UK

London Property

Quaerite EmptorIs the London Residential Property Bubble about to Unwind and, if so, what are the Implications for Stocks?

I have been struck by a number of recent data points indicating a slowdown in the London housing market. For example, data provided by Savills (Savills Prime London index) show that prime central London residential prices actually fell in Q4 2014. To put this in perspective: price inflation, having flatlined at +0.4% m-o-m in Q2 and Q3, turned negative in Q4, with prices falling by -4.2% q-o-q, taking the price move for the year as a whole into negative territory (-1.3% y-o-y, vs +7.9% y-o-y in 2013). This, I believe, marks the first annual negative price move in prime central London property (as measured by this index at least) since 2008.

Further evidential support for a slowdown comes from an analysis of the recent results issued by the listed London-focused estate agent chain, Foxtons (FOXT LN). H1 results, released in August 2014, pointed to y-o-y growth of +32.4% in revenues from property sales commissions, of which +19.6% was volume related (a combination of higher transaction volumes plus new branch openings) with the remaining +12.8% being a combination of a) the net change in average selling price per unit (the net of price inflation and mix resulted in a +14.7% increase in the average property sales price) and b) changes in the rate of commission (new homes as a percentage of total transactions had been rising, and these carry lower rates of commission). The outlook statement, however, flagged an expectation of a lower market growth rate in both transaction volumes and prices in H2. The next trading update – issued in October and covering calendar Q3 – was effectively a profit warning. The company announced that it had been “negatively impacted by a sharp and recent slowing of volumes in London property sales markets”, and revenue from property sales commissions, which in H1 had increased more than +30% y-o-y, actually fell in Q3 by -7.8% y-o-y. Quite a turnaround. Furthermore, the outlook for Q4 was also negative, with the company commenting that it expected market volumes for H2 2014 to be “significantly below levels during the same period last year”, meaning that FY EBITDA would now fall y-o-y (cf EBITDA had been up +28.7% y-o-y at the H1 stage). With the FY pre-close update in late January 2015, the full extent of the slowdown became apparent: Q4 sales commissions fell an astonishing -25.7% y-o-y.

On a similar tack, in early December the other listed London-based estate agent, M Winkworth (WINK LN/mkt cap c. £16m) lowered its 2015 expectations for the prime central London market: it now expects prices to be flat overall for the year (previously +5%), including a y-o-y fall of -5% in H1. Countrywide (CWD LN/mkt cap £890m), another listed estate agency with some London exposure, pointed to an acceleration in the rate of decline in transaction volumes in London in Q4 (vols -14% y-o-y in Q4 vs -9% y-o-y in Q3). Non-listed estate agent groups with a sizeable London presence have also highlighted a slowdown: for example, Hamptons Int’l now expect price growth of just +2% in 2015 for central London (previous forecast +7%) including just +0.5% growth in prime central London (previous forecast +3%); and Savills expects prime London residential property to fall -0.5% in the current year.

In the interests of balance, we should add that the latest Rightmove data (House Price Index for January) could be viewed as positive; average asking prices in Greater London rose by +0.9% m-o-m, which included a mixed result from Central London: Westminster strong (av prices +10% m-o-m) and Kensington and Chelsea flat (av prices unchanged m-o-m). Land registry data for the same month, which is based on actual transactions, painted a more mixed picture, with prices in Westminster +0.5% m-o-m, whilst Kensington & Chelsea saw price falls of -1.9% m-o-m. Thus far, data for February (Halifax/Nationwide) for aggregate UK house prices point to m-o-m falls, though we shall have to wait for the release of further surveys before we get data for London.

Talk of a market slowdown in London is increasingly finding its way into the media, with the Daily Telegraph, for example, recently running a series of articles on the topic: ‘Has the London house price bubble burst?’ (Oct 1st 2014); ‘Is luxury London property bubble about to burst’ (Nov 1st 2014); ‘The house price party is over: Values in ‘luxury’ London fall’ (29th Nov 2014); and ‘House Prices: Has Luxury London Bubble Finally Burst?’ (Jan 7th 2015).

The interesting questions are, in the opinion of this writer, thus: a) What has caused the slowdown?; and b) Is there further to go?

