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?

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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


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