Sector Focus
Last year was London's year for property as well as for sports and pageantry. Even as the IPD index for commercial property valuations showed consistent declines, West End real-estate companies posted high single-digit portfolio growth. Their shares performed even more strongly, in some cases rallying to within a whisker of their 2007 peaks. For the capital, it is almost as if the 2008-09 property crash never happened.
Or is it? Some investors might be inclined to take profits, on the basis that the optimism surrounding London property seems at odds with the broader economic environment, which ultimately drives commercial property needs. Indeed, that's the case we made for the wider UK commercial property sector back in September.
Yet we're inclined to be more bullish on the pure West End players. Share prices are unlikely to make the kind of exceptional gains they did last year, because they already trade substantially above book values. But there's no reason why book values cannot continue to grow at last year's rate, rewarding patient investors over a three-year holding period.
The main reason London property has been booming has been the unparalleled level of interest from overseas investors, particularly big pension funds. This theme is as true of the commercial markets as of the housing sector, which tends to receive more press attention. A Malaysian consortium bought Battersea Power station last June, but Malaysian investors also bought offices such as 10 Gresham St in the City and are rumoured to be bidding for an £800m business park in Chiswick currently being sold by US private equity group Blackstone.
Meanwhile, the Chinese sovereign wealth fund made its maiden London property investment last year, snapping up the UK headquarters of Deutsche Bank in the City. Canadians have also been active, notably buying half of
"Malaysia and Canada have got something the UK doesn't - fully funded pension schemes," points out Neil Blake, head of research for Europe and the Middle East at property brokerage CBRE. "They've got so big they need to diversify abroad, and they pick London because it has historically been the place everyone invests, and also because it's not in the eurozone."
The result is an extremely tight market, with demand outweighing supply by about four times. Property rental yields have therefore continued to fall, even though they are low by historical standards. Some worry that they have reached speculative levels, while bulls point out that the gap between real estate and bond yields is almost as wide as it was in the darkest days of 2009.
We side with the bulls on this occasion. There is little evidence that London commercial property is in bubble territory. The wall of money arriving from abroad looks a pretty sturdy one - shored up by growth in emerging markets as well as more temporary factors such as negative sentiment towards the eurozone. It is not like the 'hot' retail money that flowed into the sector through open-ended funds in 2006, only to flow out again in 2008 - pension and sovereign wealth funds have very long investment horizons. It seems perfectly possible that West End property yields could fall marginally this year, as they did in 2012.
It is more sensible to worry about bond yields: when they start to rise again, global investors will find other assets more attractive than London property. Yet when that eventually happens - after many false sunsets - it will signal a recovery that should also be reflected in rents.
These are currently stable in the core office markets of Mayfair, St James's and the City - which appeal to financial services - and growing by about 4 per cent in gentrifying areas such as Victoria, Fitzrovia and Paddington, mainly thanks to strong demand from technology companies that like slightly edgier locations. But rents are hardly high by historical standards. Office costs in the 1970s accounted for about 30 per cent of total costs; now that share is less than 5 per cent. That suggests there's plenty of scope for growth when the business services occupiers that have traditionally driven the London office market start expanding again.
Since commercial property values are a function of both rents and yields, London - and particularly the West End - looks like a rare two-way bet that should perform whether inflation or deflation is the sentiment of the month. That's why it appeals to big long-term investors from across the world, who can buy property directly. Private investors don't have that option, but fortunately the three listed real-estate investment trusts with West-End portfolios offer well-established proxies, albeit pricey ones. We profile them below, alongside two relative newcomers.
Five plays on London
The refurbishment drill is currently under way on five sites, with an expected profit on cost averaging 42.5 per cent. It also has a number of larger development projects in the pipeline near future CrossRail stations, notably a huge site between Hanover Square and Bond Street tube station and the old Royal Mail depot on down-at-heel Rathbone Place, near Tottenham Court Road.
One problem with investing in the three West-End specialists is that they almost always look expensive relative to historic book value. Those that prefer the grubbier business of value-hunting - as we tend to at Investors Chronicle - should look at
Finally,
BROKER VIEW:
Last year was an unusual year for the real-estate sector - not least because of the huge divergence between the performance of the stocks and the assets that underpin them. Less surprising was that the London specialists led this rise. A shortage of supply of property - most acute in the West End office, retail and residential sectors - coincided with continued investment in assets by sovereign wealth funds and ultra-high-net-worth individuals.
Of the three central London specialists, Shaftesbury remains the long-term value store, thanks to its eye-of-the-dartboard portfolio. Although the company is forced to pay well in excess of its cost of debt for new property, it has long since proven the success of its strategy.
The huge share price rises for Derwent London and Great Portland Estates last year (35 per cent and 51 per cent, respectively) perhaps indicate greater appetite for risk-taking among equity investors, since the average development size at both companies has increased markedly over recent years. We rate both companies highly, but prefer Great Portland because of valuation, the proximity of numerous developments to CrossRail stations and its readiness to expand following last year's equity raise.
Capital & Counties offers the prospect of a mega-development around Earls Court, but this still accounts for less than half the asset base. Returns are just too far off for us to get excited when the shares trade at close to a 30 per cent premium to expected book value.
Workspace has at last enjoyed a share re-rating, helped by the de-gearing of the balance sheet and clearer communication of strategy. A balanced refurbishment and redevelopment programme will deliver new space for a tenant base of vibrant small businesses. In our view, Workspace can benefit from this, and should perform strongly as long as the wider London economy continues to grow in 2013.
John Cahill is a property analyst at Investec Securities
visible-status-Standard story-url-SectorFocus_LondonProperty_080113.xml
