The M25 market: How can investors future proof-performance?
The M25 market continues to attract a diverse range of capital, but how can investors future-proof performance?
5 minutes to read
£3.66 billion of office stock was transacted within the M25 market during 2017, raising volumes to within a hair’s breadth of 2015’s record £3.68 billion.
This near 30% rise in activity is particularly impressive given the backdrop of political and economic uncertainty, as well as the long-running erosion of stock to residential uses. More fundamentally, this volume of activity is evidence of a liquid market with broad and deep investor appeal.
So what can the makeup of this demand tell us about the year ahead, and importantly, how should investors think about the market over the longer term?
The international market
Overseas investors accounted for 51% of transactions by volume in 2017, and were responsible for each of the six deals over £100 million. Two groups stood out amongst a diverse mix of buyers: Singaporean Frasers Property made over £700 million of acquisitions across four assets, while North American purchasers accounted for a similar volume.
That nearly half of investment came from abroad is no one-off fluke: this share has been rising steadily in recent years. As a measure of how quickly the market has internationalised, overseas purchasers were behind less than 15% of deals just 10 years ago.
"Demand to finance defensive, core, real estate assets is strong, and well-let offices in the South East certainly fit the bill."
Today, more than ever, the desire to deploy capital into relatively large lot sizes, or platforms, is undiminished amongst global investors, and we expect that 2018 will see new names enter the M25 office market with precisely this in mind.
Institutional appeal
Domestic investment continues to come from myriad sources. With over £600m of purchasers in 2017, UK institutions returned to the market in force after a year of lower activity.
Typically buying lot sizes between £10 million and £60 million, assets acquired have been good quality, if not always prime, in some cases reflecting scope for potential refurbishment uplifts.
Looking ahead, the investment rationale for the yield hungry institutional market remains intact: we do not expect central London office yields to move significantly this year, while pricing in regional cities continues to face upward pressure, meaning that M25 offices will remain comparatively attractive.
Government office
As we predicted last year, local government purchasers – largely those based in or close to the South East markets – were also very active, spending over £500 million in 2017. Although these purchases have tended to be made at lower yields than their institutional rivals, there remains a significant arbitrage for those funding via low-cost borrowing from the public works loan board.
We therefore expect further buying this year, albeit with greater scrutiny from investment committees, as new official guidance is observed.
"Benefits will accrue to those investors that have done more than simply time the market, and have proactively addressed the fundamental changes taking place for occupiers."
Lending a hand - for now
Debt finance will remain in abundance for the market more broadly during 2018, as a variety of investors have joined traditional lenders in choosing to gain exposure to real estate in this way. Demand to finance defensive, core, real estate assets is strong, and well-let offices in the South East certainly fit the bill.
However, lenders will increasingly be challenged to balance rising money market rates on the one hand, with the need to maintain competitive margins on the other. Which force will win out?
In the short-term, we expect some lenders will accept slimmer margins, but longer term, the rising cost of interest rates will eventually need to be reflected in a higher cost of borrowing. Ultimately, this will influence the amount that debt-backed investors will be able to pay for assets.
Capital rich, but asset poor?
There is no doubt that significant amounts of capital continues to target the M25 office market. But is that enough to guarantee another record year of investment? Our view is that the answer will be defined primarily by the availability of stock, not demand.
The well-documented conversion of offices to residential uses is one of the major factors behind the current shortage, although as our analysis shows, the calculations are becoming increasingly marginal in many locations as residential prices slow.
Yet while the pressure on existing stock may be abating, the issue remains live, as office construction activity in most markets is low. The very factors supporting office rental growth, and therefore investor demand, are ones that will mean that deploying capital in this market will remain a competitive endeavour.
The bigger picture
In a world in which ever more capital is being directed to real estate, transparent, liquid markets such as the South East are well-placed to benefit from the demand.
However, we believe that in the longer term, the strongest benefits will accrue to those investors that have done more than simply time the market, and have proactively addressed the fundamental changes taking place for occupiers.
Some may be wary of the practical implications: does offering greater lease flexibility equate to greater tenant churn; will the activation of vibrant shared spaces ultimately boil down to more intensive asset management requirements?
The answer is that aligning more closely to the needs of ‘customers’ will not necessarily be without cost for landlords. But neither will it be without benefit.
The investment payoff for creating and maintaining spaces that tenants truly desire is longterm stability of income, higher rental values, and ultimately the most effective way of future-proofing returns.
The M25 Report is a comprehensive study of the South East office market from inception to future prospects. The report considers both location and the changing needs of the occupier. Through expert opinion and analysis, it identifies market hotspots and offers insight into influential trends.