This chart shows our West End prime office yield, the UK inflation-linked 10-year gilt yield, and the Central London office vacancy rate.
We can see there is a clear structural break between gilts and property yields around economic shocks. The Global Financial Crisis in 2007/8 brought about a sudden change in attitudes to risk, as shown by the considerable upward correction in the yield spread between “risk-free” income and prime UK property in the following few years. After a period of relative stability, this was exacerbated further by Brexit uncertainty, and has been again by the COVID-19 pandemic. As a result, the current yield spread (while no longer at record levels) is historically high.
Also, and perhaps not surprisingly, the data show that London office yields (and property’s risk premium to gilts) compress as the occupational market improves, and the opposite happens when demand falls away. However, this correlation appears to have been broken somewhat by the economic shock of EU referendum in 2016. Immediately after the Brexit vote, and again in the wake of the first lockdown last year, vacancy rose, but prime yields stayed largely flat. This post-2016 trend suggests that the uncertainties around Brexit negotiations created a further risk premium for UK assets, while yields in the rest of Europe continued their downward trajectory (see chart right).
The risk of increasing interest rates to combat rising inflation could push bond yields higher, but the data shows that this doesn't necessarily result in an increase in property yields, especially when the gap between both is as wide as it is currently. Indeed, higher interest rates and inflation are a product of economic growth, which will boost real estate income returns.
Since the beginning of 2015, we have seen significant divergence between capital values (as determined by prime rent and yield movements) between London and the major European markets. In Berlin, we have seen a 185 bps compression in prime office yields, and prime rental growth of 74%, since Q1 2015. This has resulted in 200% growth in capital values. It is a similar story in Paris, where yields have compressed by 130 bps and prime rents have grown by 20%, resulting in a 78% growth in capital value. In contrast, prime London yields have remained stable and prime rental values have actually fallen by 6% (see chart right).
The fundamentals of each market have not altered meaningfully to justify this dislocation. In a post-Brexit and post-COVID world, with uncertainty lifted for global investors, the divergence in pricing in Europe is likely to reverse somewhat. The question is how this will unwind.
Brexit has undoubtedly created challenges for the London market; figures from Morgan McKinley show financial jobs creation has been in steady decline since 2017. Even so, the vast majority of finance professionals still expect London to remain the dominant financial hub in Europe for the foreseeable future. While share trading market share has undoubtedly been lost to Europe, London regained its position as the number one share trading centre in Europe last month, according to data published by Cboe.
Moreover, Brexit also represents a line in the sand and an opportunity to reform financial regulations to better nurture London’s strong start-up culture, encourage more IPOs, and encourage further investment. Since 2016, London has grown into a global tech hub, which last year attracted over $10.5bn of VC investment – more than Paris, Berlin and Stockholm combined – according to Tech Nation (see chart).
One of a number of caveats is the varying cost of finance throughout Europe. The cost of securing debt in Central London is undoubtedly higher than in the core European cities. Latest BNP Paribas data suggest the total cost of securing debt against Central London offices is currently at a premium of between 68 and 84 bps to that of Paris and Berlin. However, when analysing debt’s effect on prime cash-on-cash returns at varying LTVs, we can see that both the London West End and City markets still outperform core cities in Europe, with the only marginal exception being Amsterdam.
There is a risk that runaway inflation could push central banks to raise interest rates, thereby increasing finance costs. However, the Bank of England have stated they are expecting a temporary period of 'modestly above‑target inflation' focusing on the medium‑term prospects instead, and therefore are unlikely to make a change to monetary policy in the short-term.