The South East office market had been enjoying significant rental growth in key markets and solid take-up and investment figures as well as robust lending appetite. And then the EU Referendum vote arrived. All of which contributed to a particularly insightful and entertaining debate at this year’s RO Real Estate and Office Agents Society lunch, which took place with key figures in the agency, investor, developer and lending communities the week after the vote. CoStar News was in attendance.
The participants were: Richard Bourne, RO Real Estate, Ryan Dean, OAS Chairman & Knight Frank, Richard MacDowel, Lloyds Bank, Aston Woodward, Oxygen, James Silver, Landid, Rob Bray, Bray Fox Smith, Rory Carson, Oxford Properties, Chris Lewis, Cushman & Wakefield, Phil Sturdy, Mayfair Capital, Ed Smith, Strutt & Parker, Richard Talbot Williams, BNP Paribas Real Estate
The banking market appears to have initially been the most hit unless you are a housebuilder. Richard what is the analysis from a Lloyds perspective?
Richard MacDowel – The announcement was clearly a surprise, with the markets expecting Remain, but I understand there have been contingency plans put in place with the Bank of England across the financial sector to make sure liquidity remains strong. And I certainly feel that this is very different to 2008, where real estate lending books across the UK currently seem to be in robust shape, as per the latest de Montfort survey. I understand at Lloyds we are well below 60% LTV across our book and we have been running stress tests with our Regulator to ensure we are prepared for any potential period of lower values. From our perspective, we have a strong balance sheet.
In terms of appetite for continuing to support and make real estate loans to our customers, I have had no sense that it is anything other than business as usual from a credit point of view. There will clearly be scrutiny while revised valuation metrics are established, but we remain open for business.
I think there is consensus that pricing will start to be impacted and margins will go up as cost of capital increases with volatility and uncertainty. But it’s too early to determine what the new normal is.
Richard Bourne – You are lending at margins over libor but libor is coming in and looking at swap rates they are coming in too. Therefore won’t borrowing costs remain relatively stable?
Phil Sturdy – I expect margins to increase by 50 to 75 bps while swaps have come in by about 40 bps. The overall cost of debt is probably going to rise but remain at historically cheap levels.
Richard MacDowel – My gut feeling is margins have risen and will rise 25 to 50 bps and it probably won’t be as bad as 50 to 70 bps and, as you say, 10 year swap rates have dropped by 40 bps, so the net difference I don’t think will be massive. Obviously if property values drop then your overall ICR coverage should stay consistent. If you are lending at 60% loan to value against £10m and your ICR was 1.6 times and your value has dropped to now £9m and you’re still at 60% and your cost of funds have only gone up marginally, than actually your ICR should be in a better position. The key of course is making sure your income covenant remains unchanged.
Phil Sturdy – Richard do you see banks being more cautious and bringing down their LTVs and wanting better real estate and longer leases to lend against? To be more discerning on what they lend against?
Richard MacDowel – Our credit policy has not changed, as we remain a lender through the cycle and our policy is designed for such eventualities. I suspect we will be cautious while the impact of Brexit remains uncertain on occupier markets and values, but we remain very much open for business, as I gather are a number of our competitors. We got challenges from credit pre Brexit and we will get challenges from credit post Brexit.
Chris Lewis – So what happens if there is a reduced amount of activity in the market and so less opportunities for you to lend against? Have you got pressure to lend?
Richard MacDowel – I think our real estate lending business is going to be under scrutiny along with those other sectors that typically are first to suffer where there is a downturn, and we will continue to justify the use of the bank’s balance sheet against lots of other demands of capital in the bank. There is no pressure yet to lend and I believe liquidity remains good, but we hope our customers see the merit of being with a strong bank and we will look to support them in what they are doing. Whether there is another push along the lines of the Funding for Lending Scheme, remains to be seen. But I don’t see it at present.
Ryan Dean – We were gearing up to bring forward a few sales. Now they may get held a little bit. How have values probably changed?
Chris Lewis – It is a bit early to say anything in terms of where values are going but what we have seen is a few deals fall out of bed which possibly were on the brink anyway, so it’s a good excuse to pull out of deals at this stage. They have been under offer for a long time and are waiting to find a reason not to do it.
