Post on 19-Aug-2020
Real Estate and Global Capital Networks: Drilling into the City of London
Colin Lizieri and Daniel Mekic
Cambridge Real Estate Research Centre,
Department of Land Economy
University of Cambridge
Preliminary Version: Please Contact Authors For Latest Version
Contact author: Colin Lizieri Grosvenor Professor of Real Estate Finance Cambridge Real Estate Research Centre 19, Silver Street, Cambridge CB3 9EP, UK cml49@cam.ac.uk
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Real Estate and Global Capital Networks: Drilling into the City of London
1. Introduction The spatial clustering of global financial business in a small number of major cities, acting as coordinating centres for an interlinked system of international financial flows, attracted academic attention in the last part of the 20th Century (Sassen 1991, Castells 1996, Sassen 1999). This was particularly driven by globalisation and seeking to understand the place for the nation state (Ōmae 1995). There is a growing awareness in urban social science of the importance of commercial real estate as a medium by which major cities are embedded within global capital networks (Halbert and Rouanet 2013, Halbert et al. 2014a, 2014b, Lizieri & Pain, 2014, Theurrillat & Crevosier, 2014) and a “rediscovery” of real estate as a topic for critical urban analysis (see e.g. Fox Gotham, 2006; Christophers, 2010; Dörry & Handke, 2012; Guironnet & Halbert, 2014). In particular, city centre transformations emphasising office development focussed on financial and business services firms serve to tie cities into international employment cycles while the capital sunk into the real estate locks those cities into global capital markets through investment ownership and the finance and funding of the built environment (Lizieri 2009). This trend is most pronounced in developed world cities whose focus is on financial services – international financial centres – or who aspire to create a financial sector. In this paper, we examine the changing patterns of office ownership in the City of London: the financial heart of an archetypical global city. City office real estate within global cities provides the physical infrastructure that allows financial and business services actors to operate international service networks worldwide, while at the same time being important investment vehicles. Global cities with the highest concentration of office investment are found to be most exposed to risk associated with international financial market (Lizieri and Pain 2014). With such an evident link, the global financial instability that began in 2007 led to a resurgence of interest in financial crises, systemic risk and contagion effects from real estate; commercial property was at the heart of explaining the origins of the crisis:
“The UK financial crisis beginning in 2007 was exacerbated by a rapid build‐up in investments in commercial property, a large swing in property valuations and, in the aftermath, a sharp rise in non‐performing loans” (BoE 2013)
As shown in Figure 1, systemic risk arises through the process of real estate investment in such cities due to the locking together of occupational markets (functionally specialized in financial services activities), investment markets (through acquisition of offices), supply markets (both through demand drivers and the supply of finance for development), and real estate finance (through property as collateral for lending). Figure 1 Commercial property ownership in City: Intertwining of occupiers, creditors and investors
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London’s role as the pre‐eminent international financial centre in Europe has created a depth and breadth of markets that underpins demand for office space in the City and its surrounding sub‐markets. Within London, the City’s main competition comes from low cost business centres in Canary Wharf and Southbank, as well as the West End. The City of London forms the largest complex of office space in Europe, with the Corporation of London estimating the total floorspace in the City at some 8.6 million square metres as at March 2014 (City 2014). The City employs 392,400 people across the square mile (ONS 2013). Investment in the London office markets is increasingly international in nature. CBRE estimates suggest that in the ten years from 2005‐2014, 63% of office acquisitions in central London and 68% of acquisitions in the City of London were by non‐UK investors. This is part of a wider globalisation of office investment. from the late 1980s, but in particular in the first decade of the 21st century. Real Capital Analytics data for top 1000 office deals in each year from 2007 to 2014 show that 30% of transactions and 35% of the value of those transactions were cross‐border. That investment is strongly concentrated with just twenty cities accounting for over 67% of those deals by value. London, with $107billion of office transactions, was clearly the major target market over that period. Major global investors play a key role in this process (the top ten ranked individual investors were involved in $151billion of transactions, 12% of the total) as do international chains of brokers and agents (the top ten brokerage firms were involved in some 57% of sales; the headquarters of those firms are predominantly in major global cities). While urban research has identified these tendencies, the nuances of market processes are often lost in over‐simplistic categorisations such as “international financial capital”, “finance capital investors” (Attuyer et al., 2012) or “property developers”. As an example, Guironnet & Halbert (2014) identify
“(t)hree paths through which [urban development projects] are shaped for finance capital investors ... First, the production of market representations, by internationalized property consultants, skewed towards investors’ standards. Second, the tailoring of buildings as ‘quasi‐financial’ assets in the course of real estate development, through which developers seek to address this now dominant financial clientele. Third, the evolution of strategic planning and land development, whether as a by‐product of greater room gained by developers, or as a result of a direct targeting of the investment industry by local public authorities and their development agencies.”
