London office market – is there still value in the sector?

The London office market enjoyed another strong performance in 2014, remaining one of the world’s leading global investment markets. But where are we now in the London office cycle?  

10th February 2015

Is there still value in the London office market?

Continue to the other two articles in this edition of the Global Outlook...

2015 - A better year ahead?

Markets opened 2015 cautiously optimistic, but what should we expect going forward?
Click here to read more

Sweden - what's keeping inflation low?

Inflation in Sweden has been low since 2013.  What's driving it and what does this mean for investors?
Click here to read more

Another strong year for London offices

The London office market enjoyed another strong performance in 2014 (Chart 1). The latest data from IPD shows that the London office sub markets have recorded extremely strong total returns with West End delivering 23.6% y-o-y in December, the City posting a 25.6% y-o-y return and Midtown delivering 28.6%.

While 2014 was an exceptionally strong year for the London market, London office has actually been performing strongly for some time now. Over the five year period since the trough*, central London offices have recorded average annualised growth of 17.2% p.a., significantly higher than the 12% p.a. total return from UK All Property and second only to central London retail as the best performing of all UK property sectors.

While all London office submarkets have outperformed since the trough, there has still been a significant performance gap between the best and worst performing London office submarkets. Mayfair remains at the top of the London office hierarchy, delivering a blistering annualised growth of 22.5% p.a.. At the other end of the spectrum, Victoria has been one of the weakest central London submarkets, with a total return of 13.4% p.a.. 

London office total returns

But much of it has been driven by yield compression

The sustained recovery in the London office market has been somewhat surprising given that the UK economic recovery only really became firmly entrenched in early 2013. A decomposition of IPD total return data shows that much of the outperformance of London offices has thus far been due to yield compression. Yields across the City and West End have tightened significantly over the past five years. From a cyclical high of 6.5% in 2008, average prime equivalent yields in the West End and City are now pushing below 4.25% for the highest quality assets. This has contributed more than half of the total return over the past five years; excluding yield shift, total returns since 2009 would have been just 7.3% p.a. in the West End, rather than the 15.8% p.a. actually delivered. 

The boost to office sector returns from yield compression clearly can’t be sustained indefinitely.  While global bond yields have fallen further in early 2015, we expect that the Bank of England will be increasingly inclined to tighten monetary policy over the year. At some point this is likely to see greater divergence in global long-term rates, although probably not until 2016 onwards.  Even though London office has also benefitted enormously from a sustained post-crisis preference shift by global investors toward large, liquid, gateway cities, it is hard to see how yields can continue to compress for much longer. Indeed, we are already seeing early signs of an increasing appetite for higher yielding regional UK markets.

But even without further yield shift, London offices are expected to continue to deliver strong total returns for the next few years, underpinned by the continued growth in tenant demand. Vacancy rates in all London sub-markets remain low by historical standard, which suggests that real rent growth is still at a relatively early stage of the cycle.  While the supply pipeline has started to increase, it is likely to take several years before vacancy rates get back to their long-run average. On our current forecasts, we expect rent growth to remain above trend for the next three years. Indeed, based on historical performance, there is still significant upside potential for above-trend rent growth in the London offices. 

Where are we now in the London Office Cycle?

Given that the yield cycle is now well advanced, while the rental cycle still has several years to run, the question naturally arises about how long the London office cycle can last? One barometer for gauging the stage of the cycle is to look at real capital values, which are a useful way of jointly summarising the relative position of both rents and yields. Assuming London rents grow more or less in line with inflation over the long-run (which they do) and that yields will eventually revert to their long-run trend (which they do), then real capital values should provide a useful proxy for fair market value.

The accompanying chart shows our measure of market fair value based on real capital values (Chart 2), where the deviation from the long-term trend should tell us where we are in the office cycle.  This fair-value indicator catches the key turning points in the market and highlights that London offices are subject to large swings in capital value and total return. Over the last 40 years there have been three large super-cycles in the London office market (the early 1970s, the late 80s and in 2007), punctuated by two smaller mid-cycle corrections (in the late 70s and 2001).  This equates to a market downturn, of varying severity, roughly every eight years.
London offices fair value index

The latest data shows that real capital values are now around 20% above their long-run trend, which puts the market at a similar point in the cycle to where it was in 2005. However, the chart also highlights that values have historically never been sustained above trend for more than three years.

