only known cure for junkies is cold turkey, and that’s never pleasant.

Why did this happen? Several reasons, but cheap money was the critical factor. Euro zone interest rates were below 4% from September 2001 to June this year, and most of that time they were only 2%. With Spanish inflation fluctuating between 2% and 4% in the period, real interest rates in Spain were zero. Liquidity was abundant, and banks have been throwing money at developers for years, no risk premium required.

When money sloshes around on such easy terms you get an asset price boom. Property is a special case, because ordinary punters can borrow to invest in it. Rising property prices attract more investors, creating a positive feedback loop that drives prices higher and higher. Surging demand and rising prices encourage developers to build more and more, if planning authorities let them. Get the picture? In Spain this lead to roughly 800,000 housing start per year, whilst real demand for housing (a place to live or a holiday home) was estimated to be something like 400,000 to 500,000 units, even taking into account immigration, demographics, and holiday home buyers. Result? A big housing overhang.

In the process a lot of developers seem to have assumed the bonanza would never end. They went on a borrowing splurge, and banks were most happy to oblige. Borrowing in the construction sector has now reached 800% of the sector’s value added output, and the Bank of Spain has raised the alarm in its understated way.

Then along comes a pesky market downturn, coupled with a credit crunch. Sales of new developments have fallen around 40%, maybe more in some places, so operational cash flow is not good for many developers, whilst access to borrowing has dried up, and borrowing costs have shot up.

What happens next? Some companies start running out of cash. Simple really.

So what does it mean for you? Depends if you have bought on a new development, or if you plan to.

If you have bought on a new development and the developer goes bust then you’re in for trouble my friend. I’ll write about this situation, and how to deal with it, in a separate piece.

If you have bought on a top quality new development from a financially sound developer, then you will be fine. You may even benefit as people realise the true value of quality. The market has been bad at identifying and pricing quality in the boom years, but that is all going to change. I expect a flight to quality, and a premium value for the best operations.

And if you plan to buy on a new development, then don’t be put off as the coming turbulence will create opportunities for those who know how to take advantage of it (more on this another day). Just make sure you do your research, and focus on quality in all its dimensions.