London Property Prices: Significant Re-Rating

Firstly, let’s look further into the background to the current situation. In terms of price, prime central London residential prices have increased between +50% to +70% from the 2009 low, depending on which data set is taken (though Savills estimates an 80% rise from the trough for prime central London). What of rental growth? According to Savills, Prime London residential rents increased +1.8% in 2014, giving a cumulative increase of +16.6% since the June 2009 low (inc an increase of +15.4% between 2009-2011 and +1.2% between 2012-2014). On this basis, we could say that there has been a c.33% (assuming +50% price change) to c.53% (assuming +70% price change) ‘multiple re-rating’ in the prime London residential market over the last five and a half years. As a sense check, if we assume a rough pre-tax rental yield of c. 5.5% in 2009, then this would imply a current cap rate of between 2.6% to 3.7%, which looks about right.

Interestingly, this re-rating has been co-incident with the significant contraction in sovereign bond yields over the period. And this contraction in sovereign yields has in turn been co-incident with the three rounds of QE that has taken place in the US, as well as, to a lesser extent, the various iterations of the same that have occurred in the UK. In this respect London residential property exhibits similar (directional) characteristics to the price experience of listed commercial property vehicles in the US and UK stock markets: the falling risk free rate (10 year bond yield) has lead to cap rate compression – as investors price real estate assets off the spread between the bond yield (or rate at which they can borrow) and the pre-tax rental yield – boosting portfolio NAVs. Clearly, the listed property plays have tended to exhibit a magnified share price move (vs the change in underlying market prices) thanks to the impact of gearing on NAVs.

The Role of Foreign Buyers

Coming back to the prime London residential market, the strong price rises seen over the last 5 years have been accompanied by extended media commentary regarding the role played by international buyers, with Russians, Chinese and Middle Eastern buyers being the most frequently cited as driving demand, interspersed with sudden inrushes of European buyers clustered around bouts of localised political instability (e.g. Italy and Greece in 2012). According to Strutt & Parker, around 50% of buyers of prime central London residential property are foreign nationals (Strutt & Parker, London Residential Quarterly, Q3 2014), though Knight Frank points out that only around 30% of buyers are foreign nationals for whom the UK is not a home. This includes both primary and secondary markets. If we look at the primary market (i.e. new developments) alone, then around 70-80% of buyers are estimated to be foreign nationals. Playing with this idea for a while – for there are other, significant factors involved – we could argue that events that impact the circumstances of our select group of foreign buyers – Russians, Chinese, citizens of the more affluent parts of the Middle-East, various Europeans worried about political risk – may well impact demand for London residential property, particularly new developments. So: Quaerite Emptor! (which I believe to mean, ‘Seek the Buyer!’).

Chinese Buyers

As far as our theoretical Chinese buyer is concerned, we highlight the continuing rebasing of GDP growth expectations in China on the one hand, and a government clampdown on graft on the other.   In Michael Pettis’ excellent blog on the Chinese economy (blog.mpettis.com), he highlights how in the boom years of high teens nominal GDP growth, those citizens that were, let’s say, ‘politically connected’, could access loans from the banking system at c.7%, reinvest them in a commercial venture/asset (industrial, real estate etc) and lock in an immediate positive spread of around 11-14% (assuming 18-21% nominal GDP growth), assuming the return of the asset acquired tracks the growth in nominal GDP. Assume the project is 50% debt financed, then the annual (nominal) return on equity (cash invested) is c.22-28%. Nice job. Clearly, since those heady days things have changed. Firstly, our well-connected Chinese citizen probably now borrows at c.6%, but the rebasing of growth expectations means that the available return is, let’s say, closer to c.9.5% (consensus estimate of real GDP growth for China of 7% plus inflation of around 2.5%). Even 1x levered, the prospective nominal return falls to a much more pedestrian 7%. Whilst there is clearly a difference between GDP growth and prospective return, it is a useful proxy, particularly for a country as opaque as China. We can take this further and say that since investments in risk assets typically offer a geared play on GDP, during our period of strong GDP growth, an investment in residential real estate, say, would have offered a much higher return on equity: e.g. in 2005 nominal house prices rose 30%, equating to a return on equity (assuming a 50% LTV) of c.46% (and in 2010 house prices growth of 18% would have generated a RoE of 22% assuming 1x levered). Absent a pick up in GDP growth – unlikely given the ongoing rebalancing – then there should be less available speculative capital that can be exported for overseas ventures (as well as making Chinese investors particularly sensitive to the price performance of existing overseas speculative ventures, the more so in light of the recent strong bounce in the Shanghai Composite).

