Welcome to the real world: UK real estate

The UK property market may be seen as the market with the best pricing in the world today. The speed at which real estate yields (and values, accordingly) have adjusted over the past year, is unanticipated.

CBRE reported the All Property yield [rising] a further 20bp to 8.1% in February, 315bp higher than the market peak in June 2007, and with values now down by 39.7%. Central London offices are suffering the most. And what to say about the West End office market, where rents are sliding on hedge fund woes:

Rents for prime offices in London’s West End dropped by almost a third last year[], dropping from a peak of about £120 per sq ft in 2007 to £85 per sq ft by the end of 2008.

What was that rental rate again? £120 per sq ft? Well, that is an absurd office rent in the first place. Balooned by the hedge fund industry. And even £85 is quite a full price for a nice little fancy office for some hedge fund managers that presumably aren’t doing too good these days? (Weren’t they supposed to do well, good times AND bad times…?). Compare it with prime city offices:

Rents on prime City offices have fallen from £65 per sq ft at the end of 2007 to £52.50 per sq ft by the end of last year.

So, rents are down by one third, yields are up by 315 bp, vacancy up also. When you add up things, yes, a repricing of the London property market by some 40% (or even more) withing a year sounds reasonable. Welcome to the real world. Welcome to more realistic price levels and, for instance a positive yield gap, due to a rapid yield shift and lower interest rates.

Talking of yield gap. This is an interesting graph from CBRE, which actually tells you the full story:
At the peak of the market, back in June 2007, yields used to be sub 5%, for prime retail locations even 4% or so. Cost of lending was substantially higher then these days, with a base rate of 5.75%. As a result, the leverage effect was negative: property investors faced a negative yield gap when gearing up.

That was June 2007. Now, March 2009, yields are up 315 bp and the base rate is 0.5%. The property/gilts gap is widening. According to CBRE, the yield gap was at a historic high of 4.4% by year-end 2008. There’s some risk premium for faulting tenants, vacancy levels and lowering ERV’s, I suppose. But, must say, prices are much more realistic. Now: Back to basics.