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Most of the bad trends affecting Britain cross paths in London’s office buildings. Brexit threatened the capital as an important financial center. Then came the pandemic-driven shift to working from home, soaring interest rates, political instability, and now the looming recession.
The decline in share prices of publicly traded companies accounts for all of this and worse. But this gloom seems exaggerated.
The four main office stocks — Derwent London Plc and Great Portland Estates Plc, as well as the more diversified British Land Co. and Land Securities Group Plc — are down about a third on average this year. They have acted at levels comparable to the outbreak of the pandemic and the aftermath of the financial crisis.
The recent slide is a reaction to rising UK gilt yields. As these benchmark interest rates rise, property values must fall if they are to offer decent returns without offsetting rental growth. Additionally, real estate companies use a reasonable mountain of debt and ultimately have to refinance at a higher cost, leaving shareholders with less cash.
At their recent lows, stock prices assumed companies’ real estate portfolios would lose about 40% in value from currently reported levels, according to a study by Bloomberg Intelligence.
But the market may well overstate the necessary downside repricing forced by higher interest rates, especially as gilt yields have retreated from recent highs.
Analysts at UBS Group AG this week rated office stocks in London’s financial and West End districts on the back of more expensive five-year borrowing costs. They achieved capital falls of 16% for the former and 14% for the latter — not nearly as much as markets fear.
Meanwhile, individual high-quality assets are still changing hands closer to their last reported values. Land Securities recently sold the site of Deutsche Bank AG’s new London headquarters at a 9% discount to its March valuation – disappointing, not disastrous. Helical Plc has divested the premises occupied by social media company TikTok at a small premium to their book value, while GPE has divested a site leased to satellite operator Inmarsat, also broadly at book value.
True, developers still have to contend with higher debt costs. But the larger listed players don’t face big refinancing bumps in the near term.
What about the effect of hybrid working? It is becoming increasingly clear that this will reduce rather than destroy office demand. The greatest asset of London’s major financial firms is the experience of their people, and experience is best shared in person. Hence the general expectation that employees should be in the office most days.
And this appears to be happening: according to an analysis of Transport for London data by Goldman Sachs Group Inc., tube usage in London has settled at around 70% of its pre-Covid levels.
As for the UK’s political reputation, restoring a sense of stability will take time. But the process could at least have begun. Sterling is comfortably off its September lows with the recent change of Prime Minister. If foreign investors think the worst is over, it could provide a spur to invest in an iconic capital, analysts at HSBC Holdings Plc suggest.
Small wonder, then, that some analysts are suggesting that UK commercial property represents a cheap supply target, not least for private equity. Low valuations make it easier to justify paying a takeover premium and swallowing the cost of any refinancing (which a change of ownership may incur).
Going private might have a certain appeal. UK property firms do not benefit from being publicly traded. Shareholders don’t want to take on more debt and may be reluctant to inject equity. Financing the next development project increasingly depends on selling assets or finding partners.
The catch is that overseas funds interested in London offices generally target specific buildings rather than property developers with diverse portfolios. This has proven to be a persistent trend since Brexit. But if cheap equity market valuations persist and UK politics achieves some stability, then logically this preference should change.
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, the Financial Times and the Independent newspaper.
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