UK ROUNDTABLE: Capital Crush

PERE’s annual UK roundtable was held during a time of major disruption for Londoners. It was late April and a London Underground strike over plans to close multiple ticket offices was underway, affecting millions of people. It led to commuters either leaving home earlier or finding alternative methods and routes to work. 
If it isn’t stretching the metaphor too far, one might say that, like those commuters, real estate investors also need to work harder at the moment, be smarter or find alternative ways to get to where they want to go. That is because, although the economic recovery for most UK citizens is only just beginning and things are still tough, the recovery in the property investment arena is very well developed. As a result, the roundtable centered not just on the strong bounce back in property values but on the question stemming from that – namely, how to find opportunities in a market where demand from international investors has pushed pricing back to pre-crash levels.
It was against that backdrop that once assembled – and all punctually in spite of the challenges – the participants got down to the business of analyzing UK real estate. The roundtable comprised two representatives from the investment and advisory arms of major banks: Oliver Vines, senior vice president at Macquarie Capital, and Howard Meaney, managing director of UK real estate at UBS Global Asset Management. Also in attendance was Richard Bains from the independently-owned European firm Rockspring Property Investment Managers and, also on the advisory side, was Philip Cropper, managing director of CBRE’s capital advisors division.
A well-balanced market 
Meaney kicks off the discussion with an assessment of the prospects for growth in the UK real estate market. “Forecasts from Capital Economics and UBS suddenly took a big step forward a couple of months ago, predicting a 14 percent return this year,” he says. “There is momentum in the market, with predictions of 8 percent to 9 percent growth in capital appreciation this year. Over a five-year period, returns are being forecast in the order of 9 percent per annum.”
Returns of 28 percent from UBS’ £200 million (€245 million; $336 million) Central London Office Value Added (CLOVA) Fund over the previous 12 months show how rapidly the market has recovered over the past year. Meaney notes that a successor to the closed-ended fund is now in the pipeline, though he concedes that returns will not be as high now that the market has warmed up. Still, the new fund is targeting 10 percent to 12 percent, which looks achievable because of the relatively low supply pipeline in key London markets.
“With the shape that the economy is in, the property market is looking as well balanced as I can remember,” he adds.
Cropper recommends discretion and caution, as rental growth is patchy and confined to good-quality, well-located buildings in core areas where supply is low. “As soon as you start moving off those core locations, rental growth is very difficult to see,” he says, “and you still have a huge amount of risk about tenants renewing leases, so there still needs to be a certain level of caution in the marketplace. This is the same for retail and offices.”
The recovery in the investment market is still some way ahead of that in the occupational market, adds Bains. “There probably is more security in the income stream, but I don’t think there is a lot of obvious growth yet,” he says. “It is mostly filling up vacancy rather than actually driving rental growth. I think that rental growth will come, but we are not in a boom economy. We are in a steady, slowly recovering economy.” 
Certainly, there has not been a widespread return to speculative development outside central London, even within the strongest markets in the south east of England. That said, Rockspring has backed four developments in the south east, including Uxbridge and Staines in suburban West London.
“Uxbridge let last year and Staines is fully under offer, but tenants are still taking a long time to make a decision,” Bains observes. “While occupational interest is better than it was, it still is not exactly buoyant.” He adds that, now that yields have come in, backers of new developments will need to believe they are going to see rental growth if schemes are to stack up financially. 
The relatively sluggish occupational market, however, has not deterred investors – far from it. Indeed, the weight of demand for UK property investments already has left some sectors of the market looking slightly overpriced, Meaney observes.
“I agree there are large chunks of the market doing very well, but yield compression on some secondary assets has come in dramatically over the last six months, driven by the sheer weight of capital and lack of opportunity,” Cropper warns. “It is going to be difficult for some of the people who have chased yield into secondary assets to drive returns.” 
Seeking alternatives 
One of the most pressing questions facing investors in the UK market is how to identify and secure opportunities in the face of fierce competition for assets, particularly large trophy ones. Indeed, big investments like central London office blocks and regional shopping centers retained their allure even during the downturn. 
Now that the market has recovered, trophy assets like the so-called Gherkin tower and HSBC’s European headquarters in London’s Canary Wharf (see The two towers, page 56) will be in even greater demand. These assets are closely monitored by the likes of UBS, given that its central London property fund has benefitted to some extent from the increase in values as well as from active management.  
