Market view: a tale of two cities?
The London property market has seen a resurgence in investor interest over the last 12 months which has driven up the prices and driven down yields. In a market with prices at or near historic highs and yields historic lows, is there any value left in the market for investors?
To answer this question we must first think about the London property market in context of other assets and in relation to its prospects relative to property markets in other parts of the country.
Yield compression is not unique to the property market - it has been seen across many other asset markets, most notably fixed income. This is very much a global phenomenon with investors favouring higher income producing assets to equities. As a result property prices, while perhaps high in comparison to recent history may be fairly priced compared to other assets.
One key trend which has been observed over the last few years has been the narrowing of the margin between the yields on riskier assets and the less risky assets. Whether it is emerging market debt, corporate bonds or the prices paid for retail shop units investors are being rewarded less for the extra risks associated with these assets. For property markets as a whole this suggests that rather than the entire market being overpriced it is largely the secondary end of the market where prices are stretched.
The London economy is big - in terms of its GDP it generates more wealth than the entire Irish, Norwegian or Danish economies. London is the leading financial centre in Europe, handling 31% of global currency transactions in 2005 with more US dollars traded in London than New York, and more euros traded there than every other city in Europe combined.
With a greater-than-average exposure to the service sector London tends to be more cyclical than the rest of the UK. With 2005 appearing to have been the low point of the last economic cycle and growth on an upward track, we might therefore expect London to benefit more than the rest of the country.
ut London is not one property market: it is a collection of a number of discrete markets each with their own character. By value residential property dominates the London property market with the value of the total stock approaching £1,000bn (€1,492bn). However the vast majority of this is tied up in owner occupation with the investable market concentrated on offices and retail located in the core areas of the City and West End.
In the office market prime rents in the supply-constrained West End have moved ahead sharply with £80ft2 (€1,284/m2) recently achieved at Curzon Square. Investor demand has driven prices up with a number of recent deals completed at yields of 4% or lower. With rents at this level, it is likely that a number of tenants rethink their space requirements with a likely beneficial impact on demand in peripheral areas and for lower quality accommodation.
In the City office market, strong demand and limited availability suggest that short term prospects for rental growth are good. IPD reported that the rental growth in the City is at its highest for five years, and prime rents of £60ft2 have been achieved at Moor House and 99 Bishopsgate, albeit on VAT-exempt properties. Yields in the investment market have fallen to around 4.5%, but with interest rates having recently increased there is little scope for further yield compression in this market. In the medium-term an outward shift in yields is anticipated.
A key determinant of the performance of the London property market is the development cycle. Nowhere is this more evident than in the City office market where rental cycles have been exacerbated by the repeated mismatch between demand and supply. Unfortunately this may be happening again with development completions over the next three years expected to exceed that of any three-year period since 1992. One area of potential opportunity in the City is the rapidly changing retail and leisure sector. The last decade has seen a dramatic improvement in the retail and leisure offerings in the City but there is significant room for further improvement as rents remain at a significant discount to other locations.
In the retail sector, record rents are also already being paid, eg, £500 psf in Bond Street and Covent Garden. While much of this is underpinned by strong employment and earnings growth, high oil prices and tourism play a significant role in this market. Looking forward west London faces the threat from substantial new supply, in the form of the 1.6mft2 shopping centre in the White City district. This is likely to impact on retailer demand and rental growth prospects in a number of west London retail markets with Oxford Street expected to be the worst affected.
Low interest rates and a healthy economy have underpinned an unprecedented 10 consecutive years of positive house price growth in London. Despite this, the last four years have seen London underperforming the UK. Looking to the future, faster wage growth, substantial net inward migration and increasing institutional demand suggest that residential investments in London could be a strong performer over the next few years, with longer-term prospects particularly resilient.
ondon's industrial sector is another area which might offer good value for investors over the next few years. Despite investment yields falling to the lowest level recorded, this still represents the lowest value land use in a market where space is limited and competition from other uses is intense. Many investors have already realised significant profits as a result of change of use which has kept the industrial vacancy rate in London well below that of the rest of the UK. This should result in better rental growth over the next few years, although the degree to which yields can stay at their current low levels is less certain.
Within the confines of these broad trends there will inevitably be a number of micro locations which will benefit from stronger than average value and rental growth. Included in these may be locations such as Kings Cross, Paddington, Stratford and the South Bank, all of which have seen or are experiencing significant infrastructure improvements and a transformation of their living, working and shopping environment. These areas may see some of the strongest performance across all sectors of the property market over the coming years.
Docklands, Hammersmith, Paddington and most recently Kings Cross are now established or are emerging. In the short term these locations may offer better value than the core West End and City as they offer significant cost advantages.
Mark Long is director of investment strategy and research, Invista Real Estate IM in London, the company created following the extraction and IPO of Insight Investment's property fund management business