We should also add that the well publicised clampdown on ‘graft’ in China appears to have impacted other sources of finance; for example the widespread practice of raising cheap finance offshore against a stock of commodities held on the mainland (such as iron ore) and reinvesting the proceeds in a high returning mainland asset play. A rising commodity backdrop combined with lax lending standards during the boom years allowed a similar spread to be earned as described above, on a higher nominal amount borrowed, thanks to the collateral, but at an even lower cost for the borrower. However, falling commodity prices combined with a clampdown on graft and other abuses of position means that this loophole is now harder to exploit. Again, this tends to reduce the amount of available speculative capital.

Russian Buyers

Turning now to Russia and the Middle East, the macro issue here is, of course, the collapse in the Oil Price. There are additionally political factors in both regions, which may have the effect of limiting capital flows to the West. In the case of Russia, the recent collapse in the oil price has tipped the country into recession, with a 4-5% contraction in real GDP expected in 2015. Falling domestic wealth is magnified at the international level by the currency collapse, with the ruble down around 50% vs USD since September. On top of the economic issue – which clearly equates to a significant reduction in the amount of available speculative capital in the country – there is Russia’s increasing isolationist stance to consider. Putin’s nationalist stance, which requires that he make the West the aggressor in his populist rhetoric, is likely to on the one hand increase the desire of wealthy citizens to get their capital out of the Russian banking system and on the other make it more difficult to do so; taking capital out of the country is likely to become increasingly politicised, and, as such, subject to closer scrutiny.

Middle Eastern Buyers

As regards the Middle East, failure of the major oil producers to diversify away from oil has left them hostage to the price of the commodity. Whilst extraction costs are low, resulting in a low breakeven oil price for the best Saudi fields (USD 25-30) financial commitments are also high, principally transfer payments to ensure the acquiescence of populaces which are unable to find employment in economies that are operating woefully below potential. Again, lower profits in the system as a result of the oil price collapse point to less speculative capital available for export. Politically speaking, as capital becomes scarcer it might be ‘encouraged’ to flow into Dubai rather than elsewhere: Dubai real estate has traditionally been highly correlated with the Oil Price and the major Arab oil producers might focus their resources first and foremost in stabilising Dubai, were that market to show signs of weakness, having no wish to witness another property bust on the lines of 2008 (c.-50% collapse).

A New Paradigm?

The reason for examining in some depth the outlook for these particular groups of foreign buyers is in response to media commentary which has accompanied much of the price appreciation that has occurred in the prime London residential market over the last 5 years or so; viz., that we have entered a new paradigm whereby London, a global city, is now appealing to a global set of buyers – the Chinese, the Russians, the Arabs – such that increased demand meeting with limited supply results in higher prices. Reports of new landmark developments selling off plan to Chinese buyers at Hong Kong real estate fairs has further fuelled this commentary, as has the involvement in the market of Chinese/Hong Kong property developers, such as Dalian Wanda and Knight Dragon. Now the point is, if these groups of buyers – the very buyers that have consistently been highlighted as driving the boom – have indeed suffered a significant diminution in their available speculative capital, then we might be excused in postulating some sort of negative impact on London prime residential real estate.

QE

There is another aspect to consider, namely the impact of QE. As alluded to above, by lowering the discount rate QE has had the impact of boosting the price of risk assets. London real estate can be considered as a subset of the overall set of risk assets. However, that is not all. In the opinion of this writer, the very existence of QE signalled an abnormal economic environment, one in which investors were unwilling to provide long term capital. As a result, capital remained in the ‘closed loop’ of financial markets or flowed into assets where there was a perception of liquidity coupled with what we might call ‘speculative play’. The ending of QE in the US, I would argue, signals the return to a more normal economic environment. Capital should move beyond the closed loop of markets, away from the purely speculative and flow into longer-term investments. Couple this with a stronger dollar – a by-product of the US exit from QE – and its reciprocal – significant falls in the commodity complex – and we have a shift from Asia and Emerging Markets to the US in terms of growth dynamics. The greater range of investment opportunities – and higher prospective returns – that will be opened up as a result of this should have the effect of sucking capital into US assets. This may well constitute a further diminution in the amount of risk capital chasing London residential property.

Bubble?

