What are the risks that investors should look out for? Only in Central London has commercial property recovered all of the value lost in 2007-2009 by the world financial crisis. Central London shops are 55% higher than their June 2007 values and West End office values are 23% higher. City of London offices remain 4% below their June 2007 high and London industrials have almost recovered their peak.
Throughout the rest of the UK the value of commercial real estate still is a long way below its peak. Across the UK average initial yields remain 58 basis points (bps) above their June 2007 levels. Central London shops are, however, 92 bps below their 2007 level. City and West End office yields are now 50 bps lower than the level achieved at the top of the market. Clearly there is further room for some strong growth in all segments of the market outside Central London. In Central London, however, the focus is more on value and the likely trigger of the next downturn?
A comparison of the pricing, however, of Central London assets in June 2007 and today can only take us so far. Conditions now and then were very different. In June 2007 the Bank of England base rate was 5.50% and the 5-15 year gilt yield was 5.25%. Today, the base rate is 0.5% and the gilt yield is 2.0%. In 2007 Central London shops and offices and London industrials were valued at a discount to the then prevailing gilt rate.
Today although the same sectors are valued at record low yields the multiple applied reflects a premium to the gilt rate. Current yields in Central London are supported by robust levels of rental growth and investment demand particularly from overseas investors. Development starts in the first half of 2015 were at the second highest level for 20 years yet there is little immediate prospect of oversupply and falling rental values. New office space of 4.4 million sq ft has to be seen in the context of take-up of 15 million sq ft in 2014 and low availability rates. In addition since 2002 development completions have averaged 4.7 million sq ft a year.
Could any outside threats severely damage investor or occupier sentiment and trigger a collapse in London’s commercial property prices?
The Greek crisis has dominated headlines in the financial markets. As a result, gilt yields have been volatile over the past month and have risen by 46bps since the end of March. As yet there are few signs of an adverse impact on consumer and nonfinancial business sentiment.
The first round of public expenditure cuts after the 2010 General Election seem to have contributed to the ill balanced nature of the UK’s economic recovery. The latest figures available for regional and sub-regional economic activity show that between 2007 and 2013 only London and the South East have enjoyed growth greater than the UK average.
The recent Treasury announcement of £20 billion of cuts required from non-protected Whitehall Departments as well as £12 billion of welfare savings is likely to further slow growth in the regions. London, however, as the only global rival city to New York is unlikely to feel the chill wind of austerity.
Arguably these events because they have long been known about have already been priced in or discounted as having little impact on the pricing of Central London property.
Two further categories of risk need consideration. The first being the possibility of the UK voluntarily leaving the EU and the second being Donald Rumsfeld’s “unknown unknowns”.
Deregulation of Britain’s financial markets just as new European rules made it possible for firms based in London to do business anywhere in the EU attracted foreign firms to London in the early 1990s. This makes the prospect of “Brexit” especially worrisome to London’s economy.
The biggest fear is that firms based in London will lose their rights to do business throughout the EU while being supervised only by British regulators. In theory, a departing Britain might negotiate a treaty with Europe which retained such privileges but this is highly unlikely as France and Germany would seek to grow Paris and Frankfurt as rivals to London.
In the worst-case scenario, Britain would have to negotiate access for its financial firms country by country. EU regulators would seek to limit the flow of money to an offshore financial centre. Pressure would be placed on European fund managers funds to manage their investments within the bloc.
Employees already complain about the difficulty of arranging work permits for migrants from outside the EU. After Brexit new immigration rules are likely to strip current and future European employees, of which London has many, of the right to work in Britain.
Advocates of Brexit talk up the advantages of escaping from European rules on finance, in particular the cap on bankers’ pay. In the wake of the financial crisis Britain has moved far away from “light touch” regulation and, if anything, has stricter regulation than required by Brussels.
London’s ability to adapt would be tested by a shock as deep as Brexit. For the moment, however, polls suggest that Britain will opt to remain in the EU. Businesses are unlikely to start shifting functions as long as that remains the case. But there are already reports of firms delaying opening a London office until after the referendum.
At the start of 2007 collateralised debt obligations and residential mortgage backed securities were many property fund managers equivalent of “unknown unknowns”. In earlier cycles in the 1970’s, 80’s and 90’s rental growth was driven by macro-economic movements. Yields contracted as rental value growth swung up and expanded as rental value growth slowed.
The property boom of 2003-2006 and the associated crash of 2007-2009 was the first recorded property cycle which exhibited major yield movements without any associated signal from the economy or rental growth (see Chart 1). The onset of the crash was not caused by an economic downturn but by a crisis of confidence and a withdrawal of liquidity.
Rising interest rates caused the housing market in the USA to turn down in 2007 and exposed fragilities in the financial system. The financial engineering that pooled bundles of low quality loans did not provide investors with the promised protection. Mortgage-backed securities slumped in value and supposedly safe CDOs turned out to be worthless, despite the ratings agencies’ seal of approval.
Eventually, banks started questioning the viability of their counterparties. They and other sources of wholesale funding began to withhold short-term credit, causing those most reliant on it, such as Northern Rock, to founder. From September 2007 banks began to withdraw new credit from the commercial real estate sector and net investment fell sharply. By the end of the year UK All Property capital values were down 11% and by the end of March 2008 they were off 15%. The “known” risks from a declining economy and decreasing rental value growth, however, continued on an upwards trajectory as rental values grew at an annualised rate of almost 4% until the onset of recession in June 2008.
Although good opportunities always exist in Central London, commercial real estate is fully valued but supported by market fundamentals. Known risks appear to have been discounted. The real risks are the unknown consequences of “Brexit”; or something totally out of left field.