Postcard from London #18 | "Mind the Gap" | JUNE 2022

“I tell you guv’nor, I’ve had Yanks, Germans and even Peruvians in the back of my cab this week. Business is finally boomin… luvverly”

“It’s not just the cost of debt. The cost of equity has gone up too – have you seen what’s happened on the public markets”

“I’m looking forward to next week Andrew. I can finally go out to a restaurant and have dinner”

So, it’s finally open. The Elizabeth Line (Crossrail) is now operational in time for Her Majesty’s Jubilee.

Although not totally – you have to change platforms at certain stations and er, Bond Street Station is still closed…and that’s before the train strikes which are threatened for next week.

But Covid is forgotten, and London is bereft of masks, forming the pathfinder for other global cities as they too awake. This week’s good news being that even in the PRC, restaurants can finally start to reopen.

Yet investors are confused.

“Mind the gap” boom out of the speakers at Bank Metro Station and this seems to summarise the current problem in the market.

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A cursory glance in the economic history books will outline the joys and perils of the reverse yield gap. As was explained to me in my graduate days.

“Look it’s simple. Interest rates may be 8% and yields are 4% but when we have rental growth of 30% per annum, your income will rise hugely.?The return will then exceed the cost of money, so you get positive leverage and lots of profit.”.

And we all know what happened in the early 1990’s.

But the metrics today are nowhere near as challenging as then. Sure, they were different times, but as with any opportunity, the real return always comes through income growth, yield compression has been a convenient boost to performance.

And generally, that enhanced income return is down to the local nature of real estate – the architecture, the micro location, the amenities in the building and outside, the style of the space and so on. A busy building in Covid times is a building where a tenant really wants to be.

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The problem with today’s market is global investors seem to be looking for generic data points which are not really there yet before they finalise strategy. After all we have been through globally why take a risk, “until all markets are fully operational” say some which is further enhanced by generational increases in finance costs. For some, their view is heavily influenced by their own domestic markets still witnessing fully “closed” offices.

And most are wanting positive leverage immediately, irrespective of rent when buying offices… but residential and industrial appears a different mantra. There the reverse yield gap rules for now.

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The backdrop also looks challenging. Global supply issues as well as surplus of money were always going to stoke inflation. Construction pricing is marching up but will stabilise as China re-opens and as more schemes become uneconomic due to investor expectations of return.

But we are starting to see the signs of growth in rents as tenants return to their offices and want to secure their space at a reasonable increase in their cost projections.?As one tenant told me yesterday “rent is probably the one thing I can fix now. Energy and staff costs are a different matter”.

On that the same tenant told me he would “love his staff to work from home in the winter to save heating costs but they will probably all be in the office then 5 days a week”.

So today, focus on rental growth which means consider local rather than generic points.

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The capital market is interesting. The “Wall of Capital” is more a “Wall of Could be Interested Capital” which is assessing markets on a global basis. Certainly, for most global Pension Plans the denominator effect has put things marginally on hold as “underweight” real estate positions start to go to “par” due to a slide in the equity markets. Most see this as a matter of convenience which allows them time to consider the markets. Or rather to work out how tenants are behaving and how the new world of ESG is starting to play out.

But then along comes a trophy asset. 49 Park Lane, a freehold by the Dorchester Hotel which is fought over by a number of family offices to sub 3% levels or 280 Bishopsgate where some global investors have fought to get hold of a new recently let ESG friendly building. Or for any asset with indexed income which are seen as inflation proof, provided of course the face rent looks fair in the market climate – witness 5 Broadgate and Cabot Square as examples. Of course, real assets provide real “inflation proof” returns.

There are though buildings for sale which are not selling, though this is partly investor and (dare I say it) partly broker led on “aggressive to get the mandate” pricing.

There is certainly more appetite for “quiet discussions” rather than wide open marketing which can expose failure, as most investors start to take a summer pause.

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What next? Well I suspect in September, I will be talking about the value in build to core strategies as lack of supply in good office stock in London gets further exaggerated. But what is a saviour today has been the relatively higher yields since 2016 which has protected some immediate outward yield shift.

As Dickens once wrote in a “Tale of Two Cities”,

“It was the best of times, it was the worst of times”

Quite apt really.

As ever if you need more please let me know,

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Andrew