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London Property Valuations

Quick repricing drives investment

The repricing of commercial property that continues around the globe has already occurred in London. Prime yields have stabilized in the market more quickly than in other locales, particularly the United States, and yields are on the rebound for many asset classes.

As a result, investment activity is on the rise. Investors there are no longer standing on the sidelines, they are actually buying. In fact, London now outranks both New York and Washington, D.C., as the number one city for investment, according to the newest survey from the Association of Foreign Investors in Real Estate (AFIRE).

There is, however, a notable lack of stock. London’s ranking as one as a global financial center also makes it a more volatile market than many other cities. Moreover, some investors are concerned that current valuations are not supported by fundamentals.

Emma Sinclair, CEO of Target Parking, a London-based company that owns and operates car parks in the UK, says London’s property prices have shot up at a rate that does not compare with anywhere else she does business. “The sharp rise in prices and yields has been startling and it is hard to believe it will remain,” she says. “Pricing is not rational at all. There seems to be a bit of a boom, which has no correlation with logic or sense in my view. It would make sense for things to cool.”

Over the past 24 months, London property values have been on a “roller coaster,” says Andrew Hawkins, a director in Jones Lang LaSalle’s city investment team. “The industry's strict definition of RICS red-book valuations has meant that ‘mark-to-market’ benchmarking has been rigidly applied,” he notes.

In the city market, for example, peak cap rates of 4.25% in fourth quarter of 2007 moved to 7.75% in first quarter of 2009 and compressed again to 5.75% today. That represents a 40% to 50% fall from peak to trough, and a 25% bounce back.

The global credit crunch and the general dislocation of the capital market set the stage for the repricing of London’s commercial property, according to Peter Damesick, executive director of UK research and consulting for CB Richard Ellis. But increased outflows from many institutionally managed funds also contributed to the speedy repricing.

“A number of institutionally managed funds in the UK that had been seeing big inflows of retail investor money experienced a very sharp change and were subject to very sharp outflows,” Damesick explains. “That forced a number of funds to take disposals of assets. They were motivated sellers, and they created price discovery in the market.”

Overseas investor appetite

Prime yields stabilized in January 2009, dropping just 7 basis points, the smallest monthly fall since May 2009, taking the all-sector average to 6.02%, according to Cushman & Wakefield’s January briefing on the UK property investment market. The report suggests the initial repricing of the market was driven by a lack of quality product and increasing awareness that pricing had moved too far.

“Property valuations are generally very fair today,” says Ewen Hill, head of international investment at Colliers International in London. “During the crisis when transactional information was minimal, it took time for the falls to be recognized. But now there are sufficient comparable transactions to give everyone an accurate idea of where the market is.”

Hill notes that the biggest falls have been in industrial secondary properties, which have become almost unsellable in the current market, followed by secondary suburban office parks, hospitality and big-box retail. Secondary properties have been hit hardest, he contends, which has re-established a sensible prime/secondary yield gap that had narrowed in the boom.

Investor demand for London property has reversed the downward pricing trend, experts note. Yields are approaching their pre-credit crunch levels — a long-term average of 5.50% to 5.75% — and have been driven almost exclusively by supply and demand, and the perception of rental growth. “The current yield environment perhaps reflects investors’ belief in rental growth forecast of circa 40% rental growth over the next three to four years,” Hawkins says.

In fourth quarter of 2009, for example, investment volumes rose to £3.096 billion, up from £1.602 billion in the third quarter, for an annual total of £6.81 billion, according to Cushman & Wakefield. This represents the third consecutive quarter of increasing investment activity. However, the year’s total remained short of 2008’s total of £6.99 billion, and just 35% of 2007’s record total of £19.42 billion.

During the fourth quarter, the Korean National Pension Fund acquired HSBC tower at Canary Wharf for £772 million and 88 Wood Street EC2 for £183 million. An unidentified overseas investor purchased 5 Churchill Place at Canary Wharf for £208 million.

Last year, overseas buyers represented the majority of investment, accounting for 73% of all purchases, according to Cushman & Wakefield. “With the sterling still so weak, the London market represents good value,” says Clive Bull, head of central London investment for Cushman & Wakefield. UK buyers have only recently come back into the market to compete for stock.

“When we were at the bottom of the market in 2009, it was Middle Eastern money and Far East/Asia Pacific money that really cleaned up at the bottom of the market and underpinned the felling that wealth was transferring to the growth economies,” Hawkins says. “We thought we would see more U.S. opportunistic money, but without an active debt market and any rental growth story they were unable to make their IRRs work, and sat frustrated on the sidelines during one of the best buying years of the last decade.”

Lack of stock

London’s transparent market, which is arguably easier to buy in than other markets such as Paris or Manhattan, Hawkins notes, is driving investor appetite. Hawkins and other experts expect investor appetite for London assets to continue.

Interestingly, the biggest challenge for London property investors today is not accurate valuations or availability of financing. Instead, it’s lack of stock. “As such, buyers are worried they are overpaying,” Hawkins explains, adding that sellers are worried that they can't sell in time to take advantage of the current pricing.

“There’s a lot of money swimming around and not a great deal to buy, and this appears to have created a mini boom in parts of the London investment market,” Sinclair says.

Hill says prime property is likely to hold its value and prices generally are recovering, but secondary properties will still struggle to sell. The IPD index is likely to see a small rise over the year, and total returns are expected to be better than 2009 at roughly 6%.

Investors are increasingly confident that rental rates for London commercial property will increase in 2010 and beyond, particularly for office assets. In fact, CBRE is forecasting rents for Class-A office space to increase 20% this year.

“I think there has been some misperception among investors that market valuations are not based on real fundamentals,” Damesick says. “Rents are returning, so that attitude is improving, but I am not sure that has fully registered among investors.”

Indeed, there are some ongoing concerns about pricing. “I would contend there is fragility,” Hawkins says. “Confidence is everything. If all things remain equal, pricing may compress even more. However, if there is uncertainty or a wider structural issue, pricing could obviously double dip.”

London also suffers from its position as a global financial center. “By their very nature, global financial centers are very volatile and very cyclical,” Damesick says. “They show strong patterns of growth, but they are highly vulnerable to financial market shocks.”

London, in particular, experiences a feast-to-famine development cycle, which gives rise to rapid rental growth and very serious rental declines. “In such markets, investors ought to be pricing the risk that this sort of volatility creates,” Damesick says. “London is going to remain a volatile market, and in such markets the timing of investment decision — both in terms of acquisition and disposal — is critical.”

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