Ludgrove Forecast: PCL +10% in 2019

Updated: Mar 4, 2019


2018 NEWSLETTER


"Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.”

Sir John Templeton


Dear Clients and Friends


Four years into the Prime Central London Bear Market, having witnessed transactions halve and a c20% price decline we are optimistic on the outlook. We expect Q1 2019 to mark the low point of the cycle and forecast a post-Brexit relief rally with prices growing +10% in 2019. We appreciate our view is an outlier in a market characterised by extreme pessimism however the history of real estate markets has repeatedly shown long periods of depressed sentiment give way to strong returns.


Our upbeat outlook is based on the 10 reasons we have outlined below, and whilst we do not anticipate long-term PCL returns to match those seen in the heyday, we are of the view the market is likely to be ‘born on pessimism’ in 2019. Further as most of our Clients buy property with a 10 year plus horizon, we are at the very least confident that now is an excellent time to acquire, regardless of our 2019 growth forecast.



1. Capitulation Points to a Market Bottom.


Capitulation is often a gilt-edged signal of market bottoms and is used by some of the world’s greatest property investors to time turning points. In the second half of 2018 Ludgrove has experienced a significant number of capitulations. Some examples include:


  • The distressed sale of a new build property in St George’s Hill for £4.6m, -65% below its peak 2014 value of £13m, showing a c8% rental yield and an implied negative land value.

  • The repossessed sale of a super-prime property in the heart of Mayfair some -35% below (already depressed) market levels.

  • The sale of a turnkey detached house by Receivers after a £16m or -44% price cut.


We have little doubt then we are at the capitulation stage of the Prime London property cycle and from experience this alone tends to point to a market bottom.


2. A Mature Bear Market & Capacity Withdrawal is a Long-Term Positive


The PCL market has been in the doldrums for over 4 years as stream of tax changes and negative political news flow including two General Elections and Brexit has dented sentiment towards the sector. At 54 months in duration The Bear Market is mature, making it PCL’s deepest pull-back in the last 30 years. In a wider context, it is also rare for Bear Markets of any asset-class to last this long.


Peak to Trough Duration of Prime Central London Downturns

Lengthy Bear Markets also have the effect of driving development capacity out of the industry and as is the case in all Real Estate cycles, this is highly likely to restore upward price pressure over the medium to long term.

In the listed sector there has been widespread capacity withdrawals with companies such as Berkeley Group, Barratt Developments, Crest Nicholson and Redrow ceasing new developments in Central London. In the Super Prime Sector (>£3,000 psf) there is also expected to be a 75% reduction in units on offer by 2021.

Such behaviour is typical of late-stage real estate bear markets and we would expect today’s capacity withdrawals to underpin PCL prices in the early stage of the next recovery*.

*Note: Ludgrove defines PCL as Mayfair, Belgravia, Knightsbridge, Kensington, Chelsea, Notting Hill, Marylebone and St John’s Wood. We do not classify Nine Elms and Battersea (where there is a significant capacity overhang) as Prime Central London.


3. There is Potentially 1.4 years of Pent-Up Demand


PCL transactions have fallen dramatically over the last 4 years to the extent that volumes in the year to April 2018 were approximately 50% below 2014 levels. Below we use Land Registry transaction data on Kensington & Chelsea as a proxy for PCL to determine the cumulative loss of transactions versus 2014 (being the last year of normalised transactions*). Here we find 4,022 transactions have been lost cumulatively which equates to a potential 1.4 years of pent-up demand:


Pent Up Demand in Prime Central London

We would also emphasise our numbers are to April 2018, and given the weak volumes year to date, pent-up demand is likely to be significantly greater than 1.4 years.


*Note: K&C’s 2,931 transactions in 2014 were still some -29% below the annual average between 1996-2007 (4,114 transactions p/a). Using 2014 as a normalised base therefore appears conservative. Separately please note K&C’s 2018 transactions were -64% below the 1996-2007 annual average.


4. Ludgrove’s Yield-Spread Indicator Suggests Strong Returns Ahead


In my days as an Equity Fund Manager there was one indicator I found worked exceptionally well in timing Real Estate bottoms and tops. Put simply it is the rental yield premium of the Real Estate sector over risk-free Government Bonds (10 Year Gilt Yield). When there was a positive premium (or spread) the sector represented good value and forward returns were generally positive. When the spread was negative it represented poor value and forward returns were negative. Intuitively this makes sense as Investors are prepared to allocate capital when they are being offered a “yield pick-up” compared to the risk-free rate. Conversely when there is no premium or a negative spread on offer, Investors are "not being paid" to take the risk.


Ludgrove has assessed the historic performance of the same metric for the PCL market since 2000 and found that when the spread is positive PCL has on average returned +11.9% p/a and when the spread is negative, PCL has returned -0.5% p/a. Today the spread is near an 18 year high implying PCL currently offers excellent value and positive returns may lie ahead:


Prime London Rental Yields Comapared to Bond Yields

Note: One may question the suitability of this metric for residential real estate however we would argue that by definition PCL Buyers are High Net Worth individuals who have a range of choices where to allocate capital. And whilst relative investment decisions may not be a driver for the whole market place, its surely a consideration for a large number of discretionary PCL Buyers.


