London: Too big to fail?

In the years running up to the Brexit vote, London boomed. Can the UK capital continue to prosper in the face of so much uncertainty? Razak Musah Baba reports

Ever since the run-up to the referendum on EU membership, the UK economy – and, by extension, and the domestic real estate market – has been under the shadow of uncertainty. With Brexit delayed for a second time, that uncertainty has come to seem like a permanent feature.

London is one of the world’s most successful economic, financial and cultural cities, and its real estate market is one of the deepest and most liquid. The ongoing uncertainty has for some time posed a risk to the city, but many investors believe it can withstand its current predicament and that there are reasons to invest in its property markets.

The UK capital has form in overcoming unfavourable economic events. The city prospered after the financial crisis in 2008 and avoided entering a recession, unlike the rest of the UK.

James Roberts, chief economist at Knight Frank, says: “London is a perennial hub in the global economy, with a track record of weathering adversity.”

Roberts states in Knight Frank’s latest version of The London Report that the vote to leave the EU in 2016 prompted a fresh wave of prophecies that London would go into decline as a global city. “But the capital has defied the pundits before, and evidence is mounting that it is doing so again.”

London has weathered the late 1980s stock-market crash, the European Exchange Rate Mechanism crisis of the early 1990s, the dotcom bubble of 2000 – and “moved on to greater things”, Roberts says.

Commentators have many times over the decades predicted an exodus of companies and jobs to Birmingham, Dubai, Dublin, Frankfurt, Hong Kong, and New York. Inevitably, of course, some jobs have, indeed, left for these cities, but the numbers were overshadowed by further growth.

“Our timeline serves to remind us that London has faced numerous setbacks in the past but has gone on to set new market benchmarks,” Roberts says.

London has a large pool of human capital to call on from its current population of about 8.97m, which is projected to grow 10.35m by 2041.

The AT Kearney 2018 Global Cities index report shows New York City and London maintaining their number one and two positions, respectively, as the world’s most influential cities. It says these cities attract the best companies, talent and greatest investment because they possess the “right mix of factors such as business activity, human capital, information exchange, political engagement, and cultural experiences that help organisations and people to thrive”.

The UK’s breakaway from its 45-year alliance with the European Union will likely be one of the biggest challenges London will have to deal with over the long term. 

Philip Gadsden, managing partner, Orchard Street Investment Management, says London’s rich history, culture, universities and wider infrastructure attract not just top employers from around the world looking for the best talent but also global capital keen to invest in a dominant global centre.

Traditionally associated with finance and banking, London is also a top destination for technology, prompting the development of office accommodation designed to support new style of co-working, Gadsden says.

“In previous cycles, London has had more volatility than other domestic real estate markets, given its propensity for exciting new development projects, but through them all London has remained resilient,” he says. “Despite, or perhaps because of Brexit, London will remain a top global city for occupiers and will maintain its dominance as a pre-eminent destination for global capital.”

Chris Urwin, research director for real assets at Aviva Investors, says that after the 2008 crisis the London office and retail sectors “bounced back relatively quickly”, with average total returns in central London offices averaging above 15% between 2010 and 2015.

Since the referendum there has been a marked slowdown in rental growth, although take-up has held up well. Urwin says: “New supply has been restrained in this cycle, so the market is not currently over-supplied and the development pipeline does not look too concerning.”

Looking ahead, there are more risks around future demand than future supply, given ongoing Brexit uncertainty. Urwin highlights that Central London retail has grown stronger on the back of tourism. Indeed, super-prime retail in central London is reporting record rental levels. “The referendum has not significantly impacted the London retail sector, with the fall in the pound making London even more attractive to visitors,” he says. About $16bn (€14.2bn) was spent by visitors to the city in 2016.

Urwin adds that the continued growth of e-commerce has significantly boosted demand in the logistics sector, especially near large and affluent population centres such as London. “Record rents are now being achieved in London, and due to the supply-demand imbalance within London due to competing land uses, we forecast rents to grow on average 5% over the next five years,” he says.

The diversity and depth of investors in the London real estate market is a real strength, according to Urwin. On average, over the past five years, 80% of all office transactions have involved overseas capital, and investors from 22 countries have each spent over £500m (€579m) in the London office market since 2013.

“London being one of the most transparent and liquid real estate markets in the world is a major draw for overseas capital,” he says. “The presence of major corporates in London also provides a solid base of occupier demand, who are in turn drawn to London due to the highly skilled workforce. Indeed, London has more universities and business schools in the top 100 globally than any other European city.

“London locations are able to provide access to a deep pool of talented labour, supporting the office market. London has always been a major hub for certain industries, such as financial services and media. Over the past few years, new clusters have emerged within London, such as the tech sector and the life-sciences sector.”

Population growth is supporting demand for all types of real estate in London. The concern, however, is that “we are at the later stages of the current cycle, with yields already at record lows, so any capital growth in the current environment will be minimal”, Urwin says.

Jeremy Marsh, a real estate analyst at Schroders, says that, despite the political uncertainty around Brexit, London has remained the number one destination for cross-border real estate investment. In 2018 London recorded greater volumes of commercial real estate transactions than any other global city, with £16bn traded and over 80% of purchases from overseas buyers,

Marsh says. “Previous downturns have shown that the London market recovers quickly – usually values fall no longer than around 18 months before returning to positive growth. Investor demand has been resilient and diverse because of London’s established legal and tax structures, long institutional leases, transparency and liquidity,” Marsh says.

