Join our community of smart investors

The rise and rise of London property

The global appeal of London property investments makes the West-End landlords safe bets for tough times
January 10, 2013

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 Land Securities' vast development site around Victoria and Hammerson's City office portfolio. Overall, foreign investors accounted for three-quarters of the £13.6bn of office, shop and hotel purchases registered by brokerage Cushman & Wakefield last year.

"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.

NameMarket cap (£bn)Share price (p)Dividend yieldExpected book value per share (p)*Premium/discountLoan-to-value ratioExpected NAV growth*
Derwent2.252,2051.4%187717%31%6.5%
Great Portland1.694961.7%44112%35%6.1%
Shaftesbury1.425662.1%51310%31%3.9%
Workspace Group0.443082.9%335-8%41%7.5%
Capital & Counties1.852460.6%20123%24%10.9%

Source: S&P Capital IQ

*Jefferies estimates