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A word on UK Real Estate

Aug 07, 2017

On most measures UK property is expensive. It is most expensive in the South East and in London in particular. Yields in London vary between 2% in the expensive parts to perhaps 4.5% on the outskirts. More risky properties in the Midlands and North can yield 6-7%, but most of those assets require upgrading.

There is also a shortage of stock. Foreign buyers and big players domestically are moping up anything decent that comes to market. Institutional investors have moved into prime property because yields on Government and corporate bonds are so low. If these institutional investors are right, then inflation should remain low for very long time.

Signs that inflation will remain low is indicated by the fact that UK rates are not going up anytime soon. Sterling has weakened considerably since Brexit, but inflation remains subdued. The BoE forecasts that the UK economy will slow down a little from 1.90% to 1.70% and is also susceptible to Brexit risks. Already many financial institutions are making plans to move workers to EU countries. Banks, such as Deutsche Bank and HSBC may end up moving a very significant number to Frankfurt and Paris respectively. That will cause UK property market to remain capped.

Conditions in the UK High Street are tough. Retail sales are moving increasingly to online. What is being left in the High Street are things one cannot buy online. Expensive coffee, food, haircuts, massage, pharmacies, dentists and face to face conversations. In time, the High Street is not going to disappear. But transformation will take time. Transitions are always disruptive.

The weak GBP has increased the cost of imported goods, pushing prices higher. Consumer credit has been rising and savings rates are not improving. Minimum wages for Labor is squeezing margins for small businesses. Brexit uncertainties is curtailing spending. Confidence in the UK is sorely lacking. Politics is in chaos. The Conservative Government is lost for direction as we have seen in response to Grenfell Tower fire and negotiations with the EU. No one seems to be prepared. I am 63 and I have lived both in the US and UK. I have never witnessed such incompetence in the way US and UK politics is working.

Lower rates for longer and stagnant prices may hold real estate prices at current high levels for some time to come. More likely is a slow correction in property prices in and around London. At the high end in Chelsea, Holland Park etc, largely also due to to very high cost of transaction and possible exodus of ¬†highly paid bankers from London to other European cities has led to prices falls by between 10 to 20% over the last 2 years. Those prices were unreasonably high, one can argue, to start off with. But one has to keep in mind that those owners are extremely wealthy and many are holding on to nth generation assets. Most don’t have the need to sell or a need for high income. Those prices and rental yields are not representative of markets as a whole or regional markets. Also the number of transactions taking place is far fewer and drawing price trend conclusions for the whole market on few observation is not a good idea.

In time, rental yields and wage growth may improve the dynamics and prevent a significant correction. The reality remains that there is a significant shortage of dwellings in the UK. So demand can sustain high prices for very long time as long as interest rates don’t rise to cause defaults on mortgage payments.

By some measures, such as price to average earnings, property prices are already too high. But weaker GBP is bringing in foreign money and existing owners can afford to buy even more as they have accumulated significant equity since the financial crisis. Rental yields may be quite low in the expensive parts of London, but actual rental income is still very high, while the cost of repair and maintenance (average worker and cost of materials) remains relatively low. It doesn’t cost much more for a paint job in Chelsea compared with West London, but rental income per square foot can be 5 to 10 times higher!

Prospects could improve if UK softens further its stance on Brexit and Phillip Hammond’s advice having a long transition period is heeded. The Conservative government has done a great deal of damage to the United Kingdom and Labor is not vocal enough to realize the best outcome for the UK. Jeremy Corbyn’s stance on Europe remains half-heart. This is largely because he wants to have his cake and eat it as well. The white working class vote has significant number of Brexiteers. Labor has to balance its appeal on policies with their antipathy towards Europe. That sacrifies what is best for the nation over power. The lack of visibility on Brexit is like a cloud hanging over the UK economy. This gloom and doom is for real.

In 2017, in the United States and the UK we are witnessing the least well managed developed market democracies and political systems in the world. We have to thank God that we have competent Central Bankers and business leaders. Left to politicians we could have been facing much more difficult circumstances.

As far as UK Real Estate is concerned one should look for opportunities where one can add significant value. From what I have observed, finished good are really very expensive indeed. The size and quality of boxes that are on the market leaves much to be desired.

Be careful of deals (often for student accommodation) where you are being offered guaranteed returns for the first 2 to 5 years. They are basically taking your upfront cash paid, over and above fair prices, at the time of purchase and giving it back to you over the guaranteed period in the form of higher yield.

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