In conclusion, it is only possible to say in hindsight whether or not a particular asset class was in bubble territory. But we make the following observations: a) strong price appreciation off the 2009 low, which is even more impressive given the background of significant price appreciation between 2002-2007 (also note average house prices in London quadrupled between 1997 and 2007), and the significantly shallower correction at the start of the so-called GFC vs equity markets: London property fell c.-20% from the 2007 peak to the 2009 trough vs the c.-42% fall in the S & P (the latter measured from Oct 2007 cycle high of 1576 to intraday low of 666 reached in Mar 2009); b) factoring in annual rental growth of < 3.5% pa over the period, the majority of the price move thus constitutes a re-rating (i.e multiple expansion), which typically makes an asset more vulnerable to a liquidity shock; c) anecdotal evidence regarding market overheating seen in high price inflation in marginal properties/areas, rapid uptake of supply at the peak of the boom, input cost inflation in the supply chain (cf talk of London bricklayers’ declared salaries topping £100k pa) and the high frequency of observations re building activity in central London; d) justification of price moves in terms of a ‘new paradigm’ – London as a global city attracting a new breed of (global) buyer. All of the above is consistent with bubble conditions.

As Soros highlights in The Alchemy of Finance, all bubbles are founded on an element of truth. The increasing percentage of prime residential property purchases made by non-UK nationals between 2009-2014 is that element of truth in the case of (what this writer chooses to call) the London residential property bubble. Bubbles are typically formed as a result of strong price momentum: rising prices tend to beget further rising prices, with valuation anomalies vs historic experience explained away in terms of the new paradigm. The final bubble phase tends to be a parabolic move upwards; this may have taken place in the eighteen months between 2013 to June 2014, when prices increased by c.35% in central London and, in the final stage of this period (first 4 months of 2014), transaction volumes – according to Foxtons (H1 2014 results) – increased by an astonishing +30% y-o-y. It is also noteworthy that there was minimal growth in rents during the latter stages, suggesting buyers were mainly focusing on the potential for further price gains.

Bubbles typically burst when liquidity factors change; I have discussed why I believe that such is now coming to pass with our key groups of buyers, as well as the further negative impact caused by the ending of US QE and the likely redirection of global speculative capital flow into US assets. Once bubbles start to deflate, negative price momentum begets further negative price momentum and valuation arguments made during the bubble phase are discarded in favour of time-tested measures (just as ‘clicks-based’ metrics gave way firstly to the demand for revenues and, finally, profits in the 2000-2001 implosion of the Tech bubble).

Indeed, I would not be at all surprised if our theoretical Chinese buyer, deemed to be ‘price insensitive’, in the face of falls in the underlying value of the asset (as well as possible weakness in sterling) simply sells out in an attempt to avoid further losses. For those who disagree, I suggest that an examination of the Shanghai stock market between Q4 2010 and H1 2014 – a period which captures the negative rebasing of China GDP growth expectations – might prove instructive. Similarly, anecdotal reports of what transpires at the Hong Kong ‘property fairs’ in which London and other UK residential property are sold to Chinese investors are nothing short of extraordinary; it is difficult to view the Chinese interest (in particular) as anything more than a momentum game, making this class of buyer particularly sensitive to price movements (with any further RMB strength unlikely to be enough to offset losses on the underlying asset).

Policy Response

What policy response might be forthcoming to stem a fall in prices? Given recent Stamp Duty changes, there doesn’t appear to be much scope on the fiscal side; similarly, there doesn’t appear to be much room to further loosen monetary policy. In any case, the fortunes of our select group of global buyers won’t be much impacted by any actions taken by the UK to improve affordability in terms of a reduction in transaction tax or debt servicing cost. The imposition of a ‘mansion tax’ as a result of government change would add a further negative factor to the asset class (but would not in itself trigger a collapse in the absence of the other factors discussed here). Furthermore, if the thesis holds that it was US QE (rather than UK QE) that contributed to the London real estate bubble (in the first instance by facilitating the build up of speculative capital in the commodity producing nations and secondly by encouraging the flow of that capital into global risk assets with ‘speculative play’), then monetary policy responses in the UK are unlikely to solve the problem. And the recently announced Eurozone QE also shouldn’t have much impact, except perhaps removing the class of European buyer reacting to negative political developments by shoring up the periphery (Greece being the possible exception). In terms of politics, a Tory victory in the forthcoming General Election is likely to be a positive in terms of managing macro fall-out from any housing bust, but in itself cannot forestall such a bust; a Labour win, most likely, would increase negative outcomes, probably signalling a worsening in the fiscal regime. The only possible exogenous positive factor would seem to be the restatement of US QE, which is unlikely to be forthcoming in the short term.