Based on this analysis, the question naturally arises as to whether now is too late in the cycle to enter the London office market? Another useful way of looking at this question is to look back directly at how investment returns have actually performed based on when investors actually entered the market. To do this, Chart 3 shows unpublished IPD data of the average annualised property level return for assets purchased at various points through the last cycle. This yields several key insights.
London office total returns

Unsurprisingly, buying early in the office cycle delivers the largest outperformance. Savvy investors with the courage to buy assets even though the economy was still in recession during 2008/09 have enjoyed the strongest performance over the last five years.

But even those buyers who entered the market when it was marginally above fair-value (as it is now) have enjoyed above-trend returns.  Investors who bought into the London office market in 2005 have still enjoyed a healthy 9.0% p.a. annualised growth. Indeed, the case could be made that it is at this point in the cycle, as market liquidity increases, that investors can buy a better selection of tightly-held, long-term assets.

Clearly most of the underperformance from London offices has been concentrated in those buyers who entered at the very end of the cycle in 2006 (when our fair value indicator exceeds 40% above trend) and 2007 (when the market peaked at 60% above trend). Nonetheless, the end of the cycle is often the heaviest years in terms of investment activity, as the herd mentality takes hold.

While the London office market remains one of the world’s leading global investment markets, the sector is now approaching a mature stage of the cycle. Our analysis highlights that in a typical eight year cycle, investors should avoid entering the market in the last 18-24 months of the cycle.

So is there still value in the London office market?

We would answer yes, but investors need to move quickly. While rental growth in the London market is expected to remain strong for the next few years, this cannot last forever. When rents slow, yields will need to rise to restore value in the sector. Given that the market has enjoyed sustained growth for five years, this analysis suggests that investors wanting to enter the London market should be looking to buy assets through 2015, or 2016 at the latest, to avoid excessive market risk.

* Period from Q2 2009 (trough) to Q3 2014

 

View all Grosvenor contacts

Grosvenor Europe Disclaimer

Use of this Grosvenor Europe section of the grosvenor.com website (the “Grosvenor Europe Website”) is subject to the following terms and legal notices (“Conditions”).  You are being asked to agree to these Conditions because:  (a) you are accessing the Grosvenor Europe Website for the first time or (b) you are accessing the Grosvenor Europe Website from a different section of the grosvenor.com website.

The information in the Grosvenor Europe Website was prepared by Grosvenor Europe only for, and is directed only at, the limited categories of persons described under “LEGAL NOTICES” below.  The information in this Grosvenor Europe Website is not intended for the use of and should not be relied on by any other person.

Grosvenor Europe Limited is registered in England, with Company Number 04056191 and its registered office at 70 Grosvenor Street, London W1K 3JP.
This Grosvenor Europe Website contains general information about Grosvenor Europe and related entities and is intended for informational purposes only. The information contained on this Grosvenor Europe Website is not an offer to sell or a solicitation of an offer to purchase interests in any fund managed by Grosvenor Europe or a related entity, nor  is it intended to provide, and should not be relied on for, investment, tax, legal or financial advice.  Investors should seek applicable professional advice for their particular situation.  The information contained herein is a summary only, is not complete, and does not include certain material information, including potential conflicts of interest and risks associated with an investment with Grosvenor Europe and its related entities.

No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained in the enclosed materials, including hyperlinks or references to other sites, by Grosvenor Europe or its related entities, and no liability is accepted by such persons for the accuracy or completeness of any such information or opinions, to the fullest extent permissible by applicable law.  Users are responsible for evaluating the adequacy, accuracy, reliability, merchantability, non-infringement, and/or completeness of any information or the content available on this Grosvenor Europe Website or fitness for any particular purpose with respect to this Grosvenor Europe Website or any of its content.  The estimates, strategies, and views expressed herein are based upon past or current market conditions and/or data and information provided by unaffiliated third parties (which has not been independently verified) and is subject to change without notice. An investment with Grosvenor Europe is speculative and contains significant risks, including the risk of loss of some or all of an investment, and is intended only for sophisticated investors who meet certain eligibility criteria.  Such investments are not deposits or obligations of, or guaranteed or endorsed by, any bank and are not insured or guaranteed by any government or any other agency.

