City Focus, London: Beyond the Square Mile

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CITY FOCUS: LONDON The capital has long been an international marketplace, but the intensity of global capital recently flowing its way has in some respects been unprecedented. Maha Khan Phillips reports

Last year Google announced it would be building its new London offices in King’s Cross, after the internet giant purchased 2.4 acres of brownfield land in a £1bn (€1.22bn) property deal. Google plans to build an 11-storey and seven-storey complex, which is due to be completed in 2016. Facebook, meanwhile, closed a 10-year deal to move to an 88,000sqft office in Euston, while online retailer Amazon has signed a lease on a 210,000sqft property at Holborn Viaduct, a new development opposite Smithfield Market. For those who have been following the London property sector, the deals have been significant. “It just goes to show that companies are prepared to go for the quality of the building that suits them and their business needs, over the location,” says Derek Gilby, senior fund manager at Legal & General Property. “Demand for office space has been led by the TMT [telecommunications, media and technology] sector over the last two years.”

It also means that the traditional hot spots of activity, particularly the West End and the City, now have competition from other parts. In 2003, only 15% of West End office was occupied by the technology and creative sectors, a figure further reduced to 9% when looking at the City, according to Savills. In 2013, 37% of the West End was occupied by technology and creative companies, while 27% occupied the City. But, as analysts point out, with Google and Amazon leading the way, the market has become more footloose, with companies moving to wherever they can find value or good buildings. “A decade ago people referred to the West End and the City, and that is where the strong rents were,” says Chris Perkins, head of business space at M&G Real Estate. “Now we have a lot of satellite markets that are as good as the mainstream, such as Southbank, King’s Cross and Farringdon. All these locations are in occupiers’ minds.”

Last year, M&G Real Estate acquired Bankside 2 and Bankside 3, and the retail holdings of Bankside 1, in London’s Southbank, from Land Securities, for £315m, representing an initial yield of 5.2%. “There is much greater choice or occupiers, there is much greater stock, and more buildings, which are appropriate for international buyers,” says Perkins.

According to IPD, offices in the Southbank delivered the second highest total returns in London in 2012 at 9.6%, after the WestEnd at 10.6%. Southbank offered some of the best value London office stock available as well, with income returns in 2012 delivering 5.4%, 100bps higher than the central London market average. London is growing increasingly popular across all property sectors.

According to Savills, investment turnover for the central London market in 2013 reached more than £20.6bn, the highest level of investment ever achieved in central London, and a 39% increase on the 2012 figure of £14.8bn. The figure was predominately driven by Asian investors, representing £5.8bn (an increase of 99% on 2012), and UK investors, which accounted for £5.6bn of total transactions respectively.

“The UK has had an amazing turnaround in the last six months or so,” says Alan Patterson, head of European research and strategy at AXA Real Estate. “There is an optimism that has suddenly developed. GDP numbers are looking good, and London is a powerhouse. Whereas in the last 18 months to two years rental values for London were stagnant, we are now looking towards strong rental growth for the next two years, not just in prime properties. We could see returns of 9% per annum.”

Fund managers say the office sector is particularly attractive. Knight Frank estimates that a return of confidence in the economic outlook will see London office rents reach a historic high by 2018. The investment volume for the central London office market hit a record high of £19.6bn, an increase of 42% on 2012, according to the firm.

“The London office market has bucked the trend seen elsewhere by achieving capital growth,” says Chris Urwin, global research manager for real estate at Aviva Investors. “It has had a good rental growth in recent times as well. It has been a strong performer relative to other property sectors, largely because there has been a lot of overseas investment into central London over the last two or three years. A primary motivation for this has been the liquidity in the market. During the credit crunch, many real estate markets proved to be illiquid.”

Other sectors are also throwing up opportunities for investors. On the retail side, record rents are being fuelled by continued demand from international retailers for the right location, according to JLL.

In a report on property predictions for 2014, JLL suggests that the capital will continue to benefit from its position as a prime retail global destination, and as a springboard for many retailers looking for European expansion. Bond Street witnessed ‘unparalleled’ year-on-year rental growth of over 30%, and prime rents have increased by 80% since 2007. “A lot of the retail market that was unloved a decade ago has become mainstream,” says Perkins. “And there are a number of satellite shopping areas within London that are commanding very strong tenant demand and very strong growth, particularly the likes of Bond Street and Regents Street, but also Covent Garden and Carnaby Street and Camden and the King’s Road. These are locations that still attract international shoppers, but also provide for the domestic market.”

