Is there an emerging property bubble in London?

“So if a property bubble is about to pop, that’s good news for NAMA – all in all, a very good time for the agency to get the hell out of London.” Guardian’s Lisa Carroll writing on 19th August, 2011

[in the following blogpost, the term “yield” will be used a lot. Simplistically it refers to the rent on a property divided by its value eg property worth €1m generating €100,000 rent per annum has a 10% yield]

With news earlier this week that a shop in Knightsbridge generating GBP 400,000 a year in rent presently, has sold for GBP 13m, representing an initial yield of 3%; with upmarket residential agent, Knight Frank reporting that prime central London residential prices were up 9.6% in the year to the end of July 2011 and were now 35% up from the post-credit crunch trough in March 2009 and amidst a consensus that the London property market is red-hot, and given that NAMA has said that much of its UK portfolio is centred in London, now might be a good time to examine if the London property market is a bubble which might burst with unpleasant consequences for NAMA.

It should first be said that London comprises a number of markets. That may seem obvious but remember we are talking about a city whose urban area has a population of 8.3m. There is plenty of scope for segmentation of the market but this entry will really just consider two segments – prime commercial and residential. Prime typically refers to central London, the boroughs of the City of London (not technically a borough), the City of Westminster, Kensington and Chelsea. Other definitions might include outlying areas which maintain their values like Hampstead and DulwichVillage, but in the main “prime” equals “central”.

The NAMA transactions inLondonthat we have heard about so far have been in prime areas, Knightsbridge, Mayfair, St James’s, Oxford Street, Chelsea and the City of London. Having said that, NAMA has indicated that it has approved €3bn of disposals and the specific transactions that have been identified with NAMA in the media represent a fraction of that, so there may well have been disposals in non-prime parts ofLondonas well, it’s just that they might not have been reported.

In terms of commercial property overall the UK is still 35% off peak prices reached in 2007 but London prime property is down considerably less than that, but in general is still down from the peak eg City of London office rents were GBP 67.50 in 2007 and today are still hovering at the GBP 55 psf mark, the West End was GBP 120 psf in 2007 and is GBP 92.50 psf today, according to Capita Symonds and CB Richard Ellis. There are exceptions of course reflecting the fact that even the prime commercial market has many segments. Retail rents on London’s Bond Street for example continue to create new British records – GBP 900 psf in 2009 and the record is Piaget’s store at 169 Old Bond Street paying GBP 965 psf from a deal done in December 2009 – both values are for Zone A rent, that is the rent on the space closest to the shop-front.

Many property-market commentators point to yields as a guide to troughs and bubbles. Remember our very own Minister for Finance, the late Brian Lenihan holding forth on yields in September 2009 claiming that the historically high yields pointed to the bottom of the market – his rationale was that if property was delivering a yield of 8% and deposit accounts were paying 2% then people would naturally tend to withdraw their deposits and pile into property, and the increased demand for property would drive up prices. This was Baby Infants property economics and ignored the fact that the numerator in the yield calculation, rent, was also falling. The Minister’s mistake was to assume the economy had bottomed out and that rents were resilient. But the Minister and his advisers could have been partly forgiven for their faith in yields, remember 2-3% yield deals in Dublin’s commercial market just before the peak of the boom in 2007, like the 2.4% yield sale by Arnotts of 102-104 Grafton Street to David Daly for €115m. Irish property experts were looking at such deals with such low yields as evidence of a peak market, were they not entitled to view 8% yields in 2009 as indicative of the trough? And in London today with a 3% initial yield sale in Knightsbridge and with 4% being regarded as the going-rate in the West End and 5.25% in the City of London, you might be tempted to think that we were at the peak in London because investors might be able to get better returns on other classes of investment. But I don’t think that would be a safe conclusion. Here’s why.