In practice, there is considerable diversity in the nature of office investors and that diversity can lead to substantial differences both in their motivations for building international real estate portfolios and in the potential impacts of that investment for the cities concerned. We examine this in the context of the City of London’s office market. Thee empirical content of the paper is based on the fifth update of a proprietary database that tracks the office ownership in the City of London. The first two reports (Baum and Lizieri 1998, Lizieri et al. 2001) mapped out the change in ownership in the City office market over the 1980s and 1990s in response to financial deregulation, propelled by” Big Bang” – the financial deregulation that was part of the macro‐economic policy shifts in the Atlantic neo‐liberal era. They demonstrated that foreign owners were increasingly playing an important role in the City. The third report (Lizieri and Kutsch 2006) was written in the context of further innovation in the structure of the UK and European real estate markets. The rise of private equity vehicles has been accompanied by the increasing use of offshore structures in response to taxation changes, with a consequent growth in complex collective and pooled investment funds. The City office market experienced a very severe market correction over the 2005‐2011 analysis period, linked to the major shocks in global financial markets with the capital crunch, the liquidity and banking crises, the “great recession” and the sovereign debt crises. In this bleak economic context, one might
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have expected to see evidence of capital flight, a retreat to home markets. Through the crisis, however, the City remained resolutely international in character. The current survey confirms the preliminary findings of the 2011 report (Lizieri et al., 2011): foreign ownership seems to have increased in the midst of the global financial crisis; this suggests that the City is seen as a safe haven for investors. We proceed as follows, the next section shall discuss the influx of investment to the City of London, touching upon the many hypothesis that explain the disproportionate interest given the poor investment performance. Next we outline a brief history of the City of London office market that shows the evolution of specialisation and the development of commercial offices as an investment, as well as the initial limited foreign ownership. The historical perspective is intended to provide context, but also highlight some of the past trends and events that have led to an office market dominated by investor ownership. This is followed by two sections reviewing the methodology and results from the proprietary Who Owns the City of London database. Here the changes in the ownership are analysed, both in terms nationality and type of owner, to highlight the globalisation of ownership and trends in the type of owner, using supporting third party data that show investment and occupier trends. The structure is designed to help highlight the many nuances in the investment trends that show waves of interest that have built up the non‐domestic ownership of London, driven by domestic policy and global trends in deregulation and economic development. Thus, showing that the mix of non‐domestic ownership has evolved driven by the plethora of motivations that have not only maintained levels of non‐domestic ownership, but also etched away at the domestic share. 2. The Dominance of London for Investment
With the post‐crisis investor emphasis on perceived high quality low risk assets such as gold or triple‐A Government bonds, the focus of investors on prime real estate and major urban markets could be seen as a flight to safety. However, commonly accepted risk measures, such as Sharpe ratios, do not support the idea that large city office markets are inherently safer. Evidence suggests that City of London provides poor risk‐adjusted returns when compared to other European cities and to UK regional markets. It has been suggested, then that the high concentration of investment in major centres reflects behavioural and social biases, alongside investor preferences for liquidity and assets that define their benchmark (i.e. constituents of indices or proxies). The city‐making process associated with institutional and property investors and their advisors in commercial office markets is a social process. This is associated with long‐term regional variations in the spatial relationship between property investment and the pattern of economic activity in the UK (Henneberry and Mouzakis 2014). Henneberry and Mouzakis see evidence of “mis‐pricing”, or “pricing inaccuracies” on account of a supposed “bias” of actor networks toward the London market. This bias in property investment decisions is a supposed outcome of “familiarity” on the part of not only investors but also their professional investment advisors. Investments are decided by what is according to Henneberry and Mouzakis, a “relatively small, long‐established, dominant network of portfolio managers and professional advisers and intermediaries based in London” (op cit., p. 535). Familiarity is one explanation for the fact that investor and broker decisions continue to favour global city markets that are seen as likely to offer returns “that are low relative to risk” (Lizieri 2009) apparently uninfluenced by studies pointing to market price imperfections. Building on familiarity, investing in London may be a decision making bias towards safety ‐ “Nobody ever got fired for buying IBM” comes to stand for decisions whose chief rationale is safety (Buchanan and O Connell 2006). Lizieri and Pain (2014) suggest that the flight of global investors to the largest markets with higher unit prices and greater transaction volume at the expense of other cities represented a “flight to liquidity” (saleability) even though, as Henneberry and Mouzakis (2014) note, liquidity as measured by
