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Capital returns

Soaring prices might suggest it's too late to make money from investing in London property - that's not the case, argues Jonas Crosland, and there are bumper returns to be had in other global capital cities, too
July 17, 2015

Investing in London, or more specifically, investing in London property now might look like a case of missing the boat, given the meteoric rise in capital values over the last couple of years. So, is property in London approaching an apogee in valuation terms? Never say never, but it is an axiom of the real estate market that returns remain attractive as long as there is decent economic growth. In that case, given the recovering economy, there is probably more to come in the way of capital appreciation and rising rental income.

There are two key factors to consider. The first is that the London property market has been distorted to some extent by a prolonged period of low interest rates. These will rise at some point, but no-one is looking for a meaningful increase for at least a year or two. And even when they do, property as an investment asset will continue to have its attractions, particularly as real estate investment trusts (Reits) build up their revenue stream from rents and distribute it through attractive dividends. What’s attractive? Shifting through the list of Reits, you can find yields of up to 6 per cent; that’s attractive.

The second key point is that real estate companies have taken on board some tough lessons from the financial turmoil that started in 2007. There were two principal areas of heartache; debt and development. Given that few were lucky enough to spot the downturn, companies were left with highly leveraged development schemes that suddenly became hard - if not impossible - to let. Valuations started to fall, and banking covenants on the loans started to creak. This time, not only are banks reluctant to lend on speculative developments that are not pre-let, but companies have adopted a much more cautious stance to gearing, even though it is tempting to push the debt pile higher because the loan-to-value ratio is kept to acceptable levels as capital values rise.

There is another reason why interest rates are important. Low rates increase the attraction of real estate as investors steer away from fixed-interest investments in search of a decent return. Global developments have also provided a steady stream of overseas investors keen to escape localised political volatility, the occasional war and financial constraints. A high-quality asset in London has now become close to a reserve currency.

 

Residential

In the residential property market, where currently there are 30 potential buyers for every property on the market and priced at over £2m in Kensington and Chelsea, according to boutique estate agency Patterson Bowe. However, potential buyers and completed sales are two very different animals. The idea that the buyers will remain in play came after the result of the general election, which effectively ruled out any mansion tax. In 2014, flats in central London rose by nearly 20 per cent, but since then though, the picture has become more clouded, with prices in the first quarter of 2015 falling by nearly 16 per cent. And it remains to be seen how much of this will be recouped now that the election is out of the way. According to online estate agent eMoov, demand (not prices) in prime central London fell by 3 per cent in May, although some areas still showed an increase.

In the rarefied atmosphere of Chelsea and Kensington, the economic effects of what happens in the real world are that much less pronounced than elsewhere. Apart from the fact that these two boroughs attract interest from the seriously well heeled, demand is underpinned by the chronic lack of new construction. And even gaining planning consent for a major refurbishment is not easy. The second factor is demand, notably from overseas buyers. Nearly all of these are cash buyers, so lending restrictions imposed on lenders become academic. Cyclical trends will see capital values vary, but in the long term these two boroughs are as near to being as safe as houses as you can get.

Even outside these areas, but still within walking distance of central London, the gentrification of such previously avoided places such as Bethnal Green Road, and, further out, Hackney and Stratford are now seeing developers such as Telford Homes (TEF) selling apartments off-plan, years before anyone can move in or rent out. And for those operating on a buy-to-let basis, rising capital values may have compressed yields, but rental income remains strong. Rents in Greater London rose 10.7 per cent (on new lettings) in the year to May, and jumped 2.4 per cent in May from April. At an average of £1,500 per month, London rents are currently double what they are in the rest of the UK.

So why is there a queue of potential renters willing to pay such high prices? Part of this is explained by changes in social trends; the Manhattan effect is a prime example, where people are more relaxed about living near to where they work. Leisure time increases, while blood pressure, in the absence of being humiliated by having to commute on Britain's decrepit and expensive rail network, stays at acceptable levels. However, there is some argument warning against the risks of superdensity. This is designated as having over 350 dwellings per hectare generated by building tower blocks. The worry is that pushing people into the clouds and away from the vibrancy of the social ‘buzz’ generated at street level will weaken the attractions of working close to town. Time will tell, but the first residential schemes in Canary Wharf have found no shortage of interest.