Phil Sturdy – We pulled out of one deal with 25% vacancy. The deal was always subject to Brexit and we didn’t even start due diligence. I think investors will just move down the risk curve. There is natural nervousness right now for riskier assets with short term income or vacancy. The longer leased assets look relatively good value with gilt yields falling to sub 1%.
Richard Bourne – It is interesting. We have an institutional sale that has exchanged subject to a Brexit clause. They had until 5pm last night to invoke the break clause, 5pm has passed and they have asked for a completion statement and the agreed price. Now that is a long-dated income. With RPI kickers and it is a good quality covenant play - it is defensive stock. Property is a long-term game and most investors are saying this will sort itself out over 5-10 years. So there is no real issue.
"I have not been party to their investment committee decision but it must have been kicked around the table a few times and they have decided to run with it. I agree we will see a flight to quality and a lot of funds and institutions are likely to have to be seen to be not taking risk. But for us as a South East focused private property company we are looking at where the opportunities are. When this sale completes I am hoping to be sat on about £30m of cash ready to invest and looking at where the opportunities lie. South East offices over the years have done very well for us and I think there are a lot of areas where the supply and demand balance is very good, I think there will be some good opportunities going forward.
Chris Lewis – It does depend on where people’s attitudes to where the occupational dynamics are. The aggression that we have seen on occupier growth in appraisals is going to be pegged back a little bit. That said overseas buyers with the currency plays that we are going to see are probably going to lead to a more aggressive view on pricing so they may cancel each other out.
Ryan Dean – The funds will be more defensive, there will be a focus on decent quality kit and income because if they have to sell that is the stuff that goes first.
Chris Lewis – But who are the people who are going to sell? Maybe the retail funds will come under a bit of pressure but they do have good cash buffers.
Phil Sturdy – A lot of the retail funds have quite significant 15 to 20% cash buffers so they are much better placed than they were in the last downturn but I guess they are expecting or are wary of redemptions.
Ryan Dean – The press have suggested some funds have taken a 5% discount just to try to prevent redemptions.
Chris Lewis – Yes and that is the sort of thing that is understandable. They are saying let us look six months down the line. We need to have the buffers in place. Does that mean there are opportunities coming forward, probably not because those retail funds from last time around will be selling assets of top quality. They will not be looking to cut out the low quality because they will see a big impact on value. They are going to say the reason why we bought top quality assets in the first place is for these events where we have volatility and values remain high.
Richard Bourne – But do you not think they will also see this on the secondary, tertiary assets? They might think that the lot size is too small and the asset is too management intensive, so let’s get it out the door and take the cash.
Rob Bray – Because there will be capex coming up. Some of the M&G stuff that came along came out because it had capex in 12 months’ time.
Ryan Dean – If they need the money, they need the money. Trying to sell something where you have vacancy coming up, is likely to be more difficult. But if you need to put additional capex into a refurbishment then I can see those decisions being more of a challenge.
Rob Bray - But there are other parties that pick up all of these opportunities and the only way they make money is to buy low and sell high.
Phil Sturdy – I will be interested to see what the volumes are like because to date they have been pretty depressed and investment agents thrive on deal volume and I don’t see the volumes increasing significantly.
Chris Lewis – The UK investment volumes are forecast at noticeably lower than 2014, looking at down by 25%. It has been skewed by Green Park in the South East. Q2 looks quite positive because of that but you have to take that into consideration.
Ed Smith – The number of deals is down.
Chris Lewis – We are saying 25% down year on year and it could pan out a bit more than that. If people have written off to Q3 then they may think let’s write off the rest of the year and start again.
Richard Bourne – But how much of the year was annual market slowdown and how much is Brexit?
Chris Lewis – The second half of last year was a marked slowdown on the first half and we came into the beginning of this year and everyone was appraising it as pretty fully priced. It was all about property fundamentals and then the market occupational story. We are only buying decent centres with good growth stories in the face of yield compression. That is where you can see where the last six months has been going. Bolt on the Brexit and you can see that it will stay off for at least a quarter, probably until the end of the year.
Ed Smith – Is that because last year was driven by the retail funds?
Chris Lewis – The first half of last year was retail funds. But overseas still had about a third of the market.
Ryan Dean – But what they were trying to do was get their funds in decent shape should something like this happen. Yes they did buy but they bought good quality defensive assets which they paid a good price for.