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transactions’ rates is higher in “peripheral” than in “core” office property markets (Lizieri and Bond 2004). Liquidity may have been confused with a flight to quality, borrowing ideas from bond literature (Longstaff 2002, Beber et al. 2009). Given the volatility in prices, the quality argument may lack support; however, the perceived investment quality may stem from the historical classification of this area as prime office real estate, which is not reflected in recent financial performance. The notion of prime versus secondary and tertiary real estate is highly subjective and lacks precision; they are crude terms used widely by investors to grade the quality of individual properties. If there is a deliberate flight to quality, the financials suggest that it is a perceived notion of quality rather than based on investment performance data. Global city office market liquidity is considered a product of the behaviours and tacit knowledge of a complex of producer services actors, including investors and their brokers. Liquidity cannot be understood without knowledge of complex actor relations between service suppliers, office occupiers, and investors, and the interdependencies between them. The apparent irrationality of investment decisions in the UK reflects the fact that tacit knowledge and investor location preferences cannot be captured in quantitative studies. Selecting the familiar geographies of investment may also be an artefact from findings that fund managers desire to perform satisfactorily against a benchmark, restricting their investments to areas dominating the benchmark and limiting spatially diversified investment (Henneberry and Roberts 2008). The major financial centres are likely to be key components of benchmarks, making them a key target for investment. As noted in previous Who Owns the City reports, non‐domestic investors play a significant role in owning central London office space. This is a trend well publicised for the potential advantages and the questioning of what investors really understand about real estate ownership:
“It’s a global trend, the shift toward real assets that provide investors with diversification, inflation hedging, asset backing and more operational effort than some bargained for.” (PwC 2013)
Diversification, following Markowitz’s portfolio theory, is a convenient argument for holding non‐domestic real estate. Investing in foreign real estate has been found to offer more diversification benefits than foreign equities. Foreign real estate was found to have a lower correlation with U.S. stocks than foreign stocks (Conover, Friday et al. 2002). Nonetheless, the approaches to capturing the exchange rate risk vary (Sirmans and Worzala 2003), without a clear path for resolution. Assumptions (e.g. re‐investing income, hedging and repatriation of capital or income) may not be implementable or the preference for particular investors. However, while national indices of commercial real estate may exhibit low correlation, the practical investment strategies followed by investors may fail to deliver that diversification, if the assets acquired are heavily concentrated in prime offices and global cities driven by common economic drivers such that financial shocks may create downside risk across the whole portfolio (Lizieri, 2009, Lizieri and Pain, 2014).
3. The City’s Story Big Bang, the Thatcher era financial deregulation and economic liberalisation are often cited as the origins of London’s contemporary standing as a global financial centre and its economy’s bias towards international financial services. Nonetheless, the building of office space and the investment in commercial real estate, as well as the functional specialisation, has long historical antecedents. Detailed reviews can be found in prior literature (Scott 2013); here we focus on events that encouraged or facilitated office building and investment, as well as the concentration of a skilled population within London. In addition, investor interest shows a pattern of waves, where different investors have built
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and held assets depending on the economic cycle, exogenous events and the source of funds, leading to further intensifications of land use and more recently to comparably low yields. In 1700, London was the world’s largest city. London, as a trade hub for England, provided the basis for the development of the City’s commodity, insurance and money markets. Owing to the low of number of employees (if any), business was mainly conducted in homes, counting houses and coffee houses. Real estate stock consisted of warehouse, residential and industrial; therefore, still lacking the appearance of purpose built offices. Foreign ownership was predominantly from attracted settlers, who would in our City of London office Database be considered UK owners owing to place of main residence. Purpose‐built offices emerged in early 1820s, and speculative development in 1840s (Buam and Lizieri 1999). In the 1860s, the reducing supply of sites in the City led to rising land values, sparking an interest in commercial real estate investment. Publicly quoted property companies specializing in City offices emerged, with early sign of foreign interest. The City Offices Company Limited was floated by the Mercentile Credit Association in conjunction with a French bank, Credit Mobilier, in 1864. Stimuli for office development came from improvement in mass transportation and the development of the hydraulic lift which permitted larger builds. The emergence of real estate investing parallels the development of institutional investment and real estate would have been one asset class that they could choose. The 19th Century is a marked by the entry of property companies and institutional interest in the sector, making a shift away from traditional owners. In 1914, the ownership of land was mainly in the hands of traditional owners (such as the Church, aristocratic families and worshipful companies) and institutions; whereas for the ownership of buildings, property companies played a major role. Owner occupation remained strong, while smaller properties were rented by individuals. In the inter‐war years, property companies suffered from national and global recession. In the 1930s a few manufacturing firms established headquarters in the City, taking advantage of lower rents and breaking with the traditional arrangement of location next to place of manufacture, to gain access to sources