 

Offices

It comes as little surprise that the London office market has also operated very differently to the rest of the country. And even within London, there are two distinct markets; the West End and everywhere else. In general, demand for office space is again a product of economic wellbeing. And it’s not unnatural to see workers inclining towards those areas that offer the highest paid jobs. This trend seems unlikely to change any time soon. In fact, the regeneration of such areas as Docklands and Tower Hamlets, and the construction of residential towers in Southwark and Lambeth will only go some way towards accommodating a rising London population.

It’s interesting to note that London’s population peaked at 8.6m in 1939. After the war, industrial-related jobs declined and people moved out to the ‘new towns’. But this trend has been reversed, and in February this year that 1939 peak was surpassed for the first time. Estimates suggest that from 8.6m, the population in London will grow to 11m by 2050. That’s a lot of jobs to find and a lot more offices.

Office demand driven by a recent 3.6 per cent rise employment in London, a trend that is expected to register annual gains of 2.2 per cent for the next five years. In a normal world, this would see office development accelerate to meet this demand, but the residual effects of the financial crash have constrained the availability of development finance. And while the take up in office space last year was significantly above trend at 15m square feet, there will remain an acute supply/demand imbalance for some time yet. Crucially, many of the real-estate operators in London, such as British Land (BLND), have largely completed a string of developments started in 2010, and speculative development is now further down the pecking order. Plenty of construction is still under way, but a good part of this is either pre-let or residential.

The other way of boosting rental income is through refurbishment of existing buildings. This is virtually ‘de rigueur’ in the West End, where a bulk of the office stock is housed in buildings with some form of listed status. Financing such developments can be helped along by capital recycling. One chief executive told me that he would rarely hesitate to sell a building that he considered was too expensive to buy. But while the shortage of space remains an issue, rental values will rise. Office rents in May rose by 1 per cent in the City of London and by 1.7 per cent in the West End. That means that over the past year, a weighted average of City and West End rental values rose by 13 per cent. However, adjusting for inflation shows that all-property rental values are still 7 per cent below their pre-recession highs, which suggests that there is plenty of room for further increases.

Inevitably, as transport links show belated signs of starting to improve, so it has been possible to provide office space a little further out; Canary Wharf is a prime example. Songbird Estates, recently acquired by its majority shareholders, has an 11m development pipeline, half of which is adjacent to the existing offices, and this will include a large chunk of office space. Property developers have also kept a keen eye on properties ideally placed to take advantage of new transport links such as Crossrail. Derwent London (DLN) recently bought a site in Farringdon Road, just along from where the new Crossrail station will be sited.

 

Commercial

Investment in central London commercial property is on target to reach record levels, with volume in the first half of 2015 reaching £9.4bn. That figure has only been topped twice before – in 2004 and 2007 – and the first half comfortably exceeds the £6.1bn invested in the first half of 2013 in what went on to be a record-breaking year. Investment so far include Taiwanese Cathay Life Insurance’s acquisition of the Walbrook building near the Bank of England for £575m, the biggest single property purchase so far this year.

As well as an array of international investors looking to put funds to work, demand for space in and around London brings together an array of potential buyers looking for office space and residential sites. But there is also a growing demand for commercial space, underpinned by a steady increase in the number of small and medium sized enterprises. Small companies employing a handful of people need decent office space without all the hassle involved with buying outright. Companies such as Workspace (WKP) endeavour to provide an all inclusive working environment for small start-ups. It sound obvious, but providing such facilities as meeting rooms social areas, catering, safe cycle storage and the latest in communications are fairly recent innovations, and a long way from the non-bespoke offerings under railway arches. Its progress in recent years has been impressive; in the year to March 2014, the group’s net asset value jumped by a huge 43 per cent, followed up by a further 42 per cent jump in the year to 2015. Acquisition of new sites is usually followed by complete refurbishment after achieving total vacancy. Ideally, tenancies are kept fairly short, thus allowing the group to crystallise reversionary values on a fairly regular basis - in other words, put the rent up to keep pace with rising market rates.

The added attraction of acquiring new sites comes from the demand for residential use. This demand can be accommodated through striking up a deal with a housebuilder. In a typical agreement, Workspace secures planning consent, after which the housebuilder pays for the redevelopment and construction of new houses at no cost or risk to Workspace. In return, it secures a purpose built office complex built by the housebuilder on part of the redeveloped site.

Changes in consumer spending habits have provided another growth area in commercial property, as the high-street names look to centralise their distribution depots. The rise of click and collect, next-day home delivery and internet sales have prompted a root and branch reorganisation of the way that major retailers organise their distribution networks. Establishing these, close into London is even more vital, given the number of people living inside the M25 motorway ring. That change in consumer habits can be seen in the way that, over the past eight years, internet sales as a percentage of all retail sales have risen from less than 3 per cent to over 12 per cent.

