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London Office Market: Where are We Now?

Green Street’s Managing Director in London, Hemant Kotak, recently hosted a conference call on the Central London office market with Michael Cochran, Senior Managing Director at Eastdil Secured. Hemant, who leads Green Street’s coverage of 20 companies in the UK and Switzerland, kicked off the conversation with highlights from his latest report on the Central London office sector.

Drum roll please…
World markets got a shock nearly a year ago, on June 23, 2016, when 52% of the UK population approved a referendum calling for Britain to leave the European Union. Before the unexpected Brexit vote, capital allocation for Central London offices had already been decelerating quickly. Yet, capital values have held up remarkably well in the aftermath. What’s driving this?

Big NAV discounts
It is worth taking a stroll down memory lane to revisit the years of 2006 and 2007. At that time, corporate bond yields were in the mid-5% range, City prime yields were around 4.25%, and the spread to bonds was a negative 125 basis points. Today, City prime yields are similar, but corporate bond yields have dropped to 3%. That has created a positive spread of 100 basis points that is attractive to long-hold investors. There has also been healthy activity in City office deals and for the West End since the Brexit vote. However, while direct property pricing is holding up well, London office REITs are trading at large discounts to the value of their underlying assets. Many industry participants rely on REIT discounts to be a good proxy for the direction of private market values, however the predictive power is somewhat mixed. For instance, REIT discounts were a solid leading indicator ahead of the global financial crisis, but they were a false signal in 2011, and an overreaction following the dot-com bust. Could the current post-Brexit environment be similar, where public investors are overreacting to fears and an uncertain economy?

Record high transaction volume
Prior to the Brexit referendum, transaction activity in Central London offices had slowed significantly. International investors were pulling back ahead of the vote. Surprisingly, there has been a complete reversal so far in 2017.

Central London Office Transaction Volumes per Half Year

“Buyers are almost exclusively international, and the £5 billion transacted so far makes for one of the best first quarters on record,” according to Hemant Kotak. The global attractiveness of the London market overall cannot be overlooked. “London is a very deep and liquid market,” said Kotak. “It is legal friendly, culturally diverse, and private capital players are making decisions for the long term,” he added. Many investors are quite familiar and comfortable with London as a place to safely invest capital.

Strong demand from foreign capital
The weaker pound also provides an entry point, making the London market look relatively cheap today for some international investors. Asian buyers from China, Korea, Singapore and other regions have been particularly active in pursuing trophy assets. Even though London yields may seem low from a historical point of view, they are much higher compared to other markets around the globe. In addition to the large pool of capital from Asia (estimated at 80% of the ~£40 billion in current equity demand), investors from the Middle East continue to show an interest in London. This trend is attributable to a variety of factors, in spite of lower oil prices, and is expected to continue.

Not everyone gets a trophy
While high-quality office assets in London sport clear demand and stable capital values, assets at the other end of the spectrum – those with short leases and big cap-ex requirements – are showing signs of weakness and greater risk. With rents holding but concessions increasing, there is more softness. “There aren’t forced sellers like we’ve seen in past cycles,” Kotak stated. For example, some REITs seeking this type of product are experiencing difficulties acquiring these assets right now. This part of the market is more susceptible to value erosion, and if the market turns negative, it is more likely to turn earlier.

What’s on the horizon?
Green Street’s European team estimates that the full impact of Brexit on Central London office demand will be felt over the next decade, thereby allowing supply enough time to react. Banks scaling back is not all Brexit - structural downsizing and FinTech are big drivers too. Near-term rents are forecast to decline by roughly 10% with modest yield expansion, and values could fall 10%-15% on a probability basis.

For deeper insights, download the featured report Central London Office Update: Time to Brace. Green Street’s European team was an early thought leader on the Brexit vote, publishing several pre- and post- referendum reports that analysed the implications for the property markets. Information on the firm’s research coverage can be found here.

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