of finance Tariff barriers and skilled labour encouraged some foreign firms to establish a U.K. presence in City. Bomb damage and low wartime prices created sites for redevelopment and led to changes in ownership (Baum and Lizieri 1999). Speculators and developers consolidated sites for the development of larger footprints. Industry and warehouses, particularly targeted in the bombings, made way for offices. By 1963 it is estimated that net office floor space was around 50% higher than in 1939. The market value of quoted UK property companies rose from £39m in 1939 to £437m in 1960. Insurance companies and pension annual net investment in U.K. property rising from £5m in 1937 to £71m in 1960. Owner‐occupation declined in significance in the post‐war period and the age of large scale commercial real estate investment began. The City of London also bought a significant proportion of the City, with remnants of its freeholds still being observed in the Database. Even though victorious, the UK’s global economic strength was damaged and the colonies gained independence reducing its sphere of control. Nonetheless, the baton to re‐build the City was placed with property companies and institutional investors. Congestion and rising rents favouring more profitable business, lead to the City’s growing specialisation in financial services and externally‐oriented business that was to be continually reinforced when rents rose or companies needed to cut costs (e.g. during recessions). The 1974 property crash, led to a secondary banking crisis and the transfer of property assets from the property company sector to institutional investors. The 1980s deregulation helped establish the City as a global financial centre with foreign banks establishing offices and buying domestic firms. Nonetheless, it took over a decade later for foreign ownership to sharply increase: real estate was left behind in the first round of globalisation.
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Our Database shows that foreign office ownership rose rapidly from ~20% in 1998 to 63% by 2014 driven by deregulation in other markets. The significant influx of foreign investment has led to transactions in the City to be increasingly foreign to foreign, providing capital and demand for developers to continually intensify land use in the Square Mile. Over this period, foreign investment has come from different sources and there is a turnover as investor non‐UK national investors have arrived and departed. The capital flows reflect changes in foreign regulations and in investment objectives, as well as the domestic success of the economies where the funds have originated. The City’s ability to attract the next interested investor in the relay race has helped provide liquidity and helped construction cranes to continue to be part of the London skyline. London has had various actors come, remain or go, depending on their needs and preferences, as well as shocks to the economy (regulations, wars etc.). Domestic played a major role in developing the office market to be an investible asset, establishing publicly listed companies for this purpose early on. Events such as the World War II provided the opportunity to consolidate plots and increase the size of single investment opportunities, as well as encouraging the transfer of land to speculators. Initial returns drove investment. It is important to remember that institutional investment paralleled the development of that industry. Different actors have entered the market based on their preferences and temporal opportunities. In dissecting the non‐domestic investment, the dynamics of investment have become more global and non‐domestic ownership has increased; however, the specific demands from investors still show an evolving trend that is explored through the Database. 4. The Who Owns the City Database
The pivotal data for our analysis is the sample database of City of London offices used in the previous Who Owns the City reports (the “Database”)1. The database contains information on 126 properties (representing currently 14% of the City’s office floor space) and a further 65 newly constructed (or subject to significant major refurbishment and expansion) properties in the period 2001‐2014. The newly constructed properties were identified from the Corporation of London’s Development Schedules. This paper focuses on the 126 properties that have been tracked back to 1972, since we wish to trace the changing tides of ownership on the existing built structure of the City. Two of the buildings have been converted to alternative use and their contribution to the database remain until such conversion. Ownership is quantified by the net floor area of the buildings; capital values are not collected. By applying conservative assumptions on rents and yields we can estimate that the capital value of the “historic” offices in the database is in the range £8.5billion ‐ £10.5billion2. Given the new developments in the database and, at time of writing, escalating capital values, this may be an underestimate. The concept of ownership is complex. When determining ownership two principal factors are considered. The first is the flow of benefits received: that is, where the cash‐flow received is clearly linked to performance of the underlying office(s). This factor excludes conventional bondholders and lenders as owners and would define a long leaseholder paying a fixed or stepped ground rent (or peppercorn rent), rather than the freeholder, as the beneficial owner. The second factor is effective control. A shareholder in a listed REIT or a property company owns rights to the firm’s assets and residual cashflow but, typically, has very limited decision‐making influence. Thus, a listed property company (with a reasonable free float) is classified as a single owner, domiciled where its shares are principally listed. Similarly, a private real estate fund pooling investment from multiple sources was typically classified nationally by the nationality of the general partner or fund manager. However, a
1 Earlier Who Owns the City research was supported by Development Securities plc. We acknowledge the role of Andrew Baum in establishing the database and the researchers who helped build the historic records.
