Settle only for the best
London's status as a mature, developed, transparent property market makes it a core component of any institutional investor's real estate portfolio; its role as a world financial centre underpins the importance of its real estate market. But the attractions of its real estate market spread wider than the offices of the City of London.
"London is like Hong Kong, New York and DC," says Steve Laposa, director, global strategic real estate research at PricewaterhouseCoopers. "These are cities which always float to the top as favoured markets to invest in. You put a portion of your investment there. It's pricey and you know that the yields will be lower yields than those found in Istanbul or Moscow."
London differs from other key European cities in its size, transparency, volatility and the breadth of research that has been undertaken into its property market. "In the UK the pattern of rental growth is in a different phase from the rest of Europe," says Alan Mooney, head of UK research and strategy at AXA REIM. "That goes for the economy as well, and it therefore provides diversification."
But London also experiences greater volatility than other cities, with greater highs and lows, which has its advantages and disadvantages.
"In Europe the rental growth cycles are shallower compared with central London offices," Mooney adds. "There growth might be 2% one year 1% the next, with highs of 3% or low to -1%, whereas in central London growth might be 12% one year or -6% or -7% two or three years later."
Rob Bingen, senior portfolio manager at ABP, the Dutch pension fund for civil servants, points to the impact of the financial markets on some London real estate. "The City is where you find most office space. Because of its sensitivity to the financial markets the impact of downturns tends to be a bit larger than in some other markets. Paris has a more diverse base of space users. More comparable [with London] in terms of sensitivity would be Frankfurt which is very financial driven."
Factors which play heavily in the London market are limited supplies of properties and strict planning controls, which limit development and therefore boost rental growth.
Mn Services runs the portfolio for the Dutch metalworkers' pension fund and 12 other pension funds, with total real estate assets under management of €3.5bn. Bas van den Ijssel, its senior fund manager for Europe, says that the liquidity of the London market makes exiting easy: "Because it's so liquid there is always someone who wants to buy your property."
The size of the market is also attractive to investors: being bigger than other European cities it boasts a greater volume of properties, in a variety of sectors. European institutions are also drawn to its transparency.
"People can place more credence in UK valuations," says Mooney. "There is a lot of research on the market; there is a lot of performance measurement, which is not necessarily the case in other markets."
However London property is not without its drawbacks. The very qualities which make it attractive - its liquidity and transparency - could be turned around as an argument against it as well.
"That transparency and ease of access and the language make it a place where in a period of growth foreigners in the first instance will move to," says Bingen. "It's much easier for … investors starting in Europe to choose London rather than Italy, for instance. On that basis when there is growth, people tend to move into London. We are seeing this at the moment, a lot of foreign investors are coming into the market, pushing up prices."
Bingen also sees some dangers in the current state of the market, where the volume of money chasing limited investment opportunities has driven down yields.
"If you focus on London, if you buy core properties, you are looking at initial yields of 4.5% for the prime product," he says. "That means you are underwriting this based on meaningful rental growth, which is expected by the analysts but still has to be proven, so if you invest in the market now you are de facto paying for that expected rental growth. That is a more risky investment proposition."
For Mn Services the high prices and low yields loom largest as downsides of investment in London. But those considerations aside, Van den Ijssel points to the UK tax system, which he claims discriminates against foreign investors who invest opportunistically with a view to making short-term gains.
"For tax reasons that is not favourable, because then you are seen as a trader and you are taxed more highly," he says. "That's why you have to have the intention to keep investments for a longer period. But in the development period you make higher returns than you do when you have an institutional product and you keep it. Because we are investing in opportunistic funds we prefer to invest in the part of the process which produces the highest returns."
In accessing the London market ABP uses two routes: by investing in pan European funds, which have exposure to London, and secondly through funds that specifically focus on London itself or the city as part of a wider UK strategy.
Though Bingen's interest in London property primarily centres on the office market, other segments also figure - and not just the retail and industrial real estate, but also the less mainstream assets, such as student housing, assisted living accommodation or hotels or indeed residential - though they have none at the moment.
ABP is not investing in London to the same extent that it has done in the past. The difference is that now Bingen is investing in opportunities as and when he sees them:
"For a market that may be less attractive than some other markets, on a micro level we still see opportunities," he explains. "We are somewhat opportunistic."
This is the strategy also followed by Mn Services. Van den IJssel chooses focused funds that target specific opportunities with growth potential, an example being its recent investment of £30m in a fund that focuses on central London offices. "We like funds to be very focused, regionally or sector specific," he says.
The fund is focused with an investment period of only 18 months. The fund is limited in this way because, as Van Ijssel explains: "The London office market is very volatile. If you want to play the cycle you have to be very focused."
One sector of the market Van den Ijssel avoids is logistics: "Logistics especially are priced too high for me," he says. "Yields are so low that it is very difficult for an opportunistic investor to get to our required returns. In the rest of Europe the yields from logistics are more interesting."
Denmark's ATP fund also favours the London real estate market, in particular the office sector. It invests through a number of unlisted real estate funds in London and the UK and has recently increased its allocation.
ATP's commitment to London forms part of its UK real estate allocation. Arne Andreasen, ATP's investment manager believes the UK market generally holds out good prospects. "Currently we are overweighting UK since we are of the opinion that the market offers good prospects for an extended cyclical expansion in the business activity with good growth and inflation only marginally above the Bank of England target."