Richard MacDowel – A fair amount of our overseas clients have been relatively quiet in the build up to Brexit but actually in the last couple of days we feel they will come back into the market because the exchange rate has shifted. I think Q3/Q4 will see a lot more activity from overseas buyers who were basically out of the market in Q2.
Richard Bourne – Private equity and property companies have been building up funding to take advantage of the market so I think the investor market is still there. The exchange rate is also making property look relatively cheap for foreign investors now.
Chris Lewis – Yes they have their time in the sun to come because they have always been up against the institutional market where they have been struggling to win and now they have an opportunity where they say well actually we are only up against ourselves now.
Ed Smith – Overseas investment is not common in the M25 though.
Aston Woodward – This morning I had a couple of calls from South African investors, one a South African REIT and the other a South African family office who have holdings here. Their concern is over what the impact will be to existing holdings and what may happen to values and also if you have vacant space what are the effects on companies who might potentially occupy that space. We understand there will be redemptions in retail funds and we have been talking to various fund managers. It will be interesting to see how it unravels and from an overseas investment perspective it feels like an opportunity, the question is at what point do you come in? There is currently a 5% discount and this could be a 10% discount on some of the other retail funds and even greater going forward
So I think in summary there is concern but without doubt there is a sense of, is this an opportunity and should we be doing something about it and if so when should we be doing something?
Richard MacDowel – So sterling has broadly come down 9% against the dollar and euro, the rand by about 7% so I think the pound/rand exchange rate is around 21 pre Brexit and is around 19 now so I think the rand/pound differentiation is not as significant.
Aston Woodward – Now we are seeing sterling devalued, I think yes there is a buying opportunity for overseas investors. What is interesting is some of the overseas REITS have taken a lot of subscriptions as a reaction to the risk associated going forward in the U.K. The REITS with a premium associated with UK and European holdings have lost some of their value to reflect this new risk. A big question for the South East office market will be over the occupational piece.
James Silver – It is too early for us to react too much at the moment. We are building out about 600,000 sq ft in the South East and what we have done is ensure That we have bought and developed the best in the market in terms of specification so we feel positive. Actually thus far it has been strong in terms of continued talks on letting space.
Ed Smith – People have been getting to a lease event. That is the reason they move and the days of the huge expansion were gone in 2000/2001. It has really been about moving from a poor building to a good building.
Ryan Dean – Lots of investment decisions have been made on the back of forecast rental growth, post the Referendum where will they be going?
Ed Smith – We have not lost a deal or seen anybody call off negotiations but the bigger houses that work with a larger number of corporates are all thinking should they be committing tenants to a lease now if they have time on their hands or should they be waiting a couple of months longer. I am seeing that a little bit in larger ones that have a larger time horizon. So somebody who is looking at a prelet and they are in a market where they can possibly pick up an existing building between now and their lease expiry then the advice they are being given is "we might have reached the top and you might get a better deal in two months’ time" so there might be a bit of that going on but fundamentally businesses still need to move.
Richard Bourne – We have a couple of vacant buildings that have been recently refurbished and are now under offer. We have two lettings in Potters Bar where both the tenants have a lease expiry on their existing building which is going to residential so they have to get out. They are chasing me daily even after the vote.
There are still people who are going to be forced to make decisions. We have a building in Watford, only 4,500 sq ft, but we had five tenants fighting over the building and we drove rents from £24 per sq ft to £26 per sq ft.
That is driven by five people who are desperate to take space and need to make a decision. So as much as there has to be caution and the big corporates will have to rethink about committing to multimillion-pound occupation costs there are a number of reasons why people have to move whether it is contraction, cost saving, higher profile branding, lease events or it is a need to improve efficiency.
James Silver – Most of the markets have limited supply.
Ryan Dean – That’s the key that we have not seen before in previous situations. At Knight Frank we see the M25 vacancy rate at about 5.5% and yes there is some stock coming through and it is going to move vacancy out a bit but nowhere near back to where we were in 08/09 or early 03 levels where there was so much space on the market. So fundamentally that is quite different.
Aston Woodward – In some ways it could actually be quite helpful. So let’s say the balance of power goes a little back with the tenant and they can start to squeeze landlords that might unblock things and make things happen and could actually generate some activity.
