Greg Mansell says the West End no longer looks good value
In the last 12 months, UK investors have remained net sellers while foreign investors have increased their exposure to London and in particular the West End. Last year, London had £7.7bn (€8.77bn) of office transactions, and was uncharacteristically dominated by Middle Eastern and Asian investors, who committed £2bn, with the majority of their focus on the West End. Average yields in London also turned last year, hitting a peak of 7.8% in May and falling to 6.9% by December.
The attraction of London came from the belief that the worst was over, and given expectations for London's future performance, that property had reached fair value. Clearly, investors determined that at the market pricing levels in May 2009, future returns would justify the future risks.
The CoStar Group produces a Fair Value Index, which discounts its forecasts using a market-specific risk-adjusted discount rate to find the fair value of each market. The chart shows the index for London's City and West End markets using CoStar Group's Q4 2009 forecasts. An index value between +10 and -10 suggests market values are fair for an average investor (using the same +/-10% range used by UK valuers as an acceptable range of error). A value over +10 suggests that the market is underpriced (cheap), and under -10, that it is overpriced (expensive).
From the start of 2006 to the end of 2008, London was overpriced, and sellers were on the right end of the deal. In 2009, it looked fairly priced and became a justified target for buyers. However, given foreign investors' rediscovered appetite for West End property, and the considerable yield compression already seen there, the market's relative value has already been eroded. The first investors to enter the market are already reaping the benefits, but anyone looking to follow suit and chase yields lower in 2010 risks overpaying for exposure to a volatile occupier market that will remain on a downward trend in the short term.
The City, though, still looks like a good opportunity. Yields and (therefore) income returns are higher, and the occupier market is showing signs of stability, and from the tenant's point of view, affordability. The fear that oversupply will prevent rental growth is dissipating, due to an abundance of large lease deals by major tenants and tightening supply.
Over the next year, investors in London should focus on the City, and those looking to sell should consider cashing in their recent gains in the West End.
Greg Mansell is a real estate analyst at CoStar Group