2 Including the newer developments in the database, we have coverage of some £21‐24billion of office space.
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private equity vehicle such as a limited partnership with a restricted number of investors is different in nature: particularly if the vehicle is the medium for joint venture or club investment. Here, the ownership classification would reflect the characteristics of the major investors. Where possible, ownership would be apportioned amongst the partners. For each of these properties, ownership details are traced historically as far as possible. Owners are classified by nationality and country of ownership. Where the owner is a special purpose vehicle, we have attempted to “look through” the vehicle to the beneficial owners. Where there are multiple ownerships, we have sought to discover the ownership stakes of individual parties but, where it is not possible to find this information, have assumed equal shares. Prior reports identified some of the problems of defining ownership and this update of the data experienced significant rise in “unknown” owners. This rise is thought to predominantly stem from a rise in private ownership, whose identities are not actively disclosed. Ownership structures and regulatory structures (including changed in property taxes) have made tracking ownership more complicated. With traditional property market structures, attribution of ownership was a relatively straightforward task, since most buildings were owned by a single organisation or individual (with legal restrictions constraining multiple ownership), on either a freehold or a long leasehold basis. Long leaseholds generally carried a fixed or infrequently reviewed ground rent. Similarly debt structures were typically full recourse, chargeable to the company. The significance of foreign investors in UK property make nationality a challenge. While much of the investment has been direct and under the parent company name, other investors have established or acquired UK‐registered and domiciled vehicles to channel investment or have used joint‐ venture structures. In markets dominated by financial service firms, this international activity is further complicated by global mergers and acquisitions activity (such that a property can remain under the same effective management yet pass through three or four legal ownerships with different parent nationalities as a result of corporate restructuring).
4.1 Trends in City Office Ownership In 1980, only 10% of space was owned by non‐domestic investors (including owner‐occupiers). Following “Big Bang”, foreign ownership began increasing, driven by financial deregulation and the removal of entry barriers. The initial influx of foreign owners came from Japan and Europe. By 2000, with the growth of global real estate investment and the expansion of private real estate fund vehicles, a third of all space on the database was owned by non‐UK investors. The 2014 update shows the continuing decline in UK ownership of City of London offices, with nearly two thirds of the space being in foreign hands. This result is considered more robust for larger, prime office space; it is probable that the proportion of foreign owners in smaller, older, secondary and tertiary space is lower. Assuming the proportion holds over the whole of stock, the result implies that foreign investors own approx. 5.8 million square metres of City offices. In Figure 3, the ownership of the newly built/refurbished offices is shown (by 2014, it includes about 60 buildings). It shows that since 2006, the newer office stock is 50% in non‐domestic ownership, reinforcing the findings from the core part of the Database.
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Figure 2 Non‐UK Ownership of City Offices
Source: Who Owns the City Database Figure 3 Non‐UK Ownership of City Offices built/refurbished since 2001 (excl. Databases properties)
Source: Who Owns the City Database Foreign interest does not appear to have abated following the recession; far from causing capital flight, the market downturn appears to have increased the extent of non‐domestic ownership. This effect is more pronounced than the slight increase observed following the 1989/1990 downturn. Foreign ownership increased between 2007 and 2011 in the aftermath of the financial crisis, despite the falling capital values and weak return performance (see Figure 4). Using CBRE market data, we can examine the relative performance of European office markets, although it is important to acknowledge the risk of over‐interpretation of comparative data based on the views of local market agents3.
3 It should be noted, though, that CBRE are a major global real estate advisor whose views will influence global investors. While local market offices have some autonomy, a level of common practice and uniformity is imposed by the global network.
