The London office sector has been one of the main focal points over the past two years for global investors. Are there still opportunities? Yes, according to Mervyn Howard and Scott Rowland
Investors are keenly aware that there has been a significant recovery in the prices of London offices following their substantial decline during the global financial crisis, and some are now questioning whether or not prices have overcorrected.
Given the peak-to-trough fall in capital values of 43% from 2007 to 2009, and the subsequent recovery of 35%, values stand, on average, at a 23% discount to the peak of the market in 2007. This discount is the largest of any UK property sector and is principally due to the level of market rents, which remain 19% below peak levels, following declines of 27%. Meanwhile, initial yields, or cap rates, are marginally above the historical market lows experienced in 1981 and 2007.
Is this a good place, an okay place or a bad place to be? Essentially, it depends on your view of the health of the global economy, global financial services and London's competitiveness in attracting and retaining financial services business and talented people.
There is no doubt that the supply dynamics for London offices favour investment. The amount of available stock is low, with current vacancy rates significantly below long-run trends; new stock expected to arrive on the market before the end of 2015 remains well below the average over the past 15 years. Only the well capitalised developers will be able to play the development game in the near term. The recent De Montfort University's Commercial Property Lending Report suggested that development finance was now available for offices, but only for prime assets in top locations with first class sponsors.
Despite the market disruptions at the time of writing, Grosvenor Fund Management is relatively optimistic about the demand for London offices.
We have no doubt this cycle will be weaker and more volatile than previous cycles due to the overhang of debt in the OECD and the need to ‘wind back' the extraordinary monetary and fiscal policy settings currently in play. However, dynamism in emerging markets and the normal cyclical forces of consumption and investment are expected to result in world GDP expanding meaningfully over the medium term.
The global economy is the most relevant driver of the London office market. The secret of London's success over the past 20 years or so is that it has been highly competitive and innovative in the area of internationally traded financial services. GDP growth in London has consistently been higher than that of the UK and more closely linked to the global economy and international trade volumes. Over the medium term, we expect London to increase its share of global financial services output as it continues to exploit the factors it has in its favour, such as its central location between Asian and American time zones, welcoming low-cost business environment, pool of expertise, and critical mass of high quality support services, efficient telecommunications and transport infrastructure and lifestyle.
All of that leads us to believe we will see material growth in rents in certain sectors of the London office market over the next five years.
Grosvenor Fund Management has been active over many years in office markets in the West End of London and this is where we see the most interesting opportunities. So often there is a need to get underneath the headlines to get real insights. Many investors are aware that rents of around £140 (€159) per square foot were achieved at the height of the market and ask, reasonably, whether it is realistic to expect rents to return to and exceed those levels.
Our view is: probably not. But it is important to understand that those transactions represented a very small amount of market activity at the time and involved relatively small amounts of space being taken by boutique financial services businesses.
Current best rents in some of the West End's most important sub-markets are:
Source: JLL, *Grosvenor Fund Management
Grosvenor Fund Management expects rents for the best space in Victoria to grow from £62.50 to £82 per square foot (an increase of 31%), and in Mayfair from £95 to £140 per sq ft (48% growth) by 2015.
So what options are there for investors to access this stock? The UK is one of the world's most liquid markets, capturing 16% of all global property transactions in 2010. Over a third of this is attributable to London office transactions which represented 6% of global transactions last year. Not only are London offices the most liquid by value, but the market is one of the largest single sectors - 3% of global property values as measured by Investment Property Databank (IPD).
That is all very well if you want to sell a high quality London office building, but what if you want to buy one? The experience of the past two years shows this is difficult. Institutional and international investors rarely sell these high quality assets, and demand for them when they do is often very high. Investors approach this challenge in different ways. Buying directly is difficult in both accessing the stock and - unless you are already familiar with the market - identifying the best stock to buy.
Those willing to take on more risk can adopt a ‘develop and hold' approach or a ‘buy, fix and hold' strategy. In July, Grosvenor Fund Management launched a programme with the Canada Pension Plan Investment Board (CPPIB) to pursue the latter strategy.
Across London, upcoming lease events mean that 19.5m sq ft of space will expire or reach break points in the next five years, which is around three times the expected delivery of new office space. This represents a particular challenge for the owners of those buildings, who not only need to agree commercial deals to retain tenants or attract new ones but will often have to invest materially to bring depreciated buildings back to A-grade levels. Alongside development of new stock (an area pretty much restricted to the ‘big boys' within the investment community) we think there are some very interesting opportunities in this area for the right buildings.
Our view is that London offices have re-priced, but good opportunities are there. Investors have to approach this in the old fashioned way: understand the assets, understand the risks and work hard to deliver a top-quality product to the occupiers in the market. If you can do that, the rewards will follow.
Mervyn Howard (far left) is a director and Scott Rowland is a commercial fund manager at Grosvenor Fund Management UK