Sentiment plays a powerful part in determining how the London property market performs, and while the most recent indications suggest that the initial post-referendum reaction and a subsequent devaluation of capital assets were both overdone, there is little sign of any perceptible recovery in sentiment.
This is frustrating because tapping the view at the coal face suggests that the business climate is better than the overall gloomy scenario suggests. Investors dislike uncertainty, and no one in their right mind would put money on how the UK exit from the EU will develop; even the timescale is an unknown factor. So, suggesting that 2017 will be difficult but that conditions will improve in 2018 has too much of a guesswork feel about it, although historically some improvement in the real estate sector usually starts to show through after a couple of years in the doldrums.
For the London commercial market there are several contrasting influences to take into account when trying to make a decent stab at where the market is going. Perhaps the most important is the health of the economy. Here we can take some comfort from the fact that initial fears of a slide into recession - as defined by two successive quarters of negative growth - appear to have abated, although it would be unwise to rule this out altogether. And while the economy continues to grow, the rate of growth is expected to slow significantly in the year ahead. In this year's Autumn Statement, the Office for Budget Responsibility cut its GDP forecast for 2017 from 2.2 per cent to 1.4 per cent.
The second major factor, and again, this is just one big unknown, is how leaving the EU will affect the financial sector. At least, that is the major worry on some minds because abolition of passport rights that enable financial institutions to trade without barriers across the EU could prompt some banks to set up their main operation within the EU. And the cracks are already starting to show through, with Lloyd's of London planning to move part of its operation to within the EU to protect the 11 per cent of group revenue that it generates there. The problem here is that banks would require at least a year to switch operations elsewhere, and may be tempted to start the process before any outcome to the exit negotiations. But given that all EU members would have to vote in favour of whatever deal is finally mapped out, the chances of an early resolution seem remote. However, a hard exit could put up to 100,000 London-based jobs at risk, and given that offices and retail property are the two biggest subsectors of the commercial property market, that doesn't leave a lot to invest in.
However, other sectors, notably technology-related companies, are moving into London, while the City of London itself has attracted some interest from companies squeezed out of the West End market where a shortage of space has underpinned rents. There are other bright spots: Apple has signed up on 500,000 sq ft of space in Battersea Power Station, while Google is going ahead with a new headquarters at King's Cross. The other factor that could play into the sector's favour is the fall-off in development. Speculative development is strictly off the menu for the time being, and while some developments already started are likely to proceed, property companies could adopt a much more cautious approach to new developments.
At British Land (BLND), for example, the construction programme is less than 5 per cent of the portfolio value, but it remains committed to starting the 520,000 sq ft site at 100 Liverpool Street at Broadgate. This should still attract interest, sitting as it does on the Crossrail route due to open in 2018. Land Securities (LAND) is entering the final phase of its £2.2bn development programme in London, all of which is pre-let with the exception of its development at Victoria, due to complete early in 2017. Vacancy rates are low by historic standards, but despite the downsizing of development plans there is still plenty of new supply already in the pipeline. As well as those already mentioned, Derwent London (DLN) has 400,000 sq ft in Paddington and Fitzrovia under development while Axa is proceeding with the 1.3m sq ft tower in Bishopsgate. Adding all these together, and drawing on Deloitte's London Office Crane Survey, shows that office construction in the past six months actually grew by 4 per cent to 14.8m sq ft, the highest for eight years. Of this, nearly half of the let space under construction has been leased by financial sector businesses including a number of international banks. However, the momentum is slowing on construction, and whereas the peak was forecast to come in 2018, delays and postponements suggest that peak construction will be not be reached until 2019-20.
With yield compression also off the menu, the growth baton passes convincingly to building a revenue stream from rental income. Longer leases offer greater earnings visibility, and some companies are prepared to negotiate slightly lower levels of rent in exchange for a longer lease commitment. However, new leases are still being secured at levels above previously estimated rental values, and occupancy levels remain high.
This may not last, though. Inflation is expected to rise significantly in 2017, but this is not demand-pull inflation, which is commensurate with strong economic growth and occupier demand; this is cost-push inflation caused by sterling's weakness, which will erode real wages and consumer spending power. This is bad news for the retail sector as represented on the high street, already facing the growing trend towards online shopping.
IC VIEW:
The biggest worry for London landlords is tenant demand. This, in turn, depends on how well the economy performs, which is itself directly influenced by the outcome of EU negotiations and consumer sentiment. That's a messy and highly unstable string of imponderables which suggests that investors might be tempted to give the sector a miss, although current valuations are already discounting some pretty bad news that may not happen. Meanwhile, most real estate companies will batten down the hatches and rely on rental income to keep the show running, while at the same time slowing or postponing new developments. Gearing this time around is not so much of a problem as it was following the financial crash, and valuations would have to halve before covenants came under pressure. That's unlikely to happen, but with yield compression at an end and rental growth slowing, there will only be selective opportunities that merit a second look.
Favourites
Perhaps one of the brighter spots is at the other end of the office market, inhabited by small- and medium-sized enterprises (SMEs). Space has always been at a premium for start-ups, and Workspace (WKP) has done well to tap into this demand by providing purpose-built accommodation complete with all the extras such as community areas, catering and WiFi. It also de-risks development by acquiring a potential site and then selling it to a housebuilder. In return, the housebuilder carries out all the construction work, including a new block which it gives back to Workspace.
Outsiders
Capital & Counties (CAPC) remains on course to achieve its estimated rental value target of £100m on its Covent Garden portfolio, but its Earl's Court exposure is likely to remain a drag. Sales rates of apartments have continued to slow to little more than a trickle, and while prices have held up well, it may need to reduce prices to accelerate sales. Financially, CapCo is relatively secure, with a modest 20 per cent loan-to-value ratio. But given its exposure to the higher end of the London residential market, there's better value to be found elsewhere.