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Examining those Western European office markets where rental, yield and capital value data are available over the period 1995‐2014, the City of London ranks 13th of 35 markets in terms of mean capital value growth, but 6th in terms of capital value volatility. It experienced the 4th largest fall in capital values during the financial crisis, although it has rebounded strongly post‐crisis (this rebound driven by falling yields rather than rising capital values). Estimating pseudo‐returns using the rental value and yield data, the City ranks 30th of 35 markets on a Sharpe ratio basis. Over that period, real, inflation‐adjusted rental value growth is negative – indeed, real rental values per square metre in the City remain below their 1988 levels, before the 1990 crash. This evidence suggests that the City office market’s reputation as a safe haven is misplaced, for all the continued evidence of the City as a key target market for global real estate investors. As can be seen, capital value falls were far sharper than rental value falls, emphasising the importance of investment flows on total return performance. From 2011‐2014, the trend continued with the new arrivals from the BRICs, despite falling yields and rising capital values. Figure 4: City of London Offices: Rents, Capital Values and Yields
Source: authors’ calculations from CBRE Central London Office Market data. Since the Database is a sample, results regarding individual national holdings should not be over interpreted. However, there does appear to be shifts in regional ownership over time: for example the growth and then decline in Japanese holdings (which peak at around 11% in the early 1990s); the rise of German investment from the late 1990s led by the German open ended funds; and the small but significant growth of “international” investment funds that pool capital from multiple national sources. BRICS enter the Database decisively in 2012, driven by significant investment from Chinese sovereign wealth funds and private individuals. Since 2011, German and US investors have divested their share of the floor space, potentially explained by more attractive opportunities elsewhere and by deleveraging following the financial crisis. There is a significant rise in unknown investors, potentially explained by EGI’s policy of not disclosing private individuals and the rise in private investment by very high net worth individuals and family offices. Figure 5, below, illustrates the importance of foreign ownership to the maintenance of liquidity of the City of London office market, one of the market’s key investment advantages. Transactions activity provides a stream of information, reducing pricing uncertainty and giving investors confidence that
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they will be able to enter and exit the market according to their required portfolio strategy. The data illustrates how vital foreign players are in maintaining that activity. In the decade 2001‐2010, less than a third of transactions were between UK buyers and UK sellers; 19% of sales were between foreign purchasers and sellers. Following the dramatic increase in foreign ownership, only 16% of sales 2011‐2014 were UK to UK; but 33% were UK to foreign, with 14% foreign to UK. Sales of UK to foreign may be plateauing as 2011‐2014 and 2001 – 2010 have similar proportions of such sales. Supporting further rises in liquidity, transaction volumes have consistently increased from decade to decade. Figure 5: Transaction Activity, City Offices, 2001‐2014
Source: Who Owns the City Database Overall, turnover rates for the properties on the WOTC database fell sharply in the downturn. Turnover peaked in 2006 with nearly 20% of the floor space on the database exchanging hands; the numbers of investors anxious to enter the market was matched by investors taking profits near the top of the market. Turnover then fell sharply away, with very low levels of activity in 2009; however, it sharply increased thereafter, as companies de‐levered or divested for other reasons. The recent large extent of foreign to foreign sales supported the non‐domestic ownership with proportionally few sales being to UK investors. The relatively low foreign to UK sales show that there is little sign of the trend to non‐domestic ownership reversing. Turning from nationality to type of owner, the trend observed in previous Who Owns the City reports was of a shift away from traditional ownership by livery companies, institutions and established property companies, characterised by a single freehold owner, low turnover rates and passive buy‐and‐hold investment strategies, towards a more financial form of ownership by financial service firms, specialist real estate funds, non‐domestic investors and private vehicles, often with ownership split between different funds and vehicles. However, reversing this trend, in the recent period, the FIRE sector has decreased its share of the office market control from 2011 – 2014, thought be linked to seeking more attractive yields elsewhere and, possibly, being outbid by new arrivals in the City.