Because of this demand, Vines contends that Macquarie has liked alternative real estate when identifying opportunities for clients to place their money. “Many of the large sophisticated investors are really focused on these alternative property types,” he says. “They like to have access to situations with an element of complexity, which could be a recapitalization opportunity or an investment into an operationally intensive property. We believe such situations have the potential to offer highly attractive return for the inherent risk.”
Good examples of how Macquarie clients have invested in alternatives are the private rented housing sector (PRS) and the student housing sector. “The reason we got into alternatives is that they offer a proxy for core, generating a core-plus return for a core risk,” explains Vines. “An example is greater London PRS – you get an enhanced return, but actually the income quality on a PRS scheme in central London is extremely high.”
As a property type, UK private rented residential still is in its infancy. “We have looked at PRS and finding and partnering with the right operator is difficult because there aren’t many out there,” says Bains. Fizzy Living, backed by Macquarie and the Abu Dhabi Investment Authority, is one of the first to carve out a niche in the sector (see Corks pop for ADIA).
Cropper believes that PRS is set to grow. “The demographics of the country have changed,” he says. “People want to make decisions about buying a house later. You will get pockets around London – near Crossrail stations [London’s new east-west rail line due to open in 2018], for example – where PRS will be the obvious thing to develop.”
Cropper notes that the medical property sector offers similar characteristics of long-term income and attractive income yields, although it is important to identify the right manager. CBRE just raised £185 million of capital for MedicX Fund, a fund that invests into hospitals and doctor surgeries, he points out by way of example.
Loving the unloved assets 
Another strategy adopted by investors in search of opportunities has been the purchase of nonperforming loan (NPL) portfolios. Vines suggests that, by doing so, some funds have gained access to well-located property without facing the same level of competition that they would buying individual assets or portfolios directly.
Such an approach, however, is not for the inexperienced or faint-hearted. “You need a huge infrastructure to be able to go and bid for some of these loan books,” Cropper says.
Bains concurs. “We recently were involved in a deal trying to buy a portion of a loan, and it’s a very complicated process with a lot of hard work to get to the underlying real estate,” he says. “Yes, it is competitive buying assets on-market, but I am not necessarily sure it is any easier or any less competitive trying to do those sorts of [NPL] deals.”
Still, one clear benefit of NPL sales as a whole will be to bring formerly distressed assets to the market. Bains argues that, while banks have failed to release much property, private equity buyers will want to quickly sell the assets that they have bought from the banks. “The banks are not going to be selling them piecemeal, but those guys will,” he says. “For a long time, we have been saying that banks are going to create massive liquidity through de-leveraging, but it hasn’t happened.” 
Rockspring, which manages £2.5 billion of UK property, has divested one-third of its closed-ended UK Value Fund (raised in 2009) and currently is raising equity for UK Value Fund II, for which it recently held a first close on £71.5 million. Distressed real estate will offer attractive opportunities in which the new fund can invest. 
“When buying an unloved asset, the price that you are paying may not be cheap, but the opportunities within those assets for asset management specialists like us are massive,” says Bains. “We have an improving economy, so turning these assets round is a whole lot easier now than it has been over the past five years. Core-plus values have come in massively over the past six to nine months, so we will not be able to make money for UK Value II just out of yield compression. It will be all about the value we can create and, in an improving economy and occupational market, you have to back yourself to do that. There are opportunities all over the UK in all sectors.” 
London and the regions 
Bains concurs that finding such opportunities in London is increasingly difficult because yields have come in so much. It also is an issue that Meaney at UBS will be grappling with. Indeed, he soon will be looking to invest the firm’s second CLOVA fund in London property and will search for assets outside the established locations of the City, Docklands and the West End. 
“We are not going to be able to buy London core locations, so we may go to peripheral but developing locations,” Meaney says. “The established London office market has expanded into locations where there was no office market previously, such as King’s Cross or Paddington.”
Vines has noticed the same phenomenon. “The impact of central London being such a strong financial center and there being so much demand for assets is that the peripheral markets, especially office markets like Farringdon and Shoreditch, are starting to see large-scale institutional investment,” he says.
