London, a city rich in history and culture, with castles and mansions just a few kilometers from skyscrapers dozens of stories high, is the second largest financial capital of the world and the largest in Europe, and is well known for its vibrant services sector. Many say that it is also the city which prospers while Europe sinks. Now, with the latest addition of the Shard Tower to the growing London skyline, and with real estate prices nearly keeping pace with skyscrapers’ heights, investors couldn’t be happier and Londoners are caught up in the hype. While for many the emergence of new skyscrapers is a sign of prosperity, I believe it may instead be a signal of bubbles and troubles. Is London the proverbial ticking time bomb just waiting for the timer to wind down? Put another way, is this real estate boom part of a boom and bust cycle that could sink the rest of us with it?
The Train that Never Stops
Prices in the English capital are not only booming but seems as though their advance won’t stop. Even at the peak of the 2009 financial crisis when global financial markets were in utter meltdown, even the London real estate market suffered a price crunch but not long after real estate prices resumed their rise and climbed above 2009 records. In the high end districts of West End or Regent Park, prices have risen by more than 20% from their initial 20% peak and more than doubled in 10 years. But the boom is not isolated to residential housing; commercial real estate prices have also enjoyed strong investment inflows with high profile purchases like the Lloyds Bank building for £260 million by the Chinese insurance giant Ping An or the high profile deal initiated by the Saudi government which purchased a building in Canary Wharf for £385 million, according to the FT. What or who is the source or impetus of all of the hype that surrounds London’s prime and commercial real estate? It is foreign investors who chose London’s real estate market as a safe haven for their funds even as bond yields fell to record lows. Most investors, who come primarily from the Middle East, China and the Eurozone, have lately seen their currencies appreciate against the Pound Sterling, at least since 2007. And with prime and commercial real estate yielding above 4%, and Sterling low, investing in a global city like London makes sense. In fact, foreign investors accounted for more than two-thirds of commercial real estate investors.
Sterling and Real Estate
So, now the inevitable question arises; what exactly is the problem with surging prices in London’s real estate? The problem is that the market is dominated by foreign investors seeking higher yields and driven by the low Sterling. With U.K. interest rates at record lows it seems the only logical substitute of a yielding Sterling investment would be real estate, as opposed to bonds. Yet hot money from foreign investors is a double edged sword; the inflows are robust and come quickly but also tend to evaporate just as quickly. Hence, when and if circumstances change, the tide for the London real estate market could change just as quickly. With signs that the prime and commercial real estate markets are already at risk of being over-supplied, this risk is tangible. For investors, prime market yields on property stand at around 4.25% while, for example, U.K. 30-year Gilts (U.K. government bonds) yield only 3.55%, thus the so-called risk free yield is a mere 0.6% lower than that of the prime real estate market with its oversupply risks. With signs of the U.K. recovery and prospects of a BoE rate hike possibly on the horizon, Sterling appreciates and a rise in the yields on U.K. Gilts squeeze the relative attractiveness right out of the London real estate market. Once Sterling is high enough, foreign investors might be provoked to take profits back home and that’s when we worry about the bubble bursting. In other words, the single most important trigger that could ignite a correction in the London real estate market is Sterling levels.
So Why Should We Care?
Besides those who reside in London, why should any global investor care about an appreciating Pound Sterling? And why that a ticking time bomb? The answer is simple; global banks, especially U.K. ones, are greatly exposed to the U.K. real estate market in general, and the prime and commercial real estate markets, specifically. With most banks composing a substantial part of the FTSE100, as well as other key indices, a sudden turn in tides in the U.K. real estate market – which, again, only needs a high Sterling to be ignited – could create substantial pressure on global indices and push towards a sharp correction in prices. Although this threat is not imminent, many mark a break of the £1.7 resistance as the ultimate jumping point for a complete reversal of Sterling losses toward the £2.0 level, the pre-crisis 2007 level. So while the £1.7 level could signal that the good days for the Pound Sterling are back, this may also serve as a warning sign that perhaps the heated London real estate market might be ready to ignite and with it FTSE100 prices. The £1.7 is still 900 pips away and certainly no one is certain that this will indeed be the trigger, but this is just food for thought for those who buy FTSE100 for the long term that they might have a time bomb in their portfolio that is ticking away without their even realizing it.