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Figure 6: Ownership by type of investor
Source: Who Owns the City Database The Database detects the growth of two types of investor that are new to the Who Owns the City analysis: the individual private investor and sovereign wealth funds. While there has been a long tradition of private ownership of commercial real estate by high net worth investors, this has been less evident in the prime segment of the City office market. However, we now are recording private ownership of significant buildings, totalling 21% of floorspace in the Database. This high number should not be over‐interpreted as it is biased by one single large purchase. However, it might even be an underestimate, given that the “unknown” category may well contain more individuals reluctant to be in the public eye and harder to trace through standard searches. Moreover, our analysis suggests that the majority of these private owners are non‐UK individuals, although the domicile of many high net worth individuals is not always easy to define. The high holdings of office space by investors from the financial services sector are broadly matched by the Corporation of London’s analysis of the Business Register and Employment Survey (BRES) data for 2009, which shows 75% of employees in the City working in finance (41%), real estate or professional services (28%) or information and communications (6%), with much of that ICT and professional service employment being focussed on international financial services.. Once again this emphasises how functionally specialised the City is. This represents a strength for London: that specialisation produces the breadth and depth of markets that sustains the City. However, it is also a source of potential risk, as discussed in Towers of Capital and in previous WOTC reports, in locking the fortunes of the City to the volatility of international capital markets and financial systems. While there was some consolidation of ownership following the last financial crisis (for example, better capitalised firms buying out the stakes of their partners), there were also examples of part sales, possibly to obtain the equity injection required to deal with falling values and rising loan–to‐value levels. We are unable to trace the extent to which the ownership we report is debt‐funded. In the run up to the financial crisis, many purchases were heavily leveraged. In the immediate aftermath, available debt funding declined sharply and terms hardened but the arrival of new lenders (for
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example, insurance company lending or the creation of new debt funds) and the search for yield has led to more readily available debt. Leverage serves to increase the global capital market’s stake in the fortunes of City of London offices. The foregoing emphasises that the characterisation of investment ownership in much of urban social science as being by “financial capital” is simplistic and understates the nuances and complexities of the operation of a commercial real estate market such as the City of London. Financial ownership of City of London offices encompasses a wide range of entities and organisations, with very different investment and risk preferences, objectives and motivations. These differences influence behaviour and, by implication, the impact of ownership on the functioning of the city. Similarly, the nature of the ultimate beneficiaries of the cashflows and values generated (or destroyed) by office investment varies across type of investor. Many of the more recent arrivals, notably the sovereigns and the ultra‐high net worth investors have long investment horizons and, as a result, are able to tolerate short‐run volatility. For such investors, London is a safe haven in as far as it enables them to place large amounts of capital rapidly and with little concern over expropriation. Whether or not such investors have expectations of real rental and capital value growth, the long investment horizon enables them to exploit redevelopment options and benefit from intensification of land‐use and land value impacts4. To this extent, they may be less passive investors than the traditional institutional investors of the 1980s, who relied on long leases and upward only rent review clauses to deliver the solid income returns needed to meet liabilities and match inflation and may have some similarities to the traditional London landed estates with an emphasis on place‐making and value increase from stewardship. However, since many of these investors are non‐domestic (and may have relatively small investment teams), initial management is more likely to be passive and to make coordinated action across different ownership interests more difficult. Such long‐term investors should be contrasted with private equity funds and listed property companies who have much shorter horizons, tied to debt maturity, to finite time horizons for many closed fund entities and, above all, to the need to deliver short‐run promised or expected returns to their ultimate investors and stakeholders. The appetite for risk and, hence, investment behaviour, will vary across fund types: more opportunistic investors using higher leverage and promising higher returns being more vulnerable to short‐term market volatility and cyclical downturns than lower‐geared core investors, particularly those with more control over the timing of exit. These more financially‐oriented funds are more likely to lock a city’s office market into global capital market instability. This will be particularly the case for larger international investors whose real estate portfolios are more likely to be exposed to other global city markets and are thus more vulnerable to systemic contagion effects. However, the very size of those funds push them towards investing in the larger markets in order to place capital quickly without moving prices5. Just as risk appetite and investment horizon vary across investors so, too, do the beneficiaries. Within a catch‐all “financial capital” we find occupational pension funds (both defined benefit and defined contribution) with widely dispersed memberships alongside private equity funds pooling capital for professional investors, private ultra high net worth individuals and family offices and sovereign wealth funds. Even within categories, there are variations in who ultimately benefits from the performance of the real estate assets within the portfolio – for example, between a Nordic and a Middle Eastern sovereign wealth fund. With the growth of more complex forms of real estate investment vehicle, it is possible that very different types of investor may hold stakes in the same building – although one
4 This is not to say that they will realise such options and indeed may take profits and exit early: the point is that they do not have an immediate pressure to deliver high returns.