But the explosive rise in capital values brings its own challenges, or disposal dilemmas. The temptation to recycle assets and locking in a significant premium over the initial cost has to be limited, simply because replacing those assets is becoming more difficult, or specifically, more expensive. However, opportunities still exist, and LondonMetric (LMP) is achieving the ideal blend of high occupancy levels and long leases. The risk element is kept low enough to allow the directors sleep at night, with contracted developments largely pre-let, and the overall business model benefits from continued yield compression, growth in rental income and profits on asset disposals. Supply remains tight. New build is still falling from its 2006 peak, as is the supply of already constructed properties.

 

Retail/leisure

Any company with a foothold in the prime tourist areas in London should be on to a good thing. As well as being the largest city in Europe, London generates nearly a third of the UK’s GDP, attracting around 200m visits a year; that’s more than any other city in the western world.

Companies such as Shaftesbury (SHB), which owns a string of retail-focused sites – as well as a smattering of office and residential – are benefiting from the fact that space in around London’s tourist hotspots such as Carnaby Street, Chinatown, Covent Garden and Soho is very limited, and the ability to expand comes almost exclusively from redevelopment and refurbishment.

Some idea of the strong demand can be seen, in the case of Shaftesbury, from the fact that portfolio reversion, or the rental income if all properties were let at the current market rate, now stands at 29 per cent above current rental income. Demand is broad based, and the group’s portfolio stretches across shops, restaurants, cafés and pubs. Redeveloped sites don’t stay vacant for very long, and most are pre-let. The key tourist and visitor sites are already buzzing, but numbers will increase with the opening of Crossrail and before that, plans to run tube trains all through the night. Rising capital values have led to pronounced yield compression, with acquisitions made in the six months to March 2015 producing an average net initial yield of 2 per cent.

Existing property owners are also becoming more reluctant to sell their properties, given the strong rise in capital values. However, by refurbishing the properties acquired, Shaftesbury can benefit from charging much higher rents. Oiling the wheels of the planning process comes from supporting local council plans to upgrade streetscapes, and developments usually include an element of street improvements, such as pavements and lighting.

 

Student

Another side of the London property market that is sometimes overlooked is student accommodation. In the 2014-15 academic year the student intake for the country as a whole was over 500,000. And the cap has now been removed on overseas students, so the next academic year is expected to see a significant increase in student numbers, with some estimates suggesting an increase of 100,000. For the UK as a whole, investment in student housing passed £3.8bn in the first six months, and is set to reach a record £5.75bn by the year-end. Savvy investors have already recognised the investment potential here. GCP Student Living (DIGS), a real-estate investment trust (Reit) that invests in modern purpose-built student accommodation primarily in and around London, recently raised £120m through a placing and open offer that was substantially oversubscribed, despite the sum raised doubling the group’s market capitalisation. The funds will be used to finance the purchase of three additional sites to cater for the upswing in demand expected next year.

In broad terms, the companies involved are showing financial discipline, avoiding the temptation to adopt high leverage rates. What that implies is that the business model should be much more resilient to shocks.

Is it still worth investing in the companies that invest in the London real estate market, or are the publicly quoted shares now looking too expensive? The answer to both those questions should correlate tightly with your take on the general health of London’s economy. There will always be knocks that instil a note of uncertainty, although oddly enough, some of the global worries that occur outside the UK can, in many cases, encourage overseas investors to invest in London property, whether as a safe place to park funds or simply to benefit from capital growth and rental income. At some point, interest rates will start to rise, although from such a low base the initial effects will be minimal. At some point fixed income investments may regain some of their attraction, which could lead to the more cautious investor taking money out of the property sector. This is likely to be some way off however, and as long as the economic drive supports demand for more housing, more offices and more commercial space, which, at the same time, outstrips supply, then the London property market has some way to go.

 

Tired of London?

If you fancy investing in German real-estate, the current hotspot is Berlin, where a growing population is boosting demand for residential and office space. There are other attractions, too. The European Central Bank is keen to provide funds to boost the creation and growth in small companies, and the interest rates are extremely low, sometimes under 2 per cent.

Sirius Real Estate (SRE) operates primarily in Berlin and offers a mixture of storage space and office facilities for small companies. Recent acquisitions include five mixed-use business parks across Germany, and Sirius has shown its ability to increase rental income and reduce vacancy rates.

