Foreigners lift London property out of doldrums

Earlier this month, Aviva, one of a host of asset managers to impose redemption restrictions on its property funds in the wake of the financial crisis, finally lifted those constraints.

Yet at least two peers, Threadneedle and Hermes, have already moved to stagger the rate at which they accept new money amid fears that the wave of cash flooding their commercial property funds could overwhelm the managers’ ability to put that money to work.

Chris Morrogh, fund manager and director at Threadneedle Property Investments, says with some understatement: “We have probably come out of the trough more quickly than history would have suggested. [The property market] stayed in the doldrums for some time in the 1990s.”

The Threadneedle Property unit trust, which shrivelled to £280m (€313m, $466m) in the spring having peaked at £450m in the boom, is already back to £375m.

Over at Standard Life Investments, inflows have hit £500m during the past three to four months, almost back to peak levels.

“It’s remarkable how quickly things change. I think it has surprised a lot of people,” says Mark Meiklejon, investment director, who adds that retail investors are now following the lead of institutions and leaping back into the fray.

The initial wave of re-investment has been directed at prime office property, particularly in central London and Paris, where yields are tumbling fast.

Although the prime market traditionally rebounds first, observers cite a confluence of factors for the particularly sharp, rapid turnaround this time.

“This is the first time we have been through a recovery where there has been cross-border investment. Previously it was a domestic market,” says Keith Sutton, director of European real estate at Fidelity International.

Data from DTZ, a real estate adviser, suggest that 81 per cent of the £4.3bn invested in central London property in the first nine months of the year came from overseas, almost double the 44 per cent average rate between 2000 and 2008. For the UK as a whole, foreign investors accounted for a record 45 per cent of investment.

Martin Davis, head of UK markets research at DTZ, says German property funds led the way, but are now increasingly being outbid. The deeper pockets appear to belong to North American private equity and property companies such as Blackstone, which in September bought half of the City’s Broadgate complex in a deal valued at £1.1bn, and the ubiquitous sovereign wealth funds, both from the Middle East and elsewhere – witness this month’s £773m purchase of HSBC’s flagship tower by South Korea’s National Pensions Service.

“A lot of the investment in central London is from overseas. Because of that additional strong demand I’m finding better value outside London,” says Mr Morrogh

The weakness of sterling is said to be adding to London’s appeal. Yet the US, home to the world’s largest and most liquid real estate market – and to a currency that has even been weaker still over the past year – is not yet witnessing green shoots, with capital values falling 5.2 per cent in the third quarter, according to the Investment Property Databank.

Mr Sutton squares this circle by arguing that Middle Eastern investors in particular have enough exposure to the dollar.

Fidelity believes the ripples of recovery will spread to other big northern European cities such as Copenhagen, Stockholm and Amsterdam, and to regional centres in the UK, where German funds are already said to be shopping.

The attractions of commercial property are also being bolstered by the meagre income available from other asset classes.

Figures from the Association of Real Estate Funds indicate that the spread between yields on pooled property funds and 10-year gilts hit a historically high 276 basis points in the first quarter. Although this has since halved to 130bps as property yields have contracted, this is still far higher than the historical average spread of -10bps.

“In a low inflation and interest rate environment, where do you buy yield and cash flow?” Mr Meiklejon asks rhetorically.

Mr Morrogh adds: “Our trust has a yield in the mid-8s. That is attractive when you look at gilt yields. There is a healthy arbitrage between property income and cost of debt.”

There is also a belief that a dearth of new development will help support property prices and push yields lower. According to Drivers Jonas, a consultancy, development of office space in London is set to fall to its lowest level for 30 years.

“Supply is more and more limited and there is zero pipeline in the City for 2012,” says Tony McGough, global head of forecasting at DTZ.

Matthew Richardson, head of European real estate research at Fidelity, says there are overhangs of vacant property in Madrid and the City of London, but for the latter “we are only two or three deals away from supply being tight again and there are three deals on the way at the moment for 100,000 sq ft.”

The banking sector, which has become the unwitting owner of a swathe of property as a result of defaults by borrowers, might be an obvious source of supply, but Mr Richardson sees signs that banks are in it for the long haul.

“There is evidence of banks setting up workout teams. Why crystallise a loss and give the upside to a property developer? Everyone being taken on in real estate is being taken on by a bank.”

Consequently most in the industry see scope for further yield contraction, in spite of fears of overheating in the prime segment.

“For prime stock the reality is that there isn’t much choice going into 2010, 2011,” says Mr McGough.

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