Time is right to leap-step returns
The Global Macro Economic environment with high inflation, rising interest rates and geopolitical uncertainty has led to significant movements in value / pricing across all asset classes, particularly the Real Estate market. Today, London is the location demonstrating the most value. Over the past 9-12 months yields have widened significantly as the Bank of England has increased the base interest rate, creating a remarkable investment opportunity.
Traditional, strong long income yielding assets in the City of London and West End are trading significantly below their peak pre covid values.
The real question is whether the market is pricing correctly. For this, a comparison between Real Estate, Bonds and Equities is essential. Over the last 30 years, comparing risk adjusted returns, Bonds have been the best performer. However, on an absolute return basis, Real Estate is the best performing asset class.
Investors today are spoilt for choice with a wide range of financial products available to them, particularly with new structured private banking products and the rise of Crypto in the past 10 years.
We are in a unique environment, where subprime assets, can be improved and achieve Core/Core + returns.
Imran Ellahi
The crypto winter has led to write downs in value and investors repositioning their portfolios to more traditional asset classes. However, when considering where to invest, it is important to compare apples with apples. For example, a bond issuance by private banks backed by luxury private assets such as yachts is not comparable to Real Estate. To have a fair, risk apportioned comparable, Real Estate has to be measured against Government Treasury returns.
With the UK base rate at 5.15% and the UK 5yr GILT priced at 4.44% the question posed is what should be the true value of Core London Real Estate.
Real Estate should trade at a premium to Government Treasuries (to allow for risk inherent in Real Estate investments). At the moment we are seeing Real Estate assets being priced at 7% + (assets with minimum 5yr WAULT) exceeding average 10-year West End and City yields by 300bps.
With inflation where it is today and bonds being a static investment as compared to Real Estate where the asset benefit from appreciation and can be improved through active investment / asset management, we view Real Estate being a more lucrative and secure asset class to invest in. This is further enforced by Real Estate market conditions and requirements. London Real Estate is witnessing a 4% year on year Rental growth. Considering government requirements (EPC) and the post covid tenant requirements, we are seeing a big separation in rents between prime Grade A and Grade B assets.
As such, with pricing where it is today giving good yielding returns and the value add opportunities arising out of new ESG requirements, investors have the opportunity to make what we describe as infinite returns. Given we are in the decline phase of the cycle, as we enter the growth phase we expect yields to compress by 200bps in 5 years.
Core Grade A real estate is trading at 6.5%, any asset requiring capex is trading at 50bp-100bp discount.
According to a recent survey by Lambert Smith Hampton, 80% of all Q2 2023 transactions involved Grade A office space, with a significant number of those deals being pre-let with companies using improved office space as a recruiting tool.
In 2022, Grade A office space accounted for 92% of all office space take-ups, which is higher than the 10 year average of 83%. BREEAM-rated buildings account for 62 percent of all transactions, which shows how important sustainability credentials have become to virtually all tenants. Since 2020 tenants are required to include new greenhouse gas emissions and energy consumption disclosures in their directors’ reports. Leasing volumes for the last 12-months totaled 3.35 million sq ft, 3% below the five-year rolling average. The equivalent figure for grade A equated to 2.2 million sq ft in Q2, 12% ahead of the five-year average of 1.97 million sq ft.
Even though we believe from a traditional yield perspective Real Estate is priced cheaply and assets will naturally appreciate over time, the disparity between Rents and asset values of Grade A space compared to Grade B provides the additional opportunity improve your asset leading to significant returns for the investor. There is a circa 25% difference in Grade A to B Rents and a minimum 100bp value difference in Grade A buildings compared to Grade B buildings.
We are in a unique environment, where subprime assets, have the opportunity to be improved and achieve Core/Core + returns.
Let’s consider an asset priced at 100m yielding 7.5%. With Capex Expenditure of circa 20m, can result in a yield appreciation of 9.5%-10%. Taking into account market conditions and natural yield compression, the future asset value would be 200m (assuming a 5% yield) which is above the 10-year average City yield curve. At which point the asset can be sold or financed to realise gains.
We currently are working on a host of transactions that encompass our views and meet our internal investment criteria. Curious about our current transactions? Connect with us
West End Opportunity