Cropper adds that there are now many more competing office locations opening up around the capital. He points to the example of the Financial Conduct Authority (FCA), which announced at the beginning of April that it would be moving from its base at Canary Wharf to the former Olympic Park at Stratford. “You also will have other new power bases along the Crossrail line when that opens up,” he predicts.
While rental growth may not be evident across much of the country, it clearly is taking place in London. Bains cites the example of a building in Southwark where rents have increased from £46 per square foot to £56 per square foot in 12 months. 
“Rental growth really is happening in London and that is starting to ripple out, particularly down the M4 motorway into the Thames Valley,” adds Meaney. 
With high returns more difficult to achieve in central London, the question becomes whether overseas investors will look more outside the capital to cities such as Birmingham and Manchester. However, Cropper believes that the 
£300 million sale of the Royal Bank of Scotland’s 500,000-square-foot office at Spinningfields in Manchester will be a bellwether for demand. 
“There aren’t many buildings of the scale of Spinningfields in the marketplace,” Cropper says. “It will be interesting to see where the capital for that asset comes from. We have seen Chinese money coming into Manchester, supporting development at the airport,” he notes, underlining how some foreign money has been placed in the regions.
Debt funding and finance 
The other offshoot from the UK property recovery is the prevalence of debt funds. The big question around the table was whether they could retain their relevance to the UK market in an improved economic climate. 
Cropper seems sceptical. “The vast majority of debt is not coming from those funds now,” he says. “The traditional lenders are back in a big way.” 
Meaney, however, believes there still will be a niche for debt funds. In fact, at the beginning of the year, UBS established its £140 million Participating Real Estate Mortgage Fund (PREMF), with backing from three institutional investors. 
“The market is competitive, and we need to offer a product that will be attractive to borrowers,” Meaney says.  “As a result, we are willing to lend at a higher loan-to-value ratio [than the banks], and we will fund pure speculative development. In fact, one of the first things we’re thinking about is speculative development in the Thames Valley.”
Indeed, funding for development still is very difficult to obtain. Bains says most speculative schemes are backed by institutional investors, not by the banks, which have a limited appetite for development and leasing risk. Underlining that observation, Cropper adds that CBRE is managing small funds for local authorities in Manchester and Sheffield designed to provide support for development in regional cities, where financing is limited or unavailable on purely commercial terms. 
Still, Cropper contends that debt funds have not made nearly as big an impact as was predicted two years ago. “A lot of the capital that people said they were going to deploy into the debt market didn’t actually get deployed,” he says. “The returns people thought you could get probably were nearer 6 percent and they went down to sub-4 percent in a relatively short space of time. At that point, the attraction had eroded.”
Structural engineering 
While everyone around the table seems to agree that UK property has changed, they also have witnessed change in the way that investors have been accessing it. In the past two years, for example, club deals have grown in popularity while commingled funds have struggled in some cases. Now, there are signs of change.
Vines explains that, in terms of structure, investors are prepared to go slightly off-piste in search of return, but they want to have control. To some extent, it comes down to ticket size. 
“Investors writing ticket sizes of between £10 million and £50 million are probably looking at funds,” Vines says. “If they are in the £100 million-plus range, they likely will go for a separate account mandate or even an on-the-ground platform that they can back, whether it is a club format or a joint venture. The reason for this is the bigger investors like to have control, most importantly over their exit. Smaller investors can find it difficult to secure that control unless they invest in single assets, but then they don’t get diversity.” 
From his vantage point at UBS, Meaney observes that the control element is important to investors almost irrespective of what size they are. “We aim to work with clients so that we can fully understand their requirements,” he explains. The firm, by the way, has just won a very large global mandate that will look to invest up to $500 million in the UK.
Bains, whose firm is in the business of running funds and managing various separate accounts and individual mandates, says: “We are raising capital for the UK Value II fund, while the TransEuropean VI fund, our pan-European closed-ended platform, will be in the market later this year. We are seeing especially good interest in our closed-ended funds at £10 million to £50 million and, above that, people tend to want to go with a separate account.”
The final word goes to Cropper as the roundtable participants prepare to head out. “If you went back two years, everyone was saying, ‘Commingled funds are dead. Nobody wants to put money into them.’ But a certain amount of equity needs to go through that route, otherwise it won’t get access to the market. There are going to be a lot of investors that need to go down either a separate account or commingled fund route because they don’t want to build up their own infrastructure.” 
