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Real Estate Perspective

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Our quarterly review of the property market looks at the factors driving real estate values over the last three months.

10 min read

Our quarterly Real Estate Perspective launches today, providing commentary from our market experts on the real estate market.

While some areas of the market – particularly London – show some signs of cooling off, there are plenty of hot spots for investors willing to look beyond the South East. Over the next few weeks we’ll be publishing four articles covering buy-to-let (BTL), the prime central London market, country homes and our commercial property holdings in investment portfolios.

“We are looking at the UK property market from certain sectors and locations”
Katherine O'Shea
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  • Chapter 1

    Buy to let investors feeling the squeeze

    We explore the challenges and opportunities for bricks-and-mortar-loving investors.

    Buy-to-let (BTL) investors face a range of fiscal, regulatory, market and political challenges. Amateur and accidental landlords are likely to be most affected.

    BTL investors have been feeling the squeeze recently as a result of the fiscal changes affecting the market, specifically the 3% Stamp Duty Land Tax (SDLT) surcharge and the restricted tax relief on mortgage interest payments. Investors can price the 3% SDLT surcharge into the overall cost of the investment but for leveraged investors the extra stamp duty could significantly increase the upfront cash required.

    The tax changes for mortgage interest relief first announced in the 2015 emergency Budget have come into effect this tax year. The changes are being phased in from 6 April this year until 5 April 2020 and, broadly speaking, will mean an increase in the tax taken from residential let properties, as illustrated below: 

    Tax Payable 2016/17 2017/18 2018/19 2019/20 2020/21
    Rent £50,000 £50,000
    £50,000
    £50,000
    £50,000
    Expenses (£10,000) (£10,000)
    (£10,000)
    (£10,000)
    (£10,000)
    Mortgage Interest Deduction* (£20,000)
    (£15,000)
    (£10,000) (£5,000) £0
    Rental Profit £20,000 £25,000 £30,000 £35,000 £40,000
    Income Tax @ 45% £9,000 £11,250 £13,500 £15,750 £18,000
    Tax Reducer ** @ 20% £0 (£1,000) (£2,000) (£3,000) (£4,000)
    New Tax Payable £9,000 £10,250 £11,500 £12,750 £14,000
    (£10,000)
    (£10,000)
    (£10,000)
    (£10,000)

    The Prudential Regulation Authority (PRA) published new BTL lender underwriting standards in September 2016. These included a requirement for affordability assessments to take into account the investors’ tax liability associated with the property(ies), including the reducing interest tax relief. Consequently it is less likely that rental income alone will be sufficient to demonstrate affordability and lenders will be required to include clients’ net free income as part of the lending assessment. Due to this, and other PRA requirements there are currently fewer BTL products in the market.

    “Our understanding of a client’s financial profile means we can assess affordability efficiently across the client’s rental income and disposable income outside property investment activities. Additionally ahead of PRA requirements we have implemented an approach to ‘Portfolio Landlords’ (clients with multiple BTL properties) and specialist staff are available to advise on client approaches which will, or are likely to, fall into this new classification.” James Clarry, Head of Lending and Capital Management

    These headwinds will certainly have an effect on investors’ appetite for the sector. Yet investors will often have various motivations for BTL investing, such as succession planning or long term wealth preservation.

    “For some families, giving their son/daughter of a suitable age the responsibility of looking after a family owned property is a part of preparing them in a practical way for the responsibilities of wealth in the longer term. In some cases siblings may manage the property together, giving them another opportunity to learn to work as a team and make decisions together. This will help prepare them to work together in the longer term.” Maya Prabhu, Head of Wealth Advisory Services


    Income and Capital growth

    Income-seeking investors have naturally looked to the regions for opportunities. The investment case for the ‘Northern Powerhouse’ remains strong, with healthy demand for rental accommodation, infrastructure developments and increased inward investment. Other major cities also continue to attract yield-driven investors, including Birmingham and Bristol.

    In and around London, the main investment drivers are focused on infrastructure and ‘sensible’ capital values based on price per square foot. Crossrail or the ‘Elizabeth Line’ opens next year and is still attracting investors. Many large-scale developers are continuing to develop along the route, often setting new capital value records in those areas. We favour small boutique scheme over larger scheme for a number of reasons. When it comes to selling the property, the investment is less likely to be pinned to a distressed seller, and similarly, when it comes to letting the property, the rent is less likely to be pinned to units that are under rented.