Even hotel occupancy levels in London are exceptionally high, at over 90%, according to CBRE. Room rates have soared. Yields are at a record low because hotel demand outstrips supply, and unlike offices, shops, and residential markets, the hotel markets are not that susceptible to boom and bust cycles, according to Derek Gammage, managing director at CBRE. It is the central London residential sector, however, that has fared best, with annual growth at 12.5%, according to London Central Portfolio, the property services company. The firm pointed out that above-average price increases can also be attributed to an increased number of ‘super prime’ new-build properties.

“London residential property prices have seen an average growth rise of 9% a year, going back to 1969,” says Naomi Heaton, chief executive of London Central Portfolio. “To some extent, this shouldn’t be a surprise. If the market overinflates, it might correct, but you end up with this annual average price growth.” She says that the market continues to perform because of a supply-and-demand mismatch. “London property is far less volatile than the equity market, and people are holding on to their best-performing assets. There are more wealthy people, wealthy institutions coming into the market, and you don’t need that many more people to come in to keep up the pressure. There is an inequality between supply and demand in the residential market in central London.” Heaton does point out that the market dynamics fundamentally change outside the city centre, which is more of a domestic market. But the demand is so high that investors looking for residential assets are stepping on other territory as well.

“We, and other institutional buyers, have been comprehensively outbid by residential buyers, where there is a realistic potential for conversion of a building into residential use,” says John Humberstone, partner at Orchard Street Investment Management. Edouard Fernandez, a principal at Wainbridge, is not convinced that all developments in the central London residential sector will be successful. “Our feeling is that some of the super-prime residential development occurring now is not going to be successful,” he says. “People are paying very high prices for land, and it is a very niche market, which only a handful of developers really understand. At the high end there is too much interest, while at the lower to medium end a huge demand for housing in London is not being satisfied, with something like 65,000 homes needed.” Much of the activity in London has been by overseas investors, which some estimates say make up about 75% of the market.

According to Savills, in terms of the number of deals conducted, UK investors dominated in both the City and the West End, with British Land, M&G, Legal & General Property, and Canary Wharf all making notable purchases. However, an assessment of transaction volumes shows that Asian investors took the lead in the City. Asian investors accounted for £4.02bn, including the 50% acquisition of the Broadgate Estate by the Government of Singapore Investment Corporation (GIC) for approximately £1.7bn, the purchase of 30 Gresham Street by Samsung Asset Management for £335m, and the acquisition of the Lloyds’ building by Chinese insurer Ping An for £260m. Middle Eastern investors were also prominent in the city, conducting deals equating to £2.66bn.

“If you go back 20 years in central London investment history there has always been a fair proportion of overseas ownership. In the 1990s there was a lot of Nordic money. There have been periods where it has been German money but in the last few years it has become truly global,” says Bill Page, business space research manager at Legal & General Property.

Urwin says overseas investors are attracted because of liquidity. “London has been a strong performer relative to other property sectors, largely because there has been a lot of overseas investment in the last two or three years. A primary motivation for this has been the liquidity in the market. During the credit crunch, many real estate markets proved to be illiquid.”

As Phil Cann, head of UK retail at CBRE, writes in a briefing note, part of the attraction for overseas investors is cheap debt and a weak sterling. UK property prices look very competitive to overseas investors, and London is seen as a safe haven. Domestic investors have increasingly been squeezed out, while the globalisation of retail has also elevated the asset class for overseas institutional and private investors. Investor syndicates entering the market are also investing very aggressively, and completing transactions faster than ever before, with fewer conditions. They are able to outbid domestic investors because of generous financial backing from abroad.

But Robert Rackland, principal at Wainbridge, believes there is still room for domestic players in the London market. “If you look at the actual developers on the ground who are creating the product, they are domestic players who have platforms and necessary infrastructure and local expertise to take on management-intensive and resource-intensive work,” he says. Cann point outs that by teaming up with these syndicates, cash-strapped UK investors can still participate in large schemes by providing minimum equity but contributing experience and asset management for their overseas partners instead.

But is all this demand in danger of creating a bubble? Page says that while there has been a growth in speculative developments recently, it is not yet a concern. “We are keeping a close eye on speculative development. Although it has increased in the last 18 months, it is not at a level that gives us concern. History tells us that developers can almost over-develop the market, and all things being equal, can create their own downward pressure on supply.”

Philip Gadsden, partner at Orchard Street, suggests now might not be the best time to start starting new speculative developments. “We’ve been comfortable in the recent past to take on speculative development risk, and we have a project in Cheapside, a 60,000sqft office building, which we expect to finish over the summer,” he says. “We are optimistic that we have the timing of it about right, having acquired the property nearly three years ago. These things have big lead-ins. Would we start one of them today, with a view of getting something set up in three years? Maybe not.” But most fund managers agree that the overall outlook is positive. “We tend to be overweight in central London,” says Gadsden. “We see relative returns in line or better than in other areas. It is a good occupier market.”

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