Volatility : Finding the Safe haven
Whilst the more liquid equities and fixed income markets continue to re‐price the pace of the
economic recovery in the face of the latest dark clouds of sovereign debt risk and deficits,
the UK commercial real estate market continues to recover from the steep drop in values
from Q4 2008 to Q3 2009.
The key themes we have observed in recent weeks include;
Underlying performance measured via GDP growth continues to show improvement
but it is clear that the economic recovery is facing a number of challenges.
Equity markets continue to remain exceptionally volatile, characterised by 100 point
swings, with the FTSE below 5,000 and Dow beneath 10,000 at the time of writing.
Real estate lending remains constrained as banks repair their balance sheets across
the market, borrowers can leverage but have to try harder and know where to look.
Property derivative pricing sees continued improvement in sentiment, rising to a
10% plus growth expectation in 2010
Investment activity continues to increase MOM, overseas investors still driving the
market in Central London, less so in the regions
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Zaggora is a private investment partnership of outstanding individuals from the principal real estate
investment and banking universe (JP Morgan, Knight Frank, Union Bancaire Privee, The Ability Group) investing
in UK and European commercial real estate assets to provide highly visible, reliable and low volatility returns
that are high yielding for investors.
The economy remains on track to expand again in Q2, not least because retail sales posted a solid increase of
0.6%m/m in May. However, the labour market remains fragile and the Budget measures will hit households’
finances pretty hard. Of course, the flipside of soft economic activity is that inflation and interest rates will
remain low and we believe for some time, through 2010 and most of 2011.
Market intelligence last month showed that, despite negative net lending flows over the past year, lenders’
exposure to commercial property remains very high. A key reason for the failure of property debt levels to be
cut by a more appreciable amount is the “delay and pray” approach of lenders which, as illustrated by the
latest De Montfort survey, remains prominent. This was covered in our recent CMBS paper.
CPI inflation dropped further than anticipated in February, to 3.0%, underpinning the BoE view that inflation is
not of great concern and should continue to fall throughout the year.
Further good news came in the retail sales figures which showed February had been a strong month, albeit
following an appalling snow covered January. The overall spending picture remains muted, but not worrying.
Yet. House prices are seemingly rather more erratic. Although reflecting markedly different rates on both a
monthly and annual basis, both the Halifax and Nationwide indices do at least agree that Q1 saw much slower
growth than that achieved in Q4. Many commentators still anticipate negative or, at best, no growth in 2010.
Of all the key indicators, it is the outlook for sterling that is the greatest worry. Continuing uncertainty about
who’s going to be running the country is not going to help this anytime soon.
Unsurprisingly, rates were held at 0.5% in April. Although the Q4 GDP figure has been revised up yet again, his
time to 0.4%, the recovery is still perceived as having only a tentative foothold. In any event, rates were
unlikely to change until the election is out of the way. Similarly, further QE measures remain unutilised but still
possible. The next MPC meeting has been moved from its original date of 6th May until the 12th. As
Parliament will be absent at the time, perhaps the MPC will get giddy with power and do something radical.
Then again, perhaps not.
As at 8th April, LIBOR has remained relatively unchanged at 0.65% while 5 year swap rates have increased
marginally but remain below the 3% threshold, at 2.90%.
Propertydata.com’s preliminary figures showed that investment market activity was 27% higher in May than in
April, rising from £1.5bn to £1.9bn. Given that past years have seen a fairly even split between rises and falls in
investment market activity in May, the latest result was reasonably strong. Indeed, it helped to push up the
12‐month rolling total to £26.3bn, the highest level since August 2008.
Of course, the investment market remains far more subdued than in the boom years of 2004‐ 07. Turnover
levels are soft in all three main sectors, though perhaps most notably in the office sector. London’s West End
market was especially quiet in May, with just two deals (worth a total of £24m) completed. That said, with
rental prospects improving, investor demand for offices may strengthen in the months ahead. Of course, it is
another matter whether there will be willing sellers.
After modest net sales in April, overseas investors made net purchases of UK property in May of £170m. As
Chart 3 shows, European investors made the biggest, positive contribution to that net total, with the most
notable transaction being Ramsbury’s (a Swedish fund) purchase of an office/retail block on London’s Regent
Street for £220m.
UK‐based investing institutions also made net property purchases in May, totalling £270m. In the past few
months, publicly listed property companies have also been active buyers. This competition for the limited
amount of property on the market may help to explain why transactions by private individuals have recently
Capital growth continued to rebound in February, putting in a monthly increase of 1.27%. Again, this was all
about yield shift, with rental growth declining by ‐0.15% and running at an annual rate of ‐7.1%.
