London market still risky

Source : Business Times – 14 Jul 2009

Estate agents such as Savills predict that there is further downside of 10%

ESTATE agents report that buyers have returned to the London and UK residential real estate market in recent weeks and prices have improved a little.

Despite this optimism the London property market is dangerously speculative for foreign investors. On average, house prices have fallen by around 15 per cent from their bubble heights and apartment prices by around 25 per cent.

But the declines were from extraordinary peaks. Estate agents such as Savills predict that there is further downside of 10 per cent, but economists fear that declines could be more.

Earlier this year, Asian, Russian and other foreign buyers were tentatively examining potential residential London property investments, according to agents.

At the time sterling had depreciated by 34 per cent from a heady 2008 peak of US$2.10 to below US$1.40. Compared with 2008, a Singaporean investor could buy sterling at a third lower than levels seen in 2008.

For Singaporeans and other foreign investors, the effective property price discounts from the top were 40 to 60 per cent.

In recent months, however, the British pound has appreciated by around 20 per cent from the lows, so the discount has been reduced considerably.

Since currency economists estimate that fair value for the pound is around US$1.50, compared with current levels of around US$1.63, Asian investors are now subject to greater risk from a currency downturn.

The UK real estate market, especially London, is difficult to read because of its diversity. On the positive side, good quality properties in prime locations are generally difficult to find. Sterling, at current rates, is 22 per cent below its 2008 top and much lower mortgage rates are positive factors.

On the negative side, the market experienced an extraordinary bubble and price declines from those levels haven’t been extensive.

Deposits on properties must be 25 per cent to 40 per cent to obtain mortgages. This extra finance is well over levels required during the property boom of 2005 to 2008. In recent months, the long government bond yield has risen sharply.

Mortgage rates follow this long-term rate and are thus rising. Layoffs from banks, brokers and other financial services have only taken place in recent months.

As redundancy payments become depleted, people with high mortgages have been under pressure to sell. Redundant foreigners who can’t find jobs in the City have to return home, leaving landlords with rental voids.

Houses and apartments of these unfortunate people have not been sold easily.

Thus although estate agents have reported renewed interest from bargain hunters, it is still a buyer’s market.

Moreover, reports of an uptick in some prices need to be seen in perspective. Volumes of transactions have been low as unwilling sellers have been trying to keep their property off the market for as long as possible.

Stressed sellers who can’t offload their houses or apartments, have decided to rent their properties and downsize.

There has thus been a sharp increase in rental properties coming onto the market and a general decline in rents.

Earlier this year, agents Savills and Knight Frank reported that gross rental yields of prime properties in London were around 4.5 per cent and net yields 3.5 per cent.

Since prices haven’t fallen much since March and there have been declines in rentals on new leases, gross rental yields on average can be estimated at 4.25 per cent and net yields around 3.25 per cent.

This compares with long-term government bond yields of around 3.9 per cent and the FTSE 100 earnings and dividend yields of 10.1 per cent and 4.7 per cent respectively.

High and rising stamp duty on property purchases to fund the huge UK budget deficit, raises the cost of purchasing property in the country and effectively lowers the net yield over the years, cautions Brendan Brown, London-based head of research at Mitsubishi UFJ Securities International.

In short, compared to financial assets, which are far more liquid and with a much smaller spread between buying and selling and much lower transaction costs and red tape, current property values are generally unattractive.

Besides the cyclical factors that could cause prices to fall further in the short and medium term, there is also a long-term structural problem. Growing numbers of baby boomers born between 1945 and 1955 are either falling due or are being forced into early retirement.

Growing numbers of companies are terminating their final salary pension schemes.

Following severe stockmarket declines in 2008, private pension funds have shrunk and payments have fallen sharply. In the UK, the bulk of private pensions must be placed in annuities and their rates have fallen sharply.

Savings are at punitively depressed levels. Equity markets have recovered from their nadirs, but pensions invested in equities are well below their 2007 highs.

In short, baby boom middle-class professionals and others, who are not on company or government schemes, are under pressure to sell their homes to supplement income earning capital. Long term, the supply of residential properties could thus trend upwards.