5 This applies equally to most sovereign wealth funds, too, contributing to investment pressure on yields.
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outcome of the financial crisis was a more widespread recognition that such juxtapositions were uncomfortable in terms of alignment of interest. 5. Conclusions
The growth of foreign investment in the City of London office market is part of an overall trend towards a more global real estate market which, in turn, has been driven by the development of a more open and interlinked international financial system across the late twentieth century and the early part of the twenty first. It is too early to say what impact the international banking crisis and global recession will have on those patterns of capital flows. What does seem clear, however, is that the City of London has a very high level of foreign ownership compared both to other UK financial assets and to other real estate markets around the world. London has remained as the principal target for office investment in Europe and stands alongside New York globally. There has been little evidence of significant capital flight from the City in the aftermath of the market downturn. Nonetheless, that investment has occurred despite poor historic real estate market performance. The City of London office market has not delivered real rental or capital value growth over the long term and has been more volatile than other UK regional markets or cities in mainland Europe (at least as far as available statistics are considered robust). What advantages does the City offer, then, which might counterbalance this risk? One contender is enhanced liquidity. We noted above that global investors have underpinned liquidity over the cycle. Transaction activity fell sharply in the downturn: but a very high percentage of the deals that did take place involved non‐UK parties – and very few of those sales were by non‐UK owners selling to UK buyers. This does not necessarily mean that the turnover rate in the City office market is much higher than elsewhere – it is a very large mass of space. However, there are two key features that might lead investors to conclude that the City has greater liquidity: first, that even in a market crisis, they will probably be able to find a buyer: and second, that if they seek to sell – or buy ‐ they are unlikely to have a pricing impact, given the scale of the market. The high value of real estate in the market also has benefits for global investors. They can gain economies of scale, placing large amounts of capital quickly rather than having to search for, acquire and manage multiple investments in other markets. We should also note that some of the international investment in the City might represent a currency effect. If sterling has depreciated against the domestic currency, London may look relatively cheap to foreign investors. Another key feature is transparency. The size of the market leads to a high volume of rental and sales transactions, irrespective of the turnover rate. In turn, this provides a flow of information to investors, which provides greater confidence, reducing required risk premia. The extensive research available on this market provides a further source of confidence. As noted above, the presence of global brokerage firms with (relatively) standardised practices provides a key benefit to investors building global portfolios. In turn, though, this will tend to direct investors to the same set of markets, increasing competition for available assets (and, hence, potentially forcing down yields) and potentially directing investors away from greater diversification potential in other markets. In considering liquidity and transparency, the differentiation between types of investors and the changing characteristics of ownership become critical. Liquidity and transparency depend on transaction activity and monitoring. If the market has seen a shift away from investors with shorter time horizons to those with longer, then this might imply a reduction in transaction activity, if holding periods lengthen and investors seek to exploit more distant redevelopment options. Private investors and foreign investors may be less willing to allow the performance of their assets to be monitored. It is evident, for example, that Investment Property Databank’s information on the performance of City
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offices is becoming a much smaller (and possibly unrepresentative) segment of the overall City market as domestic investors are replaced by non‐UK owners. This has implications for performance benchmarking for those investors seeking relative rather than absolute performance measures. Our analysis did identify some new features of the market. The shift away from UK ownership masks a trend away from continental European ownership (particularly if German investors are excluded), with an increasing share taken by US, Middle Eastern and, more recently, non‐Japanese Asian investors. The long‐run data show that there are waves of regional investment, so it may be too early to see this as a structural shift, but the capital market and current account imbalances between the Atlantic economies and the emerging Asian and Middle Eastern economies may lead to an increase in inward investment over time. The database also reveals shifts over time in the nature of investors, which suggests that an over‐simplified categorisation of “financial capital investors” or similar fails to accommodate the nuances of ownership. In the early period, we see substantial holdings from traditional investors and institutions, typically with relatively passive investment strategies grounded in the long “institutional” lease giving cashflow security. From the financial deregulation era to the pre‐GFC boom, there is an increase in financial ownership, with shifts in character within that. In particular, the rise of private equity real estate investors and other investors using leverage and with shorter investment horizons puts more emphasis on short run returns and capital appreciation (and in large measure contributes both to greater potential market volatility and systemic risk). More recently, the growing presence of sovereign wealth funds, private investors and family trusts may mark a shift back to a longer perspective on the City, albeit one perhaps more grounded in capital preservation than income return. Different types of investor have different time horizons, risk appetites and objectives: consequently, their impact on the functioning of the City cannot be collapsed into a single dimension. These changes in investor type need to be overlaid on the shifts in the nationality of ownership to understand market dynamics and the way in which investment patterns serve to integrate the City into global financial and urban networks. Understanding current and future investor needs is critical to maintain the successes of the City of London. The Database has shown an increasing trend of foreign ownership, built up by different ways of foreign investment. The influx of capital provides funds for investment that can help build up and maintain the office stock to a standard for the changing needs of occupiers. Capital values have risen sharply and yields have been compressed, with poor risk adjusted returns. Despite this, the City of London appears to attract continued non‐domestic interests. Local policy makers and planners have an integral role in managing the office stock and the needs of different investors. The results highlight the rising tide of foreign ownership and temporal changes in investor types, whose needs and preferences differ. The challenge for policy makers is to manage the increasing capital flows for economic advantage, using the different levers within each investor group while considering the impact of these investment flows and ownership patterns for the functioning and stability of the City economy.
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