    Considering new build versus existing stock, we are seeing many investors with a reluctance to pay that new build premium for an asset that is likely to demand similar rental income, particularly in well established central locations. Furthermore, the capital value of the existing stock is likely to benefit from some growth given the records being set by their new-build neighbours. There is certainly more liquidity in the market below £1.5m where the highest “slice” of Stamp Duty is yet to kick in. For this reason, many investors are seeking investment in areas with capital values of £1,000 per square foot and under which is likely to have a wider pool of prospective buyers if and when it comes to disposing the asset.


    A deflating buy-to-let bubble?

    Efforts to get first-time-buyers (FTBs) on the property ladder are driving price rises. Data from Rightmove shows that FTB prices have been rising at more than double the rate of larger homes for some time. The ’buy-to-let bubble’ has been widely reported and has definitely deflated somewhat over the last 12 month but has the government’s Help to Buy (HTB) Equity Loan artificially inflated prices at the lower end of the market? With this loan, the government lends FTBs and homeowners looking to move up to 20% of the cost of the newly built home. In London, it can be up to 40%. The scheme is available until April 2020 and there is yet to be any confirmation on whether it will be extended. If it is not, there could be some price corrections at this level. Furthermore, FTBs who bought with HTB equity loan may decide to sell up and rent a family home if HTB is no longer available and/or their equity share is insufficient to upscale in their chosen location.

    Overall, the sector has faced several challenges and as a result investment volumes have fallen. The latest data from the Council of Mortgage Lenders shows that compared to February 2016, the number of loans for BTL investors decreased 26%. The changes to taxation and mortgage criteria are likely to continue to reduce the number of investors in the market, but overall tenant demand is only likely to increase in the long-term. As a result there is an opportunity for those that remain, but they may choose to reposition their portfolio towards regional cities in order to benefit from higher yields and the ongoing regeneration of cities like Manchester. We believe there are opportunities for investors but being selective, thinking long-term and having consideration for an exit is key to sound BTL investment decisions.

    For more information on any of our lending products please speak to your Private Banker. If you are new to Coutts please speak to Business Development on 0207 753 1365.

    If you require further information regarding the residential real estate service we offer, please contact: Katherine O’Shea: katherine.o’shea@coutts.com

     

    * 100% of mortgage interest allowable as a deduction for income tax purposes in 2016/17, 75% in 2017/18, 50% in 2018/19, 25% in 2019/20, 0% in 2021/21
    ** Tax reducer available at basic rate on mortgage interest element not allowable as a deduction for income tax purposes

  • Chapter 2

    Prime central london residential property market

    Prices across prime Central London have been softening since the peak of June 2014 as buyers and sellers realign their expectations on ‘realistic valuations’.

    Higher taxes and political and economic uncertainty led to a softening of prices across prime Central London (PCL) throughout 2016. According to Savills Research, prices in PCL are down 13.2% compared to the peak of June 2014. The latest reports from Knight Frank now indicate that demand indicators, sales volumes and price growth are showing signs of stabilising and that price declines appear to be bottoming out.

     

    Political headwinds prevail

    Political uncertainty shows no sign of easing, with a UK general election to be held on 8 June and Brexit negotiations expected to continue into 2019. Robert Bailey, founder of Robert Bailey Property, one of London’s leading buying specialist firms and on our panel of approved buying agents, recently noted that commentators are forever predicting a mass exodus from London but that the ‘lifestyle’ factors that make the city so compelling are hard to match elsewhere. “For business people, it’s about the judicial system, time zone, language and international travel connections. For families, they value the unrivalled education system, comparative security and vast open spaces. And for young professionals, the international dynamic and extensive entertainment options all add to the attraction.”  

    Although some buyers may be tempted to hold off transacting until after 8 June, we believe this will have little real impact on transactions, which continue to be sluggish because of stamp duty levels.


    London's luxury living

    We remain cautious on the discretionary luxury new build market. Unlike a street of identical Victorian houses, for example, new builds are much harder to value based on what has actually sold because there is generally little in the way of precedent. Asking prices can often be highly subjective, particularly with penthouses, where there can be extraordinary discounts to be had.  Bailey advises that “most importantly [buyers should] avoid the ugly-ducklings of tomorrow.” He notes that few schemes stand out from the crowd, and those that do – such as Neo Bankside and Barts Square – do so because they have been well conceived with attractive design and good quality construction. 

    Service charges for new build schemes can be the sting in the tail. Even if buyers can afford the price tag, most resist spending high sums on facilities they do not want. Servicing costs are not always well understood and can add significant costs to owning a property in the longer term.

