London real estate enters uncharted waters
In the last two days (Brexit+13), six UK property firms suspended trading. One heavily discounted withdrawls.
The United Kingdom vote to leave the European Union may disrupt London’s property market to a greater degree than the industry currently expects.
The key question: Will a vote to restrict immigration change underlying demand? Rather than a potential market of 500 million people, London faces a new market of 65 million, plus immigration quotas to be determined.
The two greatest drivers of the London property market – that market size of 500 million people and previous global safe haven status — disrupted. The former hangs on the balance of a government in turmoil. The latter already accruing losses of 1% a day.
Voting to leave the EU breaks the vase. You can pick up the pieces and put it back together again. It won’t look the same. It may not hold water.
How does Brexit change underlying demand? How many people cooling off to UK real estate already? How many people turned away tomorrow?
A question more odious. Will there be more supply than demand? If there is more supply than demand, the domestic market effectively flips from price-setting to price-taking. Enough of a shift and the unwinding effect may look similar to oil markets.
The dual drivers of London property — domestic use and investment — converge creating what looks like an exponentially-priced market. So constrained that each additional unit of supply will always be taken up, driving prices exponentially higher.
The reverse may look like exponential price decreases brought by a simple flip of the market to oversupply. In these cases, price changes are multiples of the supply/demand balance changes.
There was gold in those hills
The record oil prices of $150 a barrel (2008) left behind as the market shifted from undersupplied to oversupplied.
In 2011, the price per barrel reached $115, when the market was less than 1% undersupplied. In 2015, the market was oversupplied by 1.5% and the price hovers around $60.
50% decrease in price on a 2.5% increase in supply. More crucially, a fundamental move to oversupply flipped the market.
The fracking agenda was always an abberation in Barak Obama’s otherwise strong commitment to climate change. Over ten years fracking rigs gradually increased supply to a tipping point. OPEC cracked and Saudi Arabia flooded the market. The market entered a new normal that continues to resonate with the budgets of oil-dependent countries.
What is our new normal?
Current wisdom suggests foreign investors will pick up property assets based on the currency drop. Existing investors take 10%-20% write-downs and cash out, instantly replaced by new foreign buyers, purchasing at a discount.
Assume that is true for the moment, and foreign investors pick up the slack. A constant level of investor demand for property assets supports prices.
The question then is of the target of the EU Referendum – European free movement. From vote, to disarray, to concrete policy. One scenario in which demand for property remains constant may be EEA (Norway) option. The UK retains both EU single market access and free movement. From an asset value perspective, that move means demand — and prices — may remain stable (or even rise). The UK traded away 20% pound value and lost a voice in European governance. An unpalatable outcome.
If the UK closes borders to European free movement, that cuts off several network effects and effectively decreases demand pressures. Will that be enough to flip property markets from price-setting to price-taking?
If exponentially-driven, tipping the balance does not decrease prices proportionally, but exponentially. A sobering prospect given relaxed restrictions on pensions poured personal wealth into prime London developments and buy-to-let properties.
I cannot predict the outcome, only that the effects already show. Given conjoined drivers of property prices — domestic use and investment value — we have little knowledge of current degree of undersupply. We have no knowledge of price effects from reducing a market size by 90%.
Real estate’s awkward affairs with finance
Reactions to a prior piece — The coming rebirth of retail — varied. Agreement and hope that retail property prices rebalance to enable greater community use. Or a perceived attack on the property sector itself.
Real estate straddles two worlds. The first, domestic use. Homes, offices, restaurants, shops. The ultimate drivers of value, people generating incomes and paying mortgages and rent. All yield in real estate comes from that underlying driver. People using space.
The second world is that of real estate investment markets creating tradeable securities based on the real cashflows of underlying drivers. These securities were a key trigger of the global financial crisis, when the investment securities sitting atop the mortgage market collapsed because the underlying domestic use market collapsed first.
Real estate is a seductive asset class, due to its size and perceived stability. However, real estate’s domestic value underpins its investment value.