The total return over 12 months is now a fairly impressive 11.1%. This is the first time we’ve seen double digits
on the right side of the line since it all went pear‐shaped in the summer of 2007. Purchasing volumes remain
relatively muted, however. Q1’s total of £4.8bn was little more than half that seen in Q4, and more
comparable with the downturn levels during Q2 08 to Q2 09. Nonetheless, the pressure on yields has
continued. Only the average initial yield for retail remains above its long‐term average, in large part due to the
slower improvement in the shopping centre sector.
Expectations for the outturn in 2010 rose yet again during March. Clearly the election isn’t weighing on
everyone’s minds – or, at least, not in terms of its impact on performance this year. By the end of last month,
pricing had increased to reflect a return of 10.75%. It was the first time for 6 months that the expectation for
2010 had reached double digits. The medium‐term outlook remains fairly benign with a hint of gloomy,
keeping returns within the 6% to 7% patch throughout the next five years.
Real Estate Lending
Net commercial property lending flows remained negative in May, reflecting the fact that banks’ and building
societies’ exposure to the sector is still very high. Further negative lending flows are likely in the months
ahead. On a brighter note, UK investing institutions remain active buyers of commercial property.
Total net lending by banks and building societies was £1bn in May. However, given April’s weak figure of minus
£16bn, net lending remains on target to be negative for the fifth consecutive quarter in Q2. Low gross lending
and some increase in borrowers’ repayments are both likely to have contributed to weak net lending flows.
In the property sector specifically, net new lending flows were minus £50m in May. This was an improvement
on April’s figure of minus £1bn but still suggests that Q2 will see the weakest net lending flows to property
since the credit crunch began. (See Chart.) The data contradict recent anecdotal evidence that lenders’
wariness of the commercial property sector may have started to ease.
Looking ahead, Thursday’s Credit Conditions Survey from the Bank of England should provide some insight into
the near‐term prospects for property lending. However, with banks’ exposure to the market still very high,
there seems little chance of a material loosening in the availability of new credit anytime soon.
Also released this morning were Q1’s data on net asset purchases by UK investing institutions. Unsurprisingly,
given the problems in Greece and a rise in risk aversion, there were substantial net sales (£11bn) of equities in
Q1 but strong net purchases of UK government bonds (£12bn).
There was also net buying of commercial property (£3bn) in Q1. What’s more, Propertydata.com’s data show
that UK institutions made further net property purchases in April and May. In the near‐term, with these
investors still reported to have equity to be spent, property yields probably still have a little further to fall.
The Safe Haven : Yielding Assets
The opportunity exists to earn low volatility, annual equity returns of 8‐15% (received quarterly) by acquiring
UK commercial real estate assets let to excellent covenants (UK Government, Tesco leases etc) for 5‐10 years
with a 10‐15% annual IRR.
We believe in the current, limited visibility environment this represents an extremely interesting low risk, real
asset investment strategy. As a defensive play, the potential returns profile compares well with other
defensive alternatives such as cash/gold/treasuries. The strategy offers investors low volatility, transparent
returns with in‐built inflation protection at a time when GBP borrowing costs are low (2.5% for a 5 year fix and
4.04% for a 30 year fix) and exchange rates favourable relative to USD.
Real assets offering the following investment characteristics;
8‐15% Fixed annual equity return (received quarterly)
10‐15% Annual IRR
Fixed income with annual increases (RPI/CPI/Fixed)
FRI Income (All costs, management, insurance, maintenance, paid by tenants)
Strong residual value driven by quality of asset and location
The UK market structure and framework provides the strongest opportunity because;
Ultra‐Long leases 10‐20 years+ (without tenant break options)
Upward‐only rents, if markets rents fall, tenants continue paying same rent
FRI leases making tenants responsible for all management, maintenance and insurance costs
Active lending market to secure leverage on modest basis (60%‐70% LTV)
Zaggora LLP is a limited liability partnership registered in England and Wales, registered number OC344767, with its registered office at 30 Old
Burlington Street, London, W1S 3NL. This memorandum was prepared by Zaggora LLP.
This document is for information purposes only and should not be construed as a solicitation or offer, or recommendation to acquire or dispose of
any investment in real estate assets or securities or any other transaction. Whilst all reasonable efforts have been made to obtain information
from sources believed to be reliable, no representations are made that the information or opinions contained in this term sheet are accurate or
reliable. Nothing in this document constitutes investment, legal, accounting or financial or other advice. Any investment decision should only be
made after consultation of professional advisers.
Zaggora LLP is not authorised or regulated by the Financial Services Authority and does not promote, give investment advice on or make
arrangements in financial instruments. This presentation does not constitute an offer to invest. Any and all opinions contained in this document
are those of Zaggora LLP.