Indeed, as Cropper notes, US investors are back in the market for commingled funds and Asian capital will have to start getting more comfortable with that method. “There is a huge amount of capital that wants to deploy, so just about every route will be utilized to get exposure,” he says. 
UK real estate can toast that. London may present strike action on its public transport system now and again, but the country in general is motoring along nicely and capital is flowing to the parts it wants to reach. 
Richard Bains 
Partner, fund management 
Rockspring Property Investment Managers 
Bains joined Rockspring Property Investment Managers in 2009 and became a partner at the London-based fund manager this year. He primarily is responsible for the firm’s UK Value series of funds and also heads its fund advisory team. He previously worked at CIT Group, Baring Houston & Saunders and Cluttons. 
Philip Cropper 
Managing director, capital advisors 
Cropper has been working for CBRE since 1985. For the past eight years, he has headed its Capital Advisors division in the UK, providing advice to property investors on acquisitions, equity and debt funding, transaction structuring and disposals. He is an executive director of CBRE and sits on the UK executive board.  
Howard Meaney 
Managing director of UK real estate  
UBS Global Asset Management 
Meaney has more than 30 years’ experience in the UK real estate industry. In 2012, he joined UBS Global Asset Management as portfolio manager for its Triton fund, which invests in UK commercial property, and was promoted to head of UK real estate the following year. Before joining UBS, he was head of property investments at LV= Asset Management, where he was responsible for managing five UK funds with some £750 million in assets under management. 
Oliver Vines 
Senior vice president 
Macquarie Capital 
Vines joined Macquarie Capital, the investment banking arm of Australia’s Macquarie Group, in 2012 and is a member of its 10-strong European real estate team. His work involves advising the world’s leading sponsors and institutional investors on M&A, capital raising and restructurings, including investing the firm’s capital in support of its clients’ strategies. Vines previously worked for CBRE Global Investors as an associate director, as well as for Bank of America.  
The two towers 
Contrasting fortunes for two of London’s iconic office properties 
Spring has brought contrasting fortunes for two of London’s iconic office towers. In April, HSBC’s 44-story headquarters at Canary Wharf was put up for sale, demonstrating the strength of the recovery in London’s real estate market. Meanwhile, that same month, administrators were called in at 30 St Mary Axe, popularly known as the Gherkin.
The National Pension Service (NPS) of Korea, which owns the HSBC building, is believed to be seeking a sales price of more than £1.1 billion (€1.35 billion; $1.85 billion), underlining the degree to which London’s property market has recovered. Built in 2002, the 1.1 million-square-foot skyscraper became the capital’s most expensive office building when it was sold to Spanish property company Metrovesca for £1.09 billion. HSBC took ownership back in-house when Metrovesca ran into financial difficulties during the global financial crisis, and the building was sold to NPS in 2009 for £800 million in a deal criticized as overpriced in some quarters.

Meanwhile, the five banks that financed IVG Immobilien and Evans Randall’s £600 million purchase of the Gherkin in 2006 finally called in administrators five years after a rise in the value of the Swiss franc caused the partnership to breach its banking covenants. Administrators are expected to put the building, which is 99 percent let, on the market later in the year.

Corks pop for ADIA 
The sovereign fund’s investment in Fizzy Living has given a jolt to the private rental sector 
In March, the Abu Dhabi Investment Authority (ADIA) showed its confidence in London’s private rented residential market by investing £200 million (€245 million: $336 million) in Fizzy Living. The developer, which is a subsidiary of social housing provider Thames Valley Housing Association, is building four schemes in and around London at Canning Town, Poplar, Stepney Green and Epsom. Macquarie Capital had provided the venture with £40 million of seed capital and helped Fizzy to find its new investment partner. 
Oliver Vines, senior vice president at Macquarie, says the company targets a specific demographic within the rental apartment market, which it calls “renty-somethings” – young professionals with decent levels of income who want to live in a place that is safe, well-designed and has good transport connections into central London. The apartments are mainly one- and two-bedroom units, with the two-bedroom flats built for sharers seeking two equal-sized bedrooms and two bathrooms.
“We ran a marketing process and took the idea to a number of investor contacts,” says Vines. “ADIA really understood the depth of the £1,000-£2,000 per month rental market as they had done a lot of work on the private rented sector. They were considering making an investment and were very focused on finding the right operating partner.”