The Big Short explains simply how a hedge fund manager who took the time to review default rates of US mortgage notes within highly-rated investment vehicles saw domestic value collapsing.
With retail property, the domestic value of many retail assets diminishes as physical retail real estate competes with virtual real estate — the latter coming to drive down the price of the former.
The key question for London real estate related to Brexit is not only the impact on investments — already trading down over 1% a day — but also how much domestic demand has been and will be lost?
Mark Carney at the Bank of England discussed illiquidity of property funds — structural limitations leading to current losses. However, in preparing to chart the UK’s course ahead — in, out, other — we will be wise to consider investment value as an unreliable proxy for domestic value.
Can we understand the point at which domestic value of property shifts to oversupply? That must be a sober assessment about demand and the network value of the city in context of the exit options.
Social network effects of London real estate
Startups — especially marketplaces — chase network effects. As more people signed up to Facebook, its utility increased, drawing more people to Facebook. Eventually, Facebook’s network effects became so strong that other platforms built off its primary network to generate secondary networks. AirBNB used it to provide guest identity verification. The Tinder network itself a new tool for navigating the Facebook social graph.
In real estate, network effects show everywhere from gentrifying neighbourhoods to shopping centres. New investment into delapidated areas increase property prices, which increase resident turnover, which increase property prices. Similarly, anchor tenants attract customers to shopping centres, which attracts other retailers, which in turn attract more customers.
As mentioned previously — and now perhaps ominously — network effects also work in reverse.
Over the last twenty years, London real estate upgraded from assets to safe haven asset class. Prices exploded as foreign buyers moved heavily into London residential. Residents competed with local and foreign investment capital for homes. Common stories of neighbourhoods oversold and underoccupied. Value gains of 50% over 3 years culminated in the ‘London housing crisis’. Generation Rent paying 50%+ of salary in housing costs.
A great magnet of two interoperating forces. First, London’s position as the financial capital of Europe attracted top talent from 30 countries — a market of over 500 million people. The best of the best. As institutional finance grew, so did alternative finance — hedge funds, private equity, and venture capital. The capital flowing through the city attracted more asset managers, attracting more capital, attracting more asset managers.
That confluence of capital and talent generated 8% of the UK’s GDP, and commensurate salaries. Salaries translated into mortgage and rent payments, driving up housing prices, which in turn drove up investment returns, then recycled back into the loop.
As the UK dominated European finance, it drew networks of professionals and service providers from around Europe. Free movement meant any of the 500 million people in Europe who wanted to try London could do so. That opportunity created intensive competition for scarce real estate. The same network process drives property values on Manhattan and in San Francisco. Geographic reach of hundreds of millions of people. High-paying jobs. Limited supply of housing.
That constant growth brought foreign capital, which created its own network effect. Foreign safe haven buyers purchased London homes, decreasing supply, which in turn drove up costs, which attracted more foreign buyers, which in turn decreased supply. That supported prices, which led to new investment in everything from regeneration projects (like Kings Cross and Nine Elms) to Crossrail 1 and 2. At its apex, planners expected the city to grow by millions people, and planned new homes and services commensurately. A ton of development in the pipeline today.
The knock-on effect of a booming residential market flooded over to the commercial sector. The talent present in London attracted companies like Apple, Facebook, and Google to set up artificial intelligence centres. In recent years, technology companies overtook financial institutions as office space occupiers.
With a GDP per capita in London 2–3x higher than the rest of the country, consumer spending drove record retail and leisure property prices. That in turn drove new offers for tourists, adding foreign consumer spending to domestic flows.
Cities are network effects. Value exponentially multiplied as networks grow. Value exponentially divided as networks contracts. Continental European cities now warm up their fracking rigs, soliciting domestic property users, from HNWIs, to investment banks, to startups. The UK debates the rights of 3 million Europeans to remain.
Do we understand the point at which domestic value of property shifts to oversupply?