Rob Bray – But I don’t think a lot of the deals we do are about rents – it is within a bracket but if we are talking a pound or two a foot that does not impact decisions.
Richard Bourne – We have focused our buying strategy purely on where the supply is low or decreasing and demand is strong as that is where you are going to see rental growth and keep the building let, cash flow is king. I have not seen tenants pulling back on rents, in fact the opposite. I think simple economics would suggest that rents won’t stop moving on because we haven’t had the supply in recent years. There is less space for tenants so they will pay extra for the best space.
Chris Lewis – Is there a risk of a lot of grey space coming on to the market?
Ed Smith – The announcements are more City based and not so much Thames Valley where we are. This market is not so exposed to the likes of HSBC moving their headquarters. I think our biggest stress point will be companies from the States who are here looking at their European headquarters that may be impacted. There was an announcement earlier today for instance about Vodafone questioning whether their headquarters should be in the UK.
Ryan Dean – But that is the corporate headquarters in Paddington. Not to be political but this could be bigger than just what has happened in the UK which means actually would Vodafone be wise to move to Germany knowing what could unravel across Europe. Who knows what will happen? So if you have something that is working are you going to see that out for a little bit to work out what will happen? If those rents start to fall off in Central London does the discount in West London of £50 per sq ft start to have less of a pull than it did?
Ed Smith – Possibly but those rental rises have only been because local occupiers have moved from poor buildings to the new quality buildings that have been delivered in that period. Because we haven’t actually seen anybody move from the West End to Hammersmith. Has anyone mentioned that Ocado signed for a 150,000 sq ft deal on Thursday? That is obviously a business that delivers to UK households.
Ryan Dean – It is a big business with a 1,000 people and they could have delayed their decision but they simply had to do it.
Rory Carson – If you think back to the dotcom crash, the grey space that came onto the market was from companies that were expanding quickly having signed big pre-lets. It went from being a massively undersupplied market with lots of demand to a hugely oversupplied market. In the South East, however, it was a far more balanced situation, with demand fairly consistent throughout the cycle. Take-up since the credit crunch has often been driven by people going to better buildings and using them more efficiently. The supply and demand dynamic is pretty positive and I think that occupiers are, mostly, right-size at the moment.
Rob Bray - The fundamentals of the UK property market are very sound. There is not a massive oversupply in that respect and the English language is so important.
Richard Bourne - They have a skilled workforce in companies like Vodafone so those decisions are not going to be taken lightly - the costs of taking an office and moving somewhere else is going to be huge.
Richard Talbot Williams – The national investment team has continued to do deals and where there has been a change they have been value add, up the risk curve deals and where they have come back they have been “we want to trade at a different price or we are not sure whether we want to trade”. That has been two or three smaller deals. But I think in the more core stuff it has been income deals and it has been business as usual.
Chris Lewis – Is it sterling buyers that have been saying, “give me a bit more time or I need to a have a chat about it?” or was it overseas buyers?
Richard Talbot Williams – It is generally overseas money but backing UK asset managers.
Richard Bourne – In the press it is often big deals that are talked about but if you get under the skin of it the smaller lot sizes and buildings are still performing well both occupationally and investment wise. Look at auction houses, they have been absolutely rammed to the rafters and there have been high success rates off the back of that.
Phil Sturdy – A lot of the private buyers at auctions are investors who favour commercial property over an over taxed residential investment market now?
Richard Bourne – You have a two tier market in terms of large Institutional lot sizes and smaller private lot sizes. You can see the attraction for the private investor. There are always opportunities I am fascinated to see what happens in the July auctions. We have two assets going in there so I hope it continues. I think the smaller end of the market has been boosted by the tax on buy-to-let resi. Investors are switching to commercial assets to get better returns.
Chris Lewis – The smaller lot sizes have gone very well since the start of the year. I have sold for L&G in Crawley and had 15 to 16 viewings. The council bought it in the end but we saw a lot of aggressive viewings.
Phil Sturdy – We are seeing a lot of the councils buying and it is not council pension fund money buying, but council balance sheet money. The councils previously put money into Icelandic banks so UK commercial property does not look so bad!
