Updated: Mar 4, 2019
"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.
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:
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:
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:
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.
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%:
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.
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:
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.
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 vocal in their opposition to current levels of Stamp Duty and called for reform. Johnson recently called on the Government to slash the “absurdly high” levels of Stamp Duty and Rees-Mogg has urged a reduction in Stamp Duty “as a matter of urgency”. There is a reasonable chance then that a new Conservative leader may choose to reverse some of the damaging Stamp Duty rises; especially since wider London property transactions have fallen -26% since the 2014 as we highlighted in our recent Stamp Duty note.
We would also suggest that even under Mrs May, Conservative policies towards high-end property are very unlikely to become more restrictive (as witnessed by the recent rowing back on the Foreigners Stamp Duty surcharge). Further if a no-deal Brexit were to materialise, surely Stamp Duty would be one of the first tax for review given the near -46% fall in mainstream London property transactions over the last decade, the importance of property market to the UK Economy as well as the dominance of the ‘Housing Crisis’ in political debate. Of course, a Corbyn led Government would worsen the situation but the broad scenario outlined above seems a much more likely outcome … we hope!
In conclusion, our upbeat outlook is based on our assessment we are in the final stage of a long, drawn-out Bear Market. The breadth of capitulations across the industry, the duration of the downturn, the widespread withdrawal of development capacity, and the extent of pent-up demand suggests we are at or near the point of maximum of pessimism which defines market bottoms.
From a valuation point of view PCL is fundamentally attractive relative to Equities and Bonds at this stage of the cycle, with the yield spread against the latter having a particularly strong record in predicting positive returns. For the c30% of Overseas based Buyers PCL is especially attractive with prices in local currency terms up to -43% cheaper than 2014 levels. We also suggest that not only is Brexit less of a worry than some fear but is fully factored into PCL prices. Finally, although ours may be an unfashionable view there may be some grounds for optimism on the political front. After all in the dark days of 1979 very few envisaged the tax liberalisation that would follow in the 1980’s!
If you have any questions on this article or would like to find out more about how we can help you access the Prime Central London market, feel free to get in touch. As well as executing searches and acquisitions on behalf of individuals Ludgrove acts on behalf of large Investors, Family Offices and Institutions. For those looking for sizeable exposure to the PCL market we currently have a US$100m Development Portfolio showing a c20% return and rental yields up to 5.5%. We also have a number of highly attractive Bulk Purchase Opportunities.
We wish you all a very happy, peaceful and prosperous 2019.
Ludgrove Property Ltd
Friday 4th January, 2019
Tel: +44 (0)207 889 2860
Biography: Fraser Slater is the CEO and Founder of Ludgrove Property. Prior to Ludgrove Fraser spent 20 years in The City. In the course of his career he was a Real Estate Analyst, the Fund Manager of a £6bn Equity portfolio for USS Ltd and the Founder and CEO of WDB Capital, a London based Fund Management business. In 2008 WDB Capital outperformed its peer group by +52% making Fraser's portfolio one of Europe's best performing Funds during the Financial Crisis. In the same year his Fund was nominated New Fund of the Year by EuroHedge. After leaving The City, Fraser developed property in Chelsea. He started Ludgrove with an ambition to be Prime London's leading Property Buying agency with an emphasis on original research and delivering a highly value-added service to clients.
Disclaimer: Ludgrove Property Limited is not authorised or regulated by the Financial Conduct Authority (FCA) and we do not provide any financial or investment advice. We recommend that any property investor seeks appropriate professional advice before entering into any contract, and we would also advise that the value of any investment can go down as well as up and that you might not get back what you put in. You may have difficulty selling a property investment at a reasonable price and in some circumstances it might be difficult to sell at any price. We would urge you not to invest unless you have carefully thought about whether you can afford it and whether it is right for you, and if necessary to consult with a professional advisor in accordance with the Financial Services and Markets Act 2000. All information is provided strictly as a guide only, is subject to change without prior notice and does not constitute an offer of investment. The Ludgrove website should not be regarded as an offer or solicitation to conduct investment business, as defined by the Financial Services and Markets Act 2000. Investors who are resident in or citizens of countries other than the United Kingdom may be subject to local restrictions. In particular, no offer or invitation is made to any US persons (being residents of the United States of America or partnerships or corporations organised under the laws of the United States of America or any state, territory or possession thereof), who are excluded from the services offered in this site. The information on this website and our publications has been obtained from sources which we believe to be reliable and accurate, but without further investigation this cannot be warranted.