Foxes and Hedgehogs

Wednesday, July 20, 2011 by Douglas And Gordon

Foxes and Hedgehogs

Investing in Prime London Residential

Tolstoy split great writers, and Isaiah Berlin great thinkers, into foxes and hedgehogs. The Fox knows lots of things, the hedgehog one big thing. The same distinction applies to investment professionals. The classic fox would be the global strategist at an investment bank or a macro-driven fund manager. They seem to know everything about everything. Emerging market bonds? They’ve got a view. Dollar-Yen? It's like this. The investment fox has intellectual confidence, the ability to assimilate reams of information, fluency of thought and word. Hedgehogs appear less impressive, one-dimensional, even dull. The American industrialist, Andrew Carnegie, was a hedgehog: asked how to become really wealthy he replied: "Put all your eggs in one basket; then watch the basket."

If money-makers divide into foxes and hedgehogs, perhaps they also divide into Churchills and Baldwins. Winston Churchill was a great wartime leader because he thought (or knew) he was always right. This made him an infuriating colleague, a successful hack and a lousy investor. By contrast his old boss and predecessor as Prime Minister, Stanley Baldwin, once observed his whole political life had been guided by the principle that society progressed from one governed by status and hierarchy to one dominated by consent and contract. He then famously added: "Or was it the other way round?".

In a previous existence working in an investment bank I tried to be a fox and had to be a Churchill. I was paid to know lots of things, to hold strong views and to be convincing. Sell side businesses are intolerant of hedgehogs and Baldwins. Yet when I crossed to the buy side I found I didn't know very much, and a lot of what I thought I knew I was not very sure about. I became a hedgehog with Andrew Carnegie-style investment strategy  in prime London residential property.

If the prime London residential property market was anywhere other than London it would be a fashionable, successful institutional investment. Perhaps because it is a "dinner party" investment, it has however – despite its spectacular return characteristics - been disregarded as a legitimate institutional asset class. Meanwhile commercial property, which is rarely the subject of dinner party conversation, is considered a sensible, "diversifying" investment even though it has produced disastrous and volatile returns over the last twenty years. 

In the spirit of Stanley Baldwin, therefore, I offer some thoughts on why Institutional property investors should own prime London residential. These days, most analysis undertaken by investment professionals ultimately is trying to answer a single question: how can I make money out of China? The obvious answer is to invest in great Chinese companies or have a product or service the Chinese masses want to buy. There is a third way. Since the late 1980s many closed economies have privatised state assets and liberalised their economies. This, as ownership of Premier League clubs demonstrates, has led to a huge transfer of wealth from the state to a small number of individuals. As many of these countries remain politically unstable, much of this new private wealth has drained out of the country of origin into mature real estate markets, the most liquid, transparent, convenient and safe of which is London. This pattern will almost certainly continue when exchange controls in China and India are dismantled.  So, one way to make money out of growing Chinese wealth is to own assets that their new rich will desire and which cannot be made by them. London residential property has for twenty years, and will continue to be, an asset-backed, legitimate way to play emerging market wealth creation.

The rationale for investing in London, as opposed to UK plc, is underpinned by a structural domestic interest rate imbalance. The UK’s anaemic GDP numbers would , without London’s contribution , make scary reading for Mr Osborne. This has always been the case. No G20 country is so dominated by the economic activity of one city. This has led to the Bank of England interest rate more often than not being wrong (i.e. too low) for London. The consequences are plain to see: the £5 pint of Guinness, the £20 starter, and the irrepressible rise of the capital’s real estate.

Commercial property investors make many of the same claims but also concentrate on yields. A bit like Trotsky, when property types say they are "yield" investors, I want to reach for my gun. Let’s keep it simple: what does any property investor want? An asset that rises in value over time and income that keeps track of inflation. That high standing, or initial, yield on a commercial asset is the price an investor demands for an uncertain or weak capital outlook.

That weakness will occur if there is potential for supply shocks. For example, capital values and rents for London City offices are lower now than they were in 1988 - in cash, let alone inflation adjusted, terms. This is because office blocks have sprung up south of the river and in Canary Wharf and undermined the City office market. Property can and should be a simple game: invest where others cannot build and where people will want to rent. In 1988, if you had been a "yield" investor, you might have compared the standing yields on City offices and prime London residential and concluded the yield on the latter was too skinny and opted for the former. Within a few years the residential investment you passed on would have been delivering more cash income than your City office, even though the yield remained lower. The yield investor’s capital would have been destroyed in London City offices while it has trebled in prime residential. If an investor wants yield, he can be sure someone will happily sell him some Greek bonds

The final engine of London’s prime residential outperformance has been sterling. Thanks to one of the great investment foxes, George Soros, sterling has had twenty years floating outside the ERM and Eurozone. Over that period, its inverse correlation with prime London residential property has been striking. Between September 2008 and March 2009, prime London values fell 26% in sterling terms, but more like 40%-60% in dollar, Swiss franc and Euro terms, once sterling devaluation was taken into account. Between March 2009 and the end of 2010, prime London asset values rose by almost the exact amount sterling had devalued. This reprised the experience of the 1992-94 recession. Then, too, the asset price rise following sterling’s collapse was ‘V’- shaped.

Of course, there are good reasons why institutions do not own prime London residential, but they have more to do with the economics and logistics of their businesses than the merits of the asset class. Investing in prime residential is time-consuming, labour and management-intensive, and hard to scale. Investing in commercial property is the opposite. Indeed, cynics might even suggest commercial property is good for Fund managers and poor for investors. Prime residential is the opposite. I will stay a prime London residential hedgehog because it will benefit as "globalisation" leads to greater private wealth worldwide. Or is it the other way round?

Stephen Yorke - CEO of D&G AM

"acquirers and managers of Central London residential property"