Ryan Dean – The big 80,000 sq ft deals get the headlines yes but from Knight Frank’s point of view we are still about sub 15,000 sq ft on average. All the buildings that you guys are developing have to be sub divisible and let in part and most of those businesses are 100 people or less. So actually the engine room that drives the market isn’t the big deals and I think the leasing advisor now is probably going to say take the deal in hand and get on with it.
Richard Bourne – And of course you are derisking the asset if it is multilet.
James Silver - If you look at the Thames Valley the market is about making space for communities.
Ryan Dean – In an occupational market that is more diverse than central London we are not reliant on the banking sector. Financial sectors have been a great part of take up in the last year but actually across the board it is pretty diverse.
Aston Woodward – I think the City will change. If you look at Bloomberg, Soho House, and many other changes due shortly I think the City has got quite a lot to offer. You cannot really question a tenant that occupationally chooses the City. Okay it may not fit your ethos or your culture but it has a lot to offer still. I think the market will be quite interesting because the rents compared to other markets not far from the City make the City look quite good value. It has good fundamentals.
Chris Lewis – What about overall occupational costs?
Ryan Dean – We had already seen pre the leave decision people looking at taking elements of businesses out of central London. So keeping a front of house in town and looking at decanting people out.
James Silver – I haven’t seen any real evidence of it yet.
Ryan Dean – In somewhere like Croydon you are seeing it with EDF and HMRC.
Ed Smith – Time Inc in Farnborough and Maersk in Maidenhead.
Ryan Dean – They actively said they would move people out there. People are more mobile than they have ever been. If you talked to a 24-year-old guy in our office and said you have to go and work abroad I don’t think it would be feared. Staff are more mobile.
Rob Bray – What we are seeing and what we will continue to see is the impact of resi. It has been a fairly amateur market in PDR. We are looking at one now and thought do these guys want to spend £20m on a refurb of this kit in this environment or do they think we will move on and take that money in this environment and buy a bargain somewhere else over the next six to 12 months? So it has almost come back into our hands a little bit. We could not get anybody to answer a phone and then in the last two days we are being asked could you just clarify this and this. Everybody knows the PDR market has had a big effect on supply in a lot of towns, to the detriment I think in some cases to the office market. I got an email from Taylor Wimpey a couple of days ago saying as you can imagine we are taking stock of things and we can’t make a decision on this. But I have others who will jump in if there is an opportunity. There is a massive undersupply and the planning system is slow and cumbersome."
Ed Smith– It is only in the very high residential value areas where it is a problem. We sold an office building about a month ago in Gerrard’s Cross - only 10,000 sq ft at £500 a foot - unconditionally you would have to let it at £45 a foot to the government for 20 years to get the same value and you would have to spend £100 a foot on refurbishing so I think affluent areas around the M25 will continue to see an erosion of office stock and they will move to the big ones like Uxbridge for example. There were four or five businesses who all want to stay in Gerrard’s Cross but they can’t because residential values are so high.
Ryan Dean – In St Albans, yes rents have gone up but actually getting a new occupier to relocate into that town is really challenging which could be quite detrimental to the town. So yes from a landlord point of view it is fantastic but actually from an occupier point of view it is a real, real challenge. We have had a couple of things from a refurbishment point of view with a landlord saying let’s just check the PDR thing again.
Richard Bourne – We look for a Plan A and Plan B where an investment asset will also stand up as a resi development. It is a defensive position. It works as a plan A with rental growth coming through and if the occupational market dies then we have a backup option. There are two ways to make a return on the investment.
Chris Lewis – Spec development will probably be put on hold.
Ed Smith – It will probably be put on hold because there is almost enough coming through.
Aston Woodward – It was almost like the catalyst to it slowing down. It feels like there were a lot of things that are a good stress test for the UK economy. We have some really good people and companies and they will come back fighting as those things they do are on demand on a global basis. We have to be confident in backing the UK.
Ryan Dean – Total offices under construction is 3.2 m sq ft. From our stats average take up is 2.6m sq ft. So if there is this pause there will be two schemes being delivered in 2018 so there will be a slowdown in new speculative development. We will see more buildings go out for alternatives whether that is resi or other uses. Tenants want to see more place-making big towns that need some significant redevelopment. If that gets delayed it could be negative for the town.
Which of the locations are primed to win across the South East?
Aston Woodward – It so much to do with the characteristics. It is amenity, skilled labour force and infrastructure.