(1) DTZ reported this week a re-assessment of investment returns in the UK commercial property market and their view of the outlook, particularly for prime property, is rosy. The rationale: other investment classes offer low return prospects, particularly UK Government bonds, for example the five-year bond currently pays 1.4% per annum. The full report – titled “DTZ Foresight UK Fair Value Q2 2011” – from DTZ is available here  (free registration required). Of course NAMA is not concerned about relative performance between asset classes, it has a finite lifespan with about nine years remaining but NAMA might be interested in DTZ’s forecasts which see rents rise by 6% per annum between 2011 and 2015 in London’s West End and 5% in the City of London and 4% in London Mid-Town (Holborn, Bloomsbury, King’s Cross, Euston)

(2) Prime central London estate agents Savills reported their preliminary H2, 2011 results last week and attributed the good performance to “strong growth in transaction advisory business driven by demand for Prime Central London Residential property and continued strength of Asia Pacific markets, particularly Greater China” and in terms of outlook “in the UK and continental Europe, we expect transaction markets to remain unsettled although the fundamentals of the Prime London Residential market remain positive”

(3) Supply, availability and vacancy is constantly cited as the reason for prime London’s robust performance. Property consultancy Driver Jonas Deloitte produce so-called “crane” surveys on the construction pipeline in UK cities. Their Summer 2011 central London report is available here.  On the commercial front, construction fell dramatically after the financial crisis in 2007 (Northern Rock heralded the start of the UK’s crisis, ours came a year later). And the immediate outlook for construction is not great until after 2015, and even then supply tends to be in non-prime areas – the Battersea Power Station development and the proposed Earl’s Court redevelopment and further developments in east London and Docklands would fall into the non-prime category. Truth be told, central London is a small area with difficult and expensive planning considerations and burdensome construction regulations. Lack of supply is cited by all the major property consultancies – Colliers International dwells on the subject more than is usual in its Q2 2011 central London offices report – as the prime driver for higher rents and capital values.

(4) Anecdotally, that is, speaking to agents and summarising personal observations, there is a lot of Chinese, Russian and Indian money coming into London residential property. The fourth member of the so-called BRIC countries, Brazil, seems to be curiously absent from the London property scene. This assessment is backed up by Knight Frank’s Spring 2011 outlook which claimed that 6% of Prime central London purchasers were from Russia and CIS countries, 5% from China/Hong Kong, 3% from India and only 0.1% from Brazil.

(5) Residential developers have grown more confident about prospects in central London, according to Jones Lang LaSalle which says  “we are now seeing increased activity from parties looking to develop in prime central London, from South East Asia, the Middle East and Turkey, with much of this being on the basis that the UK is seen as a stable and safe bet with by worldwide investors looking to diversify their assets during this uncertain period.”

(6) Inflation continues at an elevated level in the UK, running at 4-5% per annum, this despite the base rate of interest set by the Bank of England being at 0.5% since February 2009. Property is seen as a hedge against inflation and depending on NAMA’s foreign exchange hedging, property growing in value by 4%+ per annum might be worth holding onto rather than property dropping by 5-10% as in Ireland at present. Standard Life examined the resilience of property in the context of inflation here,

Of course one uniting connection between the above companies is that their businesses all depend on transactions for success, so an appropriate pinch of salt might be in order. Having said that, the independent Office for Budget Responsibility and the IMF are both modestly upbeat about fiscal management and growth in the UK.  UK Chancellor of the Exchequer, George Osborne recently claimed that the UK was seen as a safe-haven amidst the turbulence on both sides of the Atlantic. Despite facing extreme challenges with reducing a deficit which is worst than ours at over 10%, many commentators have been complimentary about the UK and its prospects. Recent revisions to economic estimates by the Bank of England might have taken some of the shine off of George’s rosy cheeks but compared with the ongoing train-wreck of the EuroZone and the uncertain handling of theUS economy, there is a basis for claiming theUK is, relatively, a safe haven.

So is there a bubble inLondon’s property market? I’d suggest it’s difficult to say. Low yields alone are not at all determinative of the future state of the market. However it will be very tempting for asset managers in NAMA to bag a profit in London now over the price paid by NAMA for loans, and to an extent in prime London that is almost like shooting fish in a barrel but a proper asset management approach would be to consider all of NAMA’s markets, as it might be financially better to offload non-performing assets in a falling market than to sell in a rising market. The Guardian last week suggested that now might be the time “to get the hell out of” London but on another view, “for heaven’s sake” stick in London and harvest profits in the years to come.

You might also be interested in this post on the “Asset Management Game”.