For most property investors, the U.K. is a country with one city.
Private-equity firms, pension funds and millionaires from Russia to Qatar spent more on real estate in London than the rest of the country for the first time last year, lifting values there while prices elsewhere sank. Now investors such as Legal & General Group Plc (LGEN) and Aviva (AV/) Plc are being attracted by higher returns available from cheaper real estate outside the capital.
The value of income-producing properties outside London fell 7.2 percent from September 2011 through March while rising 7.4 percent in the city’s center, as a double-dip recession prompted buyers to avoid all but the safest prime assets, according to Investment Property Databank Ltd. That pushed non-London yields, or income as a percentage of the price, to 6.5 percent in March compared with 4.3 percent in London’s most expensive districts, IPD said.
“The shift away from core to a higher-risk mentality is the dominant trend that I see in 2013 and 2014,” Joe Valente, head of research and strategy at JPMorgan Asset Management, said in an interview. “Not everyone is well equipped to go up that risk curve.”
That doesn’t mean all markets are appealing. Investors are focused on properties with steady rental income or those that can be put to better use. Few in the property industry predict that commercial property values outside the capital will appreciate meaningfully until the U.K. economy improves.
Pension funds and insurance companies like Legal & General and Aviva are hunting in larger regional cities such as Birmingham and Manchester, where the value of some properties has started to rise and the amount of empty space is lower than in previous recessions.
The Co-Operative Group Ltd.’s headquarters in Manchester was bought by Chinese sovereign wealth fund Gingko Tree Investment and German fund Grundbesitz Europa in February, a person with knowledge of the deal said. The price was 142 million pounds ($216 million), according to the person, who asked not to be identified because the matter is private. Gingko declined to comment.
Billionaire George Soros’s Quantum fund got a slice of the development market outside London when it bought 5.7 percent of Development Securities Plc (DSC) in January and increased its stake to 6.8 percent this month, according to stock exchange filings. About 90 percent of the developer and property investor’s income-producing assets are outside London, according to its annual report.
Although average values continue to fall outside of London and Cambridge, there are pockets of growth. More than 30 percent of non-London commercial properties tracked by IPD rose in the year through March, including top-tier warehouses in Manchester and shops in the best parts of Birmingham. Those assets gave investors returns that beat office buildings in the City of London financial district, IPD said.
Commercial properties in Leeds now produce an annual yield of 7 percent after values fell about 42 percent from their peak in 2007, according to the research firm. Broker Colliers International estimates City of London yields are 5.25 percent.
“In the first quarter, we saw a growing percentage of assets outside of London delivering flat or positive capital growth, and that trend has continued in April,” Phil Tily, IPD managing director for the U.K. and Ireland, said in a May 15 report. “Hopefully, the recent economic news will lead to further confidence and selective recovery in the regions.”
The decline is far from over in some parts of the U.K. In Middlesbrough, northwest England, values fell 15 percent in the year through March and total return, which combines price with income, decreased by 7.9 percent, IPD said. Buyers in Leicester in the Midlands region saw values drop by 9.4 percent and a 2.2 percent fall in total return.
Bank of England Governor Mervyn King gave his most upbeat forecast for the U.K. economy in five years on May 16, raising growth estimates and lowering inflation projections. Employment rose in the first quarter after the country narrowly averted its third recession since 2008.
For those willing to bet that values won’t fall further, buying conditions across Britain are the best since 2002 as returns rise while the yield on 10-year gilts remains below 2 percent, according to broker DTZ.
“We’re ready to take a bit of risk on income and buy assets that might need some capital expenditure,” Ben Stirling, managing director of European real estate at Aviva Investors, said in an interview. The manager of 274 billion pounds of assets sees value in “good quality, institutional type of assets in the U.K. which, depending on where you are in the cycle, are called prime or secondary,” Stirling said.
Development Securities has achieved internal rates of return, a measure of performance used by private-equity managers, of more than 20 percent from its trading and development division by “regenerating functionally obsolete buildings and turning them into useful ones,” Chief Executive Officer Michael Marx said in an interview.
The company converted a warehouse and office property into a supermarket as part of a development in Littlehampton in the southern county of Sussex. It then sold the building to tenant William Morrison Supermarkets Plc (MRW), bringing the internal rate of return to 27.2 percent, Development Securities said this month.
The developer rose as much as 7.6 percent to 193.75 pence in London trading, the highest in more than 18 months. The stock was up 6.3 percent at 191.25 pence as of 2:16 p.m.
Investors have stayed away from buildings outside London even though the U.K.’s economic woes have resulted in fewer empty properties than in previous recessions, Valente and Peter Reilly, head of JPMorgan Asset Management’s European real estate unit, said in a report.
Slightly more than 8 percent of the space throughout the U.K. is empty, compared with more than 14 percent in the recession in the early 1990s, according to the report. Demand from businesses for new space outside London has fallen 22 percent compared with a 40 percent decline in the early 2000s.
“The real estate market has not only overreacted, but is also lagging the gradual improvement in sentiment,” they wrote. “It is clearly unrealistic to expect yield spreads to revert back to pre-2007 levels anytime soon, but neither is it sensible to expect them to remain at current levels.”
Legal & General Property, the U.K.’s third-largest institutional real estate fund manager, is raising a fund that will spend as much as 1 billion pounds on buildings outside London.
This year will be a turning point for the regions, Charlie Walker, the company’s director of business development, said in a telephone interview. “From a pricing point of view, there are higher entry yields and they are looking out of kilter with central London.”
The fund will target assets valued at more than 50 million pounds because some rivals will struggle to secure the funding required to bid above that level, reducing competition, Walker said. The company will seek “distressed capital held by banks and funds in the wrong places that can’t afford to keep it or, frankly, don’t have the skill set to maintain the value.”
Max James, chief executive officer of Quintain Estates & Development Plc (QED), is among investors who don’t see potential for growth outside of London as long as the economy struggles. The company plans to sell its 25 regional properties to focus on large redevelopment projects in London and has yet to find a buyer for the assets it put on the market in September.
“We are struggling to see a significant correction” in regional property values, James said by telephone. “For the capital our shareholders have given us, we see far better returns in London than the regions.”
Though most foreign investors are sticking to London, some are looking further afield. Norges Bank Investment Management, the world’s largest sovereign wealth fund, acquired a 50 percent stake in the Meadowhall Shopping Centre in Sheffield, northern England, for 348 million pounds in October. The net yield was about 5.1 percent.
Marx, the Development Securities CEO, said overseas money won’t drive up prices outside London like it has in the city.
“Cheap capital being transported to the U.K., mainly London, from the Far East will not go to places like Rotherham” in the northern county of Yorkshire, he said. “They might go to places like the center of Manchester or a couple of big shopping centers, but that’s as far as they go.”
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