Thursday, 19 July 2012

Oversupply, Collusion, or Petrodollars: What drives London's property market?

As a renter in London, I have a natural interest in the capital’s unusual property market. Rents in London seem decoupled from the rest of the country, 3 or 4 or 5 times as high, due to the demand created by London’s proximity to well-paid jobs. I don’t have much insight on which way the residential property market is going to go, but this fascinating article from Buttonwood at the Economist suggests UK house prices and rental rates are out of step and may be due for a correction.

One thing that has puzzled me is the resilient prices for commercial property. I haven’t found a good source of data on office rents but piecing together a few datapoints suggests rents have risen gradually and are apparently just 15% off their peak in 2008.

My insight on this comes from two simple observations. Firstly, there is a vast amount of vacant space in the City of London. Near my office in the Monument area there is a sparkling new development, The Walbrook Building, that has been vacant since it was completed in 2010. Streets near where I work and where I used to live in the East London area have a proliferation of empty space and ‘To Let’ signs.

Secondly, there is huge amount of new office space coming on to the market based on new completions. The Heron Tower in Bishopsgate, and St Botolph’s in Aldgate are ‘prime’ examples. The Shard, which opened this month in an impressive ceremony is the epitomy of this, with some reports suggesting barely any space in it is let. The Cheesegrater, the Pinnacle and the Walkie Talkie are all still under construction.

Sooner or later economics ought to catch up with this glut of new capacity and cause a crash in the commercial property market. One apt question, then, is why have prices remained resilient so far?

With respect to rents, I think this may be a case of weak competition. Most of the properties are owned and/or managed by a handful of developers (Land Securities, Canary Wharf Group, British Land) and property brokers (Knight Frank, CBRE, Cushman Wakefield, JLL, DJD). They each have such a large exposure to rental rates overall that they would rather let properties go vacant than let them at lower rates (the natural course of events in a competitive market).

With respect to capital prices, it is no secret that London property has become a magnet for foreign cash. Two of the highest profile developments (The Shard, Battersea Power Station) have backers from Qatar and Malaysia respectively (indeed, Qatar has also recently bought the Olympic Village, Credit Suisse HQ and Harrods.) These buyers are able make high bids for these assets because they have petrodollars which they need to recycle, on which they are willing to accept lower rates of return than other investors. It’s an interesting reversal of 20th century neocolonialism. While all this investment is superficially good for the UK economy, it has the effect of inflating property prices when arguably the economy would benefit from a correction. It also leaves prices vulnerable to capital flight, with the possibility of a full on crash (akin to the 1997 Asian Financial Crisis).

Having made all these bold predictions I shall eagerly wait and see how things play out. In the meantime, I shall not be investing in commercial property in London any time soon!