Summit Germany (SMTG) operates on much the same basis and, despite an explosive rate of growth since its flotation on Aim in February, the shares are still trading at a discount to forecast net asset value. On the residential side in Berlin, the picture is more complex because rents are regulated. This has reduced the attractions of build-to-rent and has led to a shortage of accommodation in a fast-expanding city. It also means that there is a considerable reversionary element waiting to be crystallised between the rents in place and the current market rate.

Phoenix Spree Deutschland (PSDL) is beginning to realise these gains as new tenancies become available. This is because an apartment that is completely refurbished can be rented out at the market rate. Indeed, market rates are around a third higher than ‘in place’ rents on the portfolio.

Looking a little further afield, property fund manager and investor First Property (FPO) has a number of assets in Poland and Romania as well as in the UK. Income is generated through its regulated subsidiary First Property Asset Management (FPAM), which earns fees from investing for third parties in properties in the UK and central Europe. It also has six directly owned properties in Poland and Romania and a further five in Poland held by a managed fund in which the group has a 76 per cent stake. In addition, it has non-controlling interests in four other funds managed by FPAM. When the earnings from six new property investments are included, the annualised recurring contribution to pre-tax profits will be around £9.5m. The company also paid a dividend in the year to March equivalent to a yield of 3.6 per cent.

It’s not plain sailing though. In Hungary, for example, a combination of spare capacity and a ban on Sunday trading will keep retailer demand depressed for the next year or two. Furthermore, there is still a large output gap in the economy, which suggests that it is unlikely to meet capacity constraints for some time yet. This, in turn, will limit wage growth and consumer spending. The property market in Switzerland is also expected to underperform other European countries. And with the rate of deflation starting to widen further, all-property rental values are expected to fall by 1.1 per cent this year, according to Capital Economics.

Yield-hungry investors in Japan have been putting funds into Japanese Reits, with demand stimulated by the introduction of the Nippon Individual Savings Account (NISA) at the start of 2015. The tax-break facility is designed to give Japanese retail investors incentive to move funds out of low-earning savings accounts, where cash returns are slowly eroding as inflation starts to rise. Just recently, the Tokyo Stock Exchange Reit index moved up to a 13-month high, having risen by 3 per cent so far this year. The return on forward dividend projections is 3.8 per cent; not all that exciting compared with London, but a positive gold mine when compared with the return on the Japanese 10-year bond of 0.6 per cent, and even the US benchmark 10-year yield of 2.6 per cent.

However, Reit portfolios with all the top quality property assets are less attractive because their popularity has cut their upside potential, with better value seen in second-tier Reits.

 

Istanbul: travel and property hotspot

Increasingly popular as one of the world’s hottest travel destinations, Turkey’s largest city of Istanbul is now welcoming huge numbers of foreign buyers to its property market.

The population of Turkey is at a record 77.7m and Istanbul is the country’s most populous city with 18.5 per cent of the population, according to the Turkish Statistical Institute (TurkStat).

Figures from TurkStat show a surge in overseas purchases in May 2015, with an increase of 56 per cent on the previous year. Istanbul property agency Universal 21 reports that much of this interest is coming from the Middle East, including Bahrain and Qatar (www.universal21.com/)

Istanbul was ranked 20th in PwC’s Emerging Trends in Real Estate Europe 2015 report (www.pwc.com/gx/en/asset-management/emerging-trends-real-estate/european-cities-investment-and-development.jhtml).

Turkey recently held a parliamentary election in which the ruling AK Party failed to win a majority. This came as a blow to Former Prime Minister Erdogan who was recently elected Turkey’s President.

Sam Vecht, manager of BlackRock Emerging Europe investment trust, which has a 22 per cent exposure to Turkey, said: “A decisive victory for the AK Party would have been viewed by Erdogan as a mandate to give his office extraordinary powers that would significantly change Turkish democracy and prolong his reign as the country’s most powerful politician. We hope that market weakness will not distract investors from the longer-term positive that emerges from this reaffirmation of the democratic process in Turkey.”

Flats in Istanbul can be picked up for £50,000, but if you don’t want to buy direct a number of companies offer investors access to Turkish real estate. However, many are unregulated so tread carefully. Last month Bloomberg reported that Turkey is seeking to boost international investment in its property market by allowing the creation of funds that can invest in development.

In the meantime, one option is The Ottoman Fund (OTM), a Jersey-based investment company that seeks to generate total returns by investing in real-estate projects in Turkey. However, it has posted large losses in recent months so tread carefully.

Moira O’Neill. The author owns a property in Istanbul.