Marsh adds that occupier demand has proved resilient because London’s strong universities and diverse, skilled labour force have meant the city has repeatedly reinvented itself, such as the growth of the technology, media and telecommunications and life-sciences sector since the 2008 crisis.

William Beardmore-Gray, Knight Frank’s global head of occupier services and commercial agency, says London’s perception globally as an investment destination remains unchallenged and untarnished, with the city emerging as the biggest recipient of commercial property investment in 2018.

“London, which saw £16.2bn spent on commercial property, outpaced Manhattan, Tokyo, Paris and Hong Kong,” he says. “What’s more is that since the referendum investment volumes and commercial occupier activity have exceeded expectations. Total take-up last year reached 14.8m sqft, the highest level since 2014, underpinned by nine deals in excess of 100,000sqft – the long-run average is 12m sqft.”

Beardmore-Gray says the depth of occupier demand is best reflected in the fact that almost half of all activity last year was driven by business expansion, while half of the 11m sqft under construction has secured a pre-let. There was a widespread expectation that London would undergo a ‘Brexodus’ of sorts, he says, with jobs being lost to the continent. However, that has not materialised.

The finance and banking sector in particular, a stalwart of the market, has seen a net gain of 5,800 jobs since the referendum, while the tech sector has added another 70,000 jobs to London’s economy during the same period. “The resilience of rents and market performance has, to an extent, been driven by the sheer shortage of new space coming through,” Beardmore-Gray says.

Occupiers are nervous about being unable to secure space in the future and have begun to raid the supply pipeline. “In the West End, just 485,000sqft of space was completed last year, 61% below the long-run average, while 63% of the 3.8m sqft under construction has already been pre-let,” Beardmore-Gray says. “For those seeking more than 100,000sqft in this part of London, there is just one suitable scheme: West Works in White City. 

“We’re tracking 24 active and passive requirements in excess of 100,000sqft. However, there are just 12 developments in London that can accommodate a requirement of this size. On the investment side, in the wake of global macroeconomic and political uncertainties thrown up by the simmering trade dispute between China and the US, the world’s two largest economies, and ongoing conflict in parts of the Middle East, London’s commercial assets continue to retain their global appeal.”

Manish Chande, senior partner at UK real estate fund manager Clearbell, says: “When the UK voted to leave the European Union, a positive outlook for commercial property in London was completely unexpected. Despite an immediate fall in values after the vote, businesses continue to be attracted to London, and values of London commercial property have upheld. The price crash everyone’s been waiting for is yet to emerge and I expect this trend to continue.”

Chande says the biggest cause of London’s resilience is its supply-demand dynamics. “These have remained healthy in the face of Brexit,” he says. “The scales are currently balanced and as long as this is the case, values in the city will also uphold.”

But what could tip the balance? “Supply dynamics are less likely to change than demand, given that supply in London is currently constrained and this cannot change imminently,” Chande says. “However, demand dynamics could disrupt the balance and should be watched. If there is a fall in demand for office space in London, this will result in a decline in values.

“A few factors could weaken demand. These include a global economic slowdown, looking beyond Brexit, which would cause employers to consider their rents and office locations. Changing tenant make-up in the city as new sectors, including tech, seek space in the city centre could also impact demand. It’s no longer all about financial services in the city, which used to be a guaranteed tenant base. The shift towards flexible working will also affect demand as businesses look to take on smaller office spaces. Nevertheless, the London real estate market remains the most liquid in the world and long-term fundamentals for commercial property in the city will be difficult to shift.”

Richard Gwilliams, head of property Research at M&G Real Estate says Brexit uncertainty has been resurgent in recent months, so a degree of caution within the market is inevitable in the short term. “Nonetheless,” he says, “we believe that investors will take a longer-term view about investing in the UK.”

He adds: “We believe that, Brexit or no Brexit, the UK’s position as a major economic player will remain intact. What the market needs, however, is a resolution and greater clarity around what this will look like. Owing to the strength of its economy, landlord-friendly institutions, and overall market transparency, London will continue to be a target destination for capital. London will also remain a magnet for global talent, thereby sustaining the buoyancy of the office market, which has shown great resilience throughout the Brexit process.”

Gwilliams says appetite for risk, or lack thereof, is fundamentally shaping the performance of the London market across a number of sectors. On one hand, there has been a flight to prime as investors have sought to minimise their exposure to risk by investing in super-core assets. “However, due to increased competition in this area, we are seeing opportunities further up the risk curve for well-located secondary assets which can be enhanced by active asset management initiatives,” he says.

“With the UK facing a housing crisis, and high-quality rental accommodation in short supply in relation to growing demand, there are compelling opportunities for investors targeting well-located sites with good transport links for commuters and strong rental growth potential.”

Investors will undoubtedly be closely monitoring the economic cycle and its resulting impact on interest rates, Gwilliams says. “It seems likely that rates will be on an upward trajectory going forward, but we anticipate a relatively benign impact on real estate, providing the rental market holds up. The yields from property remain attractive compared with other asset classes; there is a wide spread above bond yields, which should act as a buffer to absorb a fairly significant increase in interest rates before impacting real estate’s pricing.”

Beyond this, wider geopolitical risk and the possibility of an economic downturn would affect UK real estate, but it is important to note that the UK’s long-term prospective risk-adjusted returns appear more attractive than many other global markets, Gwilliams adds.