    While many new developments offer a wide range of services - from club rooms, spa’s and golf simulators to pools and gyms - all these facilities come at a price and some new developments are seeing slower capital growth because of the high annual service charges that these add-ons attract. Many buyers from overseas, who only come to the UK for four or six weeks a year, are finding the additional cost these luxury extras difficult to justify.

    In this regard, investors should be wary when considering these buildings and think long and hard about the effect service charges could have on capital appreciation.  With off-plan sales slowing and the number of new build completions on the rise, there is likely to be further downward pressure on prices in this market.

     

    Low stock levels and competition for 'best in class' properties

    In comparison to the new build market, there is a shortage of supply of existing or traditional stock.  Many vendors are reluctant to lower prices. If they can’t achieve their desired price, they often decide not to move, instead withdrawing their property from the market. Extending a property rather than ‘up-sizing’ is sometimes more financially viable. There are few forced sellers, too, given low interest rates and lower exposure to high loan-to-value mortgages. This shortage of new listings coming to the market will go some way to insulate prices.

    There is neither lack of financial firepower among buyers, nor a lack of appetite to invest in London, but given the high levels of purchase tax it is more needs-driven than it used to be.   Buyers will not compromise on quality and will not over-pay. Bailey notes that “buyers who know London well are particularly active because they recognise that this is a good moment to buy a ‘trophy’ property that in a stronger market there would be much more competition for.” 


    Tide turning?

    While outer London continues to outperform central London, could there be a renaissance of interest given the significant fall in prices in prime central London since 2014? We expect the shift to be gradual but as the year progresses we expect prices to continue to become more aligned with buyer expectations of value, and therefore help the market become more fluid.

    When asked about calling the ‘bottom’ of the market, Bailey said that in his experience “if you look too hard for it, you’ll most likely miss it.” Instead he advises buyers to focus on buying the very best quality property within their budget, as this type of best-in-class property generally stands the test of time. 

    For more information on any of our lending products please speak to your Private Banker. If you are new to Coutts please speak to Business Development on 0207 753 1365.

    If you require further information regarding the residential real estate service we offer, please contact: Katherine O’Shea: katherine.o’shea@coutts.com

  • Chapter 3

    Demand outstrips supply for country homes

    The performance across the country homes market is patchy but buyers overall remain very price sensitive, particularly at the top-end, as they continue to adjust to higher purchase costs.

    Demand for prime country homes remains robust, but the shortage of good quality, prime property continues to be a challenge for buyers. This will be a barrier to sales volumes and is likely to affect the market for the remainder of the year. The latest data from Knight Frank shows that prices for prime country homes have increased by 0.6% between January and March this year indicating that prime markets are starting to stabilise.

     

    Patchy Performance

    The country market within a two-hour radius of London, where there is quality schooling and decent transport links back to the capital, has recently seen a surge in activity as needs-driven domestic buyers decided to get on and buy. Areas that have a more international market, driven by factors like proximity to Heathrow Airport, have also been more buoyant with competition still continuing for best-in-class homes. However, higher purchase costs continue to constrain the market and the market for homes over £5m is still quite challenging.

    Tom Hudson of Middleton Advisors, one of the UK’s leading buying agents in the prime country homes market and one of the firms on our panel of buying agents said that, “demand for good country houses is as strong as we can remember but the supply of country houses is as weak as we can remember.”

     When speaking about his recent experience helping clients source property in a market where there is a severe lack of good prime housing stock, he said, “many buyers remain unaware of the amount of potential competition in open-market situations. Once competitive bidding starts, buyers will invariably compete to a higher level than they expected.” This year, Middleton has secured approximately 60% of country homes off-market.

    Hudson noted that pricing is driven by selling agents’ need to win new instructions and is often much more than open-market worth. However, Brexit has undoubtedly allowed selling agents to bring vendors’ expectations down and this has led to a number of homes being re-launched at more reasonable levels compared to May 2016.

    The performance across the country homes market is patchy but buyers overall remain very price sensitive, particularly at the top-end, as they continue to adjust to higher purchase costs.

     

    City of London and Prime Commuter Town

    Areas that rely on buyers who are tied to London have seen more negotiation as a result of concerns over Brexit. In March, the UK government invoked Article 50, launching the two-year process of leaving the European Union. Interestingly, the April report from The Morgan McKinley London Employment Monitor showed that there had been a fall in March hiring numbers as a result, with a 17% month-on-month increase in jobs available. However, the May report reversed these figures with a 16% month-on-month decrease.  The report highlights the Easter holiday, which includes two bank holidays when many professionals take extended leave, as a significant contributor to the downward shift. The 8 June snap election announcement may also mean that businesses are pressing the pause button on hiring until the results are known.

