The property renaissance started in London's West End; the question now is when will it end? Office rents have been rising, but capital values have risen faster still, and yield compression has taken yields back to pre-crash lows seen in 2007.
Conventional wisdom suggests that this part of the real estate market is fast approaching its apogee. However, the current climate stands conventional wisdom on its head for a number of reasons. The UK economy has been pump primed with hundreds of billions of pounds through quantitative easing, a tactic never employed before on such a scale. Interest rates have been held at nominal levels for more than half a decade, prompting institutional funds to seek alternative investments. And overseas investors, notably those in up-and-coming affluent parts of the world, and those in troubled areas, have been seeking a relatively safe parking lot that delivers at least some return. We also have a rapidly recovering economy. These provide the ingredients sufficient to justify continuing the current status quo.
However, the big real estate companies are already starting to pencil in a date after which asset management becomes more heavily weighted than the more risky development side. Land Securities (LAND), for example, still has plans to build another 2m square feet of space by 2016, but the development cupboard looks pretty bare after that.
Perhaps the next area of uncertainty that might colour sentiment is the run-up to the general election in 2015. Little is expected to change if the current administration is re-elected. There are worries that a Labour win might pave the way for some type of legislation principally to raise nominal sums of money and pay lip service to calls for greater controls. These worries we believe to be largely groundless, but there is no way of preventing such thoughts from affecting sentiment. The second area of concern is interest rates. Higher rates in themselves pose little threat to the glitzy offices and retail outlets in the West End. However, at some point, gilt-edged investments will start to offer a more than nominal return, and this could affect the inflow of funds into the sector. There also remains the risk that even without higher interest rates, continuing yield compression pushes returns below those offered in the bond market.
But for the time being, the reality is that there is not enough office space to accommodate demand generated by the economic recovery and, more importantly, there is a limited supply coming onto the market. A lot of the buildings in the West End are under some sort of restriction or listing that limits the scope for new build and to a lesser extent refurbishment. There is currently 1.9m sq ft of speculative space under construction, but only 600,000 sq ft is scheduled for delivery this year, which means that supply levels will remain tight.
So there will come a point where prospective clients will have to look elsewhere. The shift will be encouraged by regeneration of areas previously ignored; Battersea Power Station is a good example. For now, though, the limited development pipeline is being eagerly snapped up, with potential customers starting the search for new or bigger premises as much as two years in advance of their current lease expiring.
And when the development pipeline slows to a trickle, landlords will see their bargaining power increase on raising rents. Indeed, as leases expire, landlords will be able to cystalise reversionary gains built up as old rental agreements are replaced with new and higher ones. This will help to offset what might be a levelling off in the meteoric rise in capital values since the credit crunch.
| Company | Share price (p) | Div Yield (%) | Premium to NAV (%) | Gearing (%) |
| British Land | 716 | 3.8 | -6 | 69 |
| Derwent London (DLN) | 2,744 | 1.3 | 11 | 40 |
| Great Portland Estates (GPOR) | 659 | 1.3 | 6 | 30 |
| Helical Bar (HLC) | 363 | 1.9 | 1 | 92 |
| Land Securities | 1077 | 2.9 | -1 | 40 |
| McKay Securities | 223 | 3.9 | -1 | 21 |
| Safestore (SAFE) | 216 | 2.7 | -5 | 111 |
| Workspace | 635 | 1.7 | 10 | 47 |
Source: S&P Capital IQ
Two obvious migration points from the West End are central London and Canary Wharf. It has been suggested that a good way to gauge the investment climate in the City is to count the number of cranes in action. During a quick walk across Southwark Bridge, I counted 25. The metrics are slightly different here though because there is still a significant amount of office space tucked away behind the glitzy façade of areas such as Broad Street that has yet to be revitalised. As a result, the scope for rental uplifts is perhaps a little more sensitive. Rents in the Square Mile always seem to hit a barrier, because after a point prospective tenants simply look for office space further outside the city rather than paying up. Oddly, rents in the City are now less than some of the surrounding areas. But there is a steady influx of prospective tenants, notably from the IT sector. And as surrounding areas develop, the scope for rental growth in the City still improves, not least because of the availability of developed space, which, in the first quarter of this year was down 17 per cent from a year earlier.
One example of how the area is being developed is an office block in Wilson Street being refurbished by McKay Securities (MCKS). It has yet to secure a tenant, or tenants if the floors are let separately. But from around £240,000 rental income before refurbishment, estimated rental value when fully let is £400,000. And with transport connections improving significantly thanks to Crossrail, areas relatively adjacent that two years ago would have been deemed unfashionable are now experiencing strong interest. Prime rents in Hammersmith, for example, are now hovering around £50 per square foot.
At Canary Wharf, Songbird Estates (SBD) owns about two-thirds of Canary Wharf Group, and over the years has transformed previously derelict docklands into 16m sq ft of retail and office space. And while the portfolio received a £212m valuation uplift in 2012, last year it rose by £856m boosting the underlying book value (NAV) by an astonishing 38 per cent. On top of this, there is a development pipeline of 11m sq ft, the largest of any London developer.
FAVOURITES
Companies operating in areas with more room for expansion offer the best growth prospects. None sticks out more than Workspace (WRK) which offers space to small and medium-sized enterprises. Transport links have opened up new areas that customers might not have considered moving to before, and this has had a dramatic impact on valuations. In fact, book value last year rose by an exceptional 43 per cent. Like-for-like rental values also grew by 12 per cent, and the company has even booked a useful profit from selling off land for residential development.
OUTSIDERS
Picking an outsider in a market that is growing at an almost unprecedented rate is not easy. You might want to argue that some real estate companies currently offer a pretty modest dividend yield (see table), while others may be les favoured for their high level of gearing. But both of these can and will be addressed before there is more than a hint of the market levelling off.