Safe Haven?

The other area where the thesis falls down is if foreign buyers are ‘price insensitive’ in a symmetrical manner: i.e., they are as indifferent to holding/buying during a falling market as they are to buying into a rising market. One could be forgiven from thinking this might be the case given commentary around London property being viewed as a ‘safe haven asset’. However, I would argue that price inflation has led to a misconception on this topic: no investor likes to witness falls in the value of their investment, less so the margined momentum buyer (or middle-class Chinese buying a London property partly financed with a mortgage from a Chinese bank). Anything that calls into question the soundness of the asset – such as price falls – is likely to rapidly reduce demand for those assets that previously had been deemed to benefit from ‘safe haven’ demand, particularly amongst speculative buyers.

Implications for Stocks

So what are the implications for stock prices? A theoretical short basket would in the first instance focus on those companies directly exposed to transaction volumes and price inflation (estate agents/developers/house builders/self-storage companies with a London and South East focus) and to those exposed to the potential negative credit impact from falling asset values (providers of mortgage finance with a London and South East focus). Our core underlying thesis is that the collapse of the prime London residential market triggers a housing crisis in the markets of Greater London and the South-East (ie, the inverse of the bubble experience of prime central London price inflation spilling over into Greater London and the South East). To this we would also add a number of the London-focused commercial real estate developers as an unwinding of the London residential bubble would most likely negatively impact these as well; the premia to NAV at which these trade, low dividend yields at current share prices and the much-touted ‘weight of money’ arguments used to justify current cap rates suggest these names may also prove vulnerable.

It should be noted that none of the charts thus far indicate that the negative scenario described above is coming to pass; most likely, the market views the recent data as marking a temporary lull, rather than as signalling the beginning of a collapse. There may be a case for waiting for a technical signal from the charts before instigating the short strategy. If the thesis is correct, such a signal should be forthcoming in the months ahead.

Expansion of the short basket from here would depend on whether the impact of a collapse in London prime residential real estate spreads beyond London and the South-East to the regions. This is difficult to assess with any certainty; just because London house prices have pretty much decoupled from the regions since 2009, does not mean that the regions would remain immune to what happens in the capital: the importance of London to the GDP of the UK is simply too great. If a London housing crisis were to spread to the regions, then the short basket could be expanded to include the mainstream mortgage lenders, house builders, building merchants and selected consumer discretionary stocks. More commercial real estate names could be added, moving beyond those with purely London exposure. There should also be further mileage in shorting sterling vs USD. This second stage is likely to occur with a lag and would constitute the second iteration of the short trade.

We would also highlight – most likely in the second stage – the potential for negative impacts to occur in tangential areas; the Chinese banking system and Hong Kong property developers would seem to be fruitful areas to search for tail-end risk. For the listed players, these exposures will become apparent as the market unwind intensifies, and shorts can be instigated at that point.

Please see Disclaimer

Theoretical Short Basket (First Iteration):

Foxtons (FOXT LN/Mkt Cap £560m) Estate agency: Double hit from lower transactions and lower prices in an operationally geared P&L

Berkeley Group (BKG LN/mkt cap £3.6bn) House-builder: A fantastic company, with very shareholder friendly distribution policy, but c.80% exposed to London

Bellway (BWY LN/mkt cap £2.4bn) House-builder: c.22% sales into London (with c.50% of vols from South inc London)

Quintain (QED LN/mkt cap £513m) London-focused property developer

Paragon (PAG LN/mkt cap £1.3bn) Buy-to-let lender: estimated 40%+ of mortgage book is London/&SE

Savills (SVS LN/mkt cap £987m) Estate agency/property consultant: negatively impacted by direct exposure to London mkt as well as indirect exposure via H Kong client base (c.30% EBITA from UK prime residential property transactions, London & Regions)

Safestore (SAFE LN/mkt cap £552m) Self-storage company: c.50% revs London/SE

Big Yellow (BYG LN/mkt cap £994m) Self-Storage company: c.30% revs London/SE

Derwent London (DLN LN/mkt cap £3.7bn) London-focused REIT

Capco (CAPC LN/mkt cap £3.4bn) London-focused REIT

Great Portland (GPOR LN/mkt cap £2.8bn) London-focused REIT

Workspace (WKP LN/mkt cap £1.4bn) London-focused REIT

Please see Disclaimer

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