LEGAL NOTICES

Information displayed on this Grosvenor Europe Website may contain material that is interpreted as a financial promotion for purposes of the Financial Services and Markets Act 2000 of the United Kingdom (the “FSMA”).  Grosvenor Europe is not an authorised person for purposes of the FSMA, and accordingly, the communication of information on this Grosvenor Europe Website is provided only for and is directed only at persons in the UK reasonably believed to be of a kind to whom such promotions may be communicated by an unauthorised person pursuant to an exemption under the FSMA (Financial Promotion) Order 2005 (the “FPO”).  Such persons include: (a) persons having professional experience in matters relating to investments (“Investment Professionals”) and (b) high net worth bodies corporate, partnerships, unincorporated associations, trusts, etc. falling within Article 49 of the FPO (“High Net Worth Businesses”). High Net Worth Businesses include: (i) a corporation which has called-up share capital or net assets of at least £5 million or is a member of a group in which includes a company with called-up share capital or net assets of at least £5 million (but where the corporation has more than 20 shareholders or it is a subsidiary of a company with more than 20 shareholders, the £5 million share capital / net assets requirement is reduced to £500,000); (ii) a partnership or unincorporated association with net assets of at least £5 million and (iii) a trustee of a trust which has had gross assets (i.e. total assets held before deduction of any liabilities) of at least £10 million at any time within the year preceding the promotion.  Any investment opportunities mentioned in this Grosvenor Europe Website are available only to such persons, and persons of any other description in the UK may not rely on the information in it.  Most of the protections provided by the UK regulatory system, and compensation under the UK Financial Services Compensation Scheme, will not be available.

Grosvenor Europe is established in the United Kingdom, which is a member state of the European Economic Area (the “EEA”).  Accordingly, this Grosvenor Europe Website is issued by Grosvenor Europe to the categories of persons described in the paragraph above that are both resident in and accessing this Grosvenor Europe Website from any member state of the EEA in reliance on its rights under the Directive on Electronic Commerce (2000/31/EC).  The member states of the EEA are:  Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, Netherlands, Norway, Poland, Portugal, Romania, Slovak Republic, Slovenia, Spain, Sweden and the United Kingdom.

If you are not resident in an EEA member state or you are viewing this Grosvenor Europe Website in a country that is not an EEA member state, information displayed on this Grosvenor Europe Website contains material that may be interpreted by the relevant authorities in the country from which you are viewing the Grosvenor Europe Website as a financial promotion or an offer to purchase securities. Accordingly, the information on this Grosvenor Europe Website is only intended to be viewed by persons who fall outside the scope of any law that seeks to regulate financial promotions in your country of residence or in the country in which the Grosvenor Europe Website is being viewed. Examples of such persons may be governmental agencies, persons sufficiently experienced in investment business to appreciate the risks associated with investment services promoted on this Grosvenor Europe Website, large corporations and trusts and high net worth individuals. These examples are not country specific, may not be relevant to the country in which the Grosvenor Europe Website is being viewed and are provided for illustration purposes only. If you are uncertain about your position under the laws of your country of residence or the country in which the Grosvenor Europe Website is being viewed then you should consult your legal adviser.

Notice to Persons in the United States:

With respect to U.S. investors, investments in funds managed by Grosvenor Europe or a related entity are restricted to institutional investors who meet certain eligibility requirements.  Any potential investor should satisfy him or herself that an investment in any product of Grosvenor Europe or a related entity is permissible under the rules and regulations of his or her domicile.  This Grosvenor Europe Website is not directed to any person in any jurisdiction where the publication or availability of this Grosvenor Europe Website is or would be prohibited.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU SHOULD CONSULT WITH YOUR LEGAL, TAX, FINANCIAL, AND OTHER ADVISORS PRIOR TO MAKING AN INVESTMENT WITH GROSVENOR.

The related entities of Grosvenor Europe include Grosvenor Investment Management Limited, which is registered in England (Company Number 02774291) with its registered office at 70 Grosvenor Street, London W1K 3JP and which is authorised and regulated by the Financial Conduct Authority.

By ACCEPTING this disclaimer, you consent to the above Conditions and, in particular, you confirm that either:

(a)     you are resident in and accessing this Grosvenor Europe Website from one of the United Kingdom or another member state of the EEA and you qualify as an exempt category of person under the FPO (such as an Investment Professional or High Net Worth Business, as described under “LEGAL NOTICES” above); or

(b)     you fall outside the scope of any law that seeks to regulate financial promotions both in the country of your residence and in the country in which you are viewing this Grosvenor Europe Website, and therefore by accessing this Grosvenor Europe Website you will not contravene or cause Grosvenor to contravene any such law.