    Bucking post-Brexit expectations, the City of London appears buoyant and in March the FTSE 100 reached an all-time high of 7429.81. Despite these factors, buyers still remain cautious.

    The shortage of open-market stock coupled with buyers who remain slow to commit, continue to suppress transaction volumes, but the prime country house market appears to be seeing the end of price falls.  Overall, we believe the prime country homes market will outperform the prime central London market this year

    For more information on any of our lending products please speak to your Private Banker. If you are new to Coutts please speak to Business Development on 0207 753 1365.

    If you require further information regarding the residential real estate service we offer, please contact: Katherine O’Shea: katherine.o’shea@coutts.com

  • Chapter 4

    Weak sterling bolsters Commercial Property

    UK commercial property is shrugging off political and economic uncertainty and remains an attractive destination for investors around the world

     

    Brexit shakes property foundations

    The UK’s commercial property sector was one of the biggest casualties in the months following last year’s surprise vote for Brexit. Investors were worried about economic uncertainty ahead and pulled their money from property funds.

    The high level of requests forced some managers to suspend redemptions and defend their decisions as necessary to stop a ‘fire sale’ of assets. Meanwhile, listed commercial property stocks suffered double-digit falls.

    However, the market soon stabilised after the result and activity picked up over the second half of 2016. Most property funds managed to ride out the volatility and soon resumed trading, while stock prices also recovered their losses.

     

    An attractive destination

    Two factors have been significant in the recovery.

    Firstly, the fall in sterling made UK property very attractive for non-sterling buyers. Sterling has remained depressed and London’s commercial real estate sector attracted record levels of international investment in the first quarter of 2017 as foreign investors saw attractive prices outweigh lingering uncertainty over Brexit.

    In the meantime, the UK economy has held up much better than expected and was one of the fastest-growing among the G7 in 2016. This has encouraged investors that there is still life in the UK as a commercial centre .

    That said, activity in the commercial property sector slowed significantly in the first quarter of 2017 and Brexit concerns still linger in some areas. For example, central London offices have been affected by uncertainty over whether financial institutions and other multinational businesses could move their head offices to continental Europe.

    In contrast, commercial real estate in regions outside London has been holding up relatively well. Investment is strong in warehouse distribution centres, which are benefiting from the increase in online shopping, regional offices and industrial parks, and retail outlets in favourable location . These sectors are less vulnerable to Brexit-related events and more correlated with the strength of the broader economy.

     

    Top-down perspective

    The main source of return from commercial property is usually the rent paid by the tenants. The UK benefits from a longer lease structure than Europe and the US, with typical lease lengths in a London office of between 10 and 15 years. This offers more security relative to the returns offered by shares, making property more like a bond as income is contracted at a set level for an extended period of time.

    Forecasts suggest rental income will be the main source of return in the coming year rather than capital appreciation. Interest from overseas should also continue given the value of sterling, boosting investment volumes in 2017. Meanwhile, the outlook for higher inflation is positive for real assets like property that can incorporate an element of inflation protection in lease agreements.

    “London’s commercial real estate sector attracted record levels of international investment in the first quarter of 2017 ”

    Commercial property in Coutts portfolios

    We hold two open-ended property funds in our client portfolios and funds, the M&G Property Portfolio and The L&G UK Property Fund. After a challenging 2016, both made positive contributions to our investment returns in the first quarter of 2017.

    The M&G Property Portfolio is our preferred vehicle because it has historically provided the ‘purest’ exposure to the asset class, holding relatively low amounts in cash and property securities. However, this approach led to a somewhat illiquid portfolio, and the fund was one of the first to suspend dealing after the EU referendum, and one of the last to resume trading in November 2016.

    The management team used this time to sell assets to ensure it could meet any investor redemptions without being pushed into disadvantageous forced sales of assets. The number of holdings fell from 180 to 120, and the fund increased its allocation to cash. In particular, it reduced its exposure to the London office market.

    After suffering negative performance in 2016, the M&G fund returned 1.4% in the first quarter of 2017.

    We also hold the L&G UK Property Fund, which has always invested in a higher proportion of liquid assets, a combination of cash and property securities. As a result, it managed to avoid any suspension of dealing throughout 2016.

    Following a 1.8% return in 2016, the L&G fund returned 2.3% in the first three months of 2017. In line with its peers, the portfolio manager is underweight London offices and overweight industrial properties. Just two-thirds of the portfolio is invested in bricks and mortar. The remainder is in real estate investment trusts (REITs) and cash, reflecting a cautious long-term view.