James Silver – It is about being in town centres where you know your staff are going to be happy.
Ryan Dean – When they are trying to change structurally it is about different drivers. The infrastructure changes for the South East are quite significant whether it is the Elizabeth Line, the Bracknell town centre regeneration or West Ham in Croydon.
Rory Carson – One thing that might be derailed following the change in Tory leadership is Heathrow.
Phil Sturdy – Gilt yields are at historic low rates so now is a great time for the Government to be borrowing to fund infrastructure projects.
Richard MacDowel – In terms of our risk exposures, we are well spread across sectors and regions. From my understanding of research done by de Montfort, I understand the UK clearers have been focusing more on London over the last 18 months and grown market share there (vs non-bank lenders) where you would have expected increased market share in the regions. We are happy with our footprint: We are a UK wide platform so that is a marked point of differentiation for us and we have been active in the regions as well as backing our share of deals in central London and the South East. We watch to make sure no overexposure in any one area, but otherwise we are not top down strategy driven, but rather borrower and opportunity driven.
Aston Woodward - How are you affected by the competition of overseas lending coming in?
Richard MacDowel – The market share of all of the UK clearers has decreased over the past 6 to 8 years. This is probably no bad thing as it results in a more diverse and liquid debt funding pool. Overseas lenders are part of that diversification trend.
Phil Sturdy – German banks are not talking about retracting but they will be more conservative lenders in terms of lower LTVs.
Richard Talbot Williams – The lenders who have agreed lending ongoing will complete. But if you go to ask for new terms you are probably not going to get a great deal.
Richard MacDowel – UK clearers have seen market share reducing over recent years. As I have said this is probably healthy. I think Brexit may see this market share erosion stabilising if not slightly reversing as overseas lenders may refocus on home markets while the UK clearers continue here. Within Lloyds Banking Group, we have Scottish Widows, our own insurance business, and they remain open for lending where the term is longer-dated, 10 years and above. Pricing is very hard for them just at present as bond prices are very volatile post Brexit, but this will quieten down to allow them to continue. The cost of this longer-dated money has been attractive in the run up to Brexit and we expect this to be the case going forward.
Ryan Dean – On a global basis structurally we are still in a good place.
Richard Bourne – How are we going to price property right now? It is still cheap compared to other asset classes so I cannot see yields moving very far. The risk free rate is now the lowest it has ever been – 10 year government bonds are sub 1%. The arbitrage remain irrationally wide.
Phil Sturdy – Property’s unique selling point is its income return in a lower for longer interest rate environment. There will be more divergence of performance with core income being more defensive and outperforming the more risky, secondary assets which will be vulnerable to value declines. It will take three to six months to discover where secondary pricing settles.
Aston Woodward – I agree on the property side but sentiment is the unknown factor. The discount will be driven not by the value of real estate compared to other asset classes but by UK sentiment and how people feel about life. Secondary property will be under pressure. I do think property in the scheme of things still looks good value. Meanwhile there is likely to be a great period of buying opportunity.
Richard Bourne – We as an industry have to move forward. RO will continue to look at towns with strong supply and demand fundamentals and I am not going to discount them as a buying opportunity going forward. It will come down to pricing against alternative returns and focusing on our core strategy.
Phil Sturdy – The extra stamp duty costs will encourage investors to hold assets for longer to write off the extra stamp duty costs.
Chris Lewis – That is the risk. How desperate are they to sell. The biggest risk is nothing happens.
Richard MacDowel – The economy has been on a downward trajectory even before Brexit and if you are looking at the yield curve and swap curve it looks like markets expect growth to be tough going forward. We are cautious about where values might get to. All things being equal, the cost of capital has gone up due to volatility and uncertainty. So even if one’s assumptions of real estate cash flows remain constant, values will drop to some extent. But this in itself will provide opportunity for the astute investor community and the key question is by how much values have to drop before they come back in.
For further information:
Edward Rowlandson / Nick Moore, RO Real Estate
01707 601400 / 0207 025 1780
Kirsty Allan, Tavistock
020 7920 3150
Notes to Editors:
RO Real Estate is a privately-owned company specialising in commercial property investment and development in the south east. It is the property division of the RO Group, which has majority interests in businesses involved in residential development, high-quality holiday lodge developments, domiciliary and specialist care services.
