COMMENT Despite the market restrictions and uncertainty that have been imposed by Covid-19, the case for investing in London real estate remains compelling, particularly if you look at it in terms of optionality and relativity.
For those mulling over their investment options the alternatives to property are gold, gilts, the bank or equity markets. All have limitations.
Gold provides no income and the ‘in’ price today looks very full at roughly $1,900 per ounce compared to $1,300 per ounce this time last year, while 10-year gilts are unattractive on a risk adjusted basis. For example, the German Bund is negative at -0.62% and even in most stable countries in the current challenging market are between 0% and 0.4%. The highest gilt yields can be found in Italy (0.8%) and Greece (0.78%).
There is also little income to be had from keeping money in the bank with base rates so low and in Europe institutional investors will face charges to hold their money. Consequently, this is not a viable option – a charge on cash, coupled with inflation, however small, is a disaster at fund level.
In addition, the ongoing volatility in the equity markets makes achieving a reliable income uncertain as globally dividends have been slashed or cancelled as a consequence of the pandemic. The VIX index gives us the clearest picture of this and reflects the sentiment of the market. In January 2020 volatility was 12.5, jumping to 82.69 on 16 March and now back down in the 20s. This means capital gain is very possible but sustainable short-term income is unlikely.
Paying a low premium
There is also the option of investing in real estate’s debt markets, which ticks the income box, but it is a competitive world with low margins. Spreads have moved to reflect uncertainty and supply, which means the level of return is low unless risk is taken.
This leaves investing directly in property. The real estate yield should be the risk-free rate, plus an illiquidity premium, plus a risk premium.
The risk-free rate is incredibly low and the illiquidity premium must depend on location and sector but, as an example, a grade-A central London office building is as saleable today as it was in February. The risk premium again will depend on lease length, covenant and, of course, 2020 rent collection.
Consequently, on a risk-adjusted basis, a grade-A London office building at circa £200m, showing a triple net initial yield of 4%, represents a very attractive income return against other asset classes. If levered at 60% this can deliver a 6%+ cash-on-cash yield on equity invested.
True liquidity
Turning now to the relativity, if we take the same asset and same hypothetical location in continental European markets, then the case for London increases further. Yes, there is the argument that the cost of debt is cheaper in the eurozone, but ultimately not every investor is leveraged. What is 4% in London is 2.75% in Paris and 2.5% in Berlin or Munich. Multiple cities across Europe, including Amsterdam and Brussels, are now sub-3%.
This spread seems to be too wide – either continental Europe is overpriced, or London is too cheap. With the highly restricted development pipeline and the long-term fundamentals of London, I suggest it is the latter.
While London yields have stayed static since the beginning of the year, many of the prime European markets have seen compression.
Looking too at the comparative levels of UK investment versus European, volumes in the UK have remained relatively steady since the great financial crisis. However, they are now significantly above trend in Europe and therefore yields have compressed beyond their normal range. Is this a red flag risk for investors into key European cities?
London is the most liquid and transparent market in the world with limited barriers to entry and, whilst short-term performance is being challenged by Covid-19, we are seeing true liquidity, and an opportunity exists to secure assets which are not typically available in stable market conditions.
James Hammond is executive director at CBRE