5. PCL Rental Yields are Reasonable Value Relative to Other Asset Classes


When compared to World Equities and England & Wales Property, PCL is also showing reasonable value trading at the mid-point of its 10 year trading range:


Prime London Rental Yields vs Other Asset Classes

6. … And PCL Rents Are Rising


As a consequence of the Government’s Buy to Let tax changes, rental supply is dwindling and we are witnessing upward pressure on rents. In Q3 2018 the wider London market saw the number of rental properties available to let fall -19% yoy and asking rents grew almost +4% (Rightmove). And as the excellent research by Knight Frank highlights below, rental listings in PCL continue to decline at a similar rate whilst rents are also hardening:

Ironically it appears strengthening rents are a direct consequence of Government policy. Indeed the lesson from the Republic of Ireland when mortgage interest expense became non-tax deductible in 1998 is a telling one. Here rents rose +26% over a 2 year period and the policy was subsequently scrapped. With BTL tax changes being phased in until March 2020, we expect PCL rents to continue on an upward path for some time, in turn providing support to capital values.


7. PCL is Cheap Relative to London


Since the lows of the Financial Crisis in 2009 PCL property values have traded on average at a +203% premium to London in a range of a +140% to a +260%. At present PCL trades towards the bottom of its historic range (+162% premium), representing good value against the wider London market.


Prime London Valuation Against London

More importantly relative price extremes tend to encourage trading up activity. For example, Ludgrove recently had an enquiry from the owner of a house in Balham whose property had increased in value by +30% since 2014 and after a -20% fall in PCL prices over the same period he could now afford to sell his Balham house and purchase a small terraced house in Kensington.


8. Around 30% of PCL Buyers Enjoy Record Discounts & Sterling is Cheap


With Overseas Buyers accounting for around 30% of PCL Purchases, exchange rates play a significant role in determining PCL demand. When Sterling is cheap Overseas Buyers tend to acquire and when Sterling is expensive they steer clear.


As the chart below highlights when we add the -18% decline in PCL values since the 2014 peak (blue bars) to local currency movements over the same period (red bars), Overseas Buyers can acquire at significantly lower levels in local currency terms. Indeed in a number of regions (such as the US, UAE, Hong Kong & Singapore) the discount versus 2014 is approaching 45%:


Prime London Currency Discounts

Clients also often ask our view on purchasing a Sterling denominated asset given my background as a Fund Manager. In my opinion Sterling is attractive and fundamentally cheap for a number of reasons. First, Developed Market currencies tend to trade within long-term ranges. At present Sterling/Dollar is trading near the bottom of its 36 year range (at $1.27) and some -21% below is $1.60 long-term average. A number of Clients have also suggested that Sterling is likely to head towards parity with the USD as Brexit unfolds in 2019 and so they are better to wait. We feel this is unlikely as historically GBP/USD rarely trades below $1.20 (see chart below). What’s more, currency markets are ‘discounting mechanisms’, factoring-in all known and likely possibilities into the price. The recent stubbornness of GBP/USD around the 1.25-1.27 level as the Brexit pantomime unfolds on a daily basis suggests the FX market has already discounted a negative outcome and we are unlikely to see parity.


Sterling Dollar Long Term Chart

Finally Purchasing Power Parity (PPP) is used to measure the fundamental fair value of a Currency. In the chart below we can see Sterling is the most under-valued in 18 years, trading some -9% below its PPP fair value of GBP/USD $1.40:


GBP USD PPP Fair Value 2000-2018

9. Brexit: Our Worst Case Scenario is a ‘Managed No-Deal’.


Unfortunately no 2018 Newsletter would be complete without some commentary on Brexit and in brief we are sanguine. Our worst-case scenario is for a ‘managed no-deal’ whereby the UK & EU agree basic exit terms to ensure the continuation of trade, until a future free trade deal is agreed. Such an outcome won’t be entirely smooth and without instance however we are confident the impact on the UK Economy will be far less than some suggest. We appreciate the subject is a complex one that could justify a long commentary however for the purpose of this newsletter (and to save our Clients from Brexosis overload!) we would make the following points:


  • Only 8% of UK Businesses do any trade whatsoever with The EU.

  • UK Goods Exports to the EU represent just 7.4% of UK GDP. Assuming a highly unlikely -10% Depression type fall in this segment of Economy we would see a -0.74% fall in UK GDP; unwelcome but hardly Armageddon. (Many commentators quote the 48% of UK Goods Exports go to the EU and ignore the fact these exports accounts for just 7.4% of GDP).

  • Dover accounts for only 6% of UK port volume and therefore disruption at Dover will not grind the UK Economy to a halt.

  • We would expect significant fiscal and monetary stimulus to offset the worst effects of a ‘managed no-deal’. There is also the possibility that Stamp Duty on property may be slashed as was the case during the Financial Crisis.


Again we would emphasise a worst case “managed no-deal” will not be entirely smooth but we are confident it will be far less disruptive to the British economy than many suggest and in this context depressed PCL prices offers our Clients an excellent buying opportunity.


10. Politics & PCL: Unlikely to Get Worse. Could get Better.


As the chart below shows, politics has not been kind to PCL recently as a barrage of tax changes and political events including two General Elections and The Brexit Referendum have conspired to depress property values.


Politics & Prime Central London

The consensus industry view is that politically motivated policies against high-end property are here to stay although we are not convinced and tentatively we believe there are grounds for optimism.


Under the Fixed Term Parliament Act there is unlikely to be another General Election before 2022 and we know that Theresa May has committed not to lead The Conservative Party into the next General Election. It is quite feasible then that a new Conservative Prime Minister with fresh views and policies is likely to be in Government at some point in 2019.

Conservative Party Leaders are elected by Party Members and from opinion polls we know those Members favour more economically right-of-centre (low-tax) candidates with Boris Johnson, Dominic Raab and Jacob Rees-Mogg amongst the favourites. All three have been voca