Our asset management CEO Stephen Yorke thinks 10 yrs ahead in PCL

Tuesday, March 11, 2014 by Douglas And Gordon

This report is a thought stream from D&G Asset Management CEO Stephen Yorke and although detailed and requiring a few minutes application helps give some serious insight into how Asset Managers think about deploying money into, and analysing, the prime central London property market.


Seven years on from the  launch of our Prime London Capital Fund – what do we think will drive capital values and rents in PCL over the next ten years  ?




Summary :


Since 2008/09 there has been a combination of economic and financial conditions that have favoured the owners of assets . QE was introduced , firstly by the US Federal reserve ,  then by the Bank of England and finally by the Bank of Japan , to stave off deflation , mass bankruptcy and unemployment . It has succeeded in ensuring that the credit/financial crisis of 2008/09 did not become the great depression . But the transfer mechanism by which QE works is asset prices . The hope of the central banks is that as  asset prices rise so balance sheets will get restored , confidence will return ,  jobs get created and wages rise . To some extent this has happened but only in those parts of the global economy that work with money and assets ( Fund management , banking , services that supply these industries ) and those places where the people that work in these sectors live ( Financial centres like HK , Singapore , NYC and London ) . At the same time the developed world economies are working hard to improve their national fiscal positions through public spending cuts and /or tax rises. This global fiscal tightening is a serious headwind and means that monetary policy (and QE again) has to do the heavy lifting in getting the economies back to growth. On top of these cyclical brakes on economic growth there are the larger demographic and technological trends that suggest that wage growth and inflation will not be an issue for many, many years . Thus, for as long as these same conditions apply , namely large numbers of workers able and willing to move where the jobs are, technology allowing employers to extract more productivity out of each worker and keep a lid on wage growth, developed economies facing years of fiscal tightening and aging populations using up capital for retirement consumption the global policy mix is likely to be very loose monetary policy and tight fiscal policy. These are financial conditions that will lead to the continued rise in capital value of AAA assets and, especially, those assets that the wealthy want to own to preserve their wealth. London is uniquely placed to benefit from these financial, macro conditions and, with increasing political and economic risk in Russia, China, the Middle East and the EU, PCL assets will remain in demand. Our view is that these “big picture” matters will be the main drivers of PCL asset prices over the next ten years.


Footnote: In January 2014 Fleming Family and Partners conducted a survey of 90 families across the World worth  collectively over $100 billion . 92% of them said that PCL would “outperform” as an investment and that PCL values would quadruple over  the next 30 years. This equates to a 5% annual rise,  half the current 30 year trend of 9% p/a.



Our Basic Approach – PCL is a “macro”  trade  :


  • In 2005 , ahead of the launch of the Fund , we published a report that set out why  we thought that Prime Central London ( PCL ) residential property was a distinct asset class and how it was uncorrelated not only  to other UK property markets but to the UK credit/economic cycle ;
  • In 2009, in the teeth of the financial crisis , we stuck our neck out and forecast that PCL values would recover in a “ V “ shape , and invested accordingly ;
  • In 2010/11 we published research that indicated that there was a close relationship between PCL capital values and (a) the state of global High Net Worth ( HNW ) liquid assets , and (b) the yields on sterling ( and the US dollar ) and the available gross rental yields on PCL ;
  • The underlying theme throughout these reports is that PCL is a “macro” play where  values and rents move in accordance with global economic and financial trends;
  • Our view of the future for the asset class of PCL is driven mainly by our view as to what the future holds for the global economy and financial system;


  • Asset allocation decisions since 2009 should have been based on the answer to the question, what is more likely inflation or deflation? We have consistently argued the latter is the greater risk and, more importantly, we think that the authorities consider it the greater risk. We still think that deflation is what haunts central banks and that, accordingly , policy will be very accommodative/abnormal  for , in the words of the ex CEO of Pimco , “light years to come”;




The Centrality of easy monetary policy and demographics to PCL asset price growth:



  • There is now widespread agreement that the introduction of QE and very low interest rates has made a huge contribution to rising asset prices , particularly those assets that the global HNW community want to own ;
  • Very loose monetary policy will only end and/or the selling of the bonds acquired under QE ( meaning a rise in yields and a tightening of policy ) only start when the underlying real ( as opposed to financial ) economies of the USA , the UK and Japan  have demonstrably and clearly  recovered . We think that these developed world  economies are  miles away from being in a fully recovered state and thus QE will remain a core piece of their central bank strategies for the foreseeable future . Furthermore, we think the risks are weighted to these authorities  keeping policy too loose for too long rather than tightening  too early ;
  • We published research on the correlation between QE and PCL capital values in 2011 /12 . We think the direction , and longevity of global monetary policy ,  continues to be the single most important consideration when trying to assess the future direction of asset prices , and especially prime real estate prices ;
  • Our view is that the world will continue to be characterised by   new technology and global labour mobility both of which will keep a lid on wage growth and sustain very low interest rates ;
  • In particular the huge downward pressure on wages through an increase in the global labour force will continue to keep wage  inflation at bay . Between 1980 and 2005 the effective labour supply to the global economy increased from 500m to 2 billion –source IMF . The IMF  predicts that the global work force will double again by 2050 ;
  • We have always argued that residential property is , in the end , a bet on demographics . This demographic trend , because it will keep money loose and wages down , will be very supportive for those that own assets and capital ;
  • Faced with the majority of the population suffering low wage growth and low to falling prices  we do not think Global Central banks will  tighten monetary policy because of a fear of asset price bubbles  . Further , from a purely macro-economic perspective Central Banks would be right  . As Alan Greenspan , the ex -Chairman of the Federal Reserve , has noted the dot com bubble bursting made little or no impact on USA GDP figures in 2001-02 , similarly the 1987 crash did not make an impact on that years USA GDP numbers ;
  • The asset price inflation that has been prompted by QE has not caused consumer price inflation ( see below )  ;
  • This partly explains why the Governor of the Bank of England has made it quite clear that UK monetary policy will not be determined by what happens within the Central London economy ;
  • Specifically when asked about the rise of values of London residential property he replied  :  “ We as the Central Bank can’t influence that “ – Governor Carney February 2014 on the Andrew Marr show , BBC1 .




So why do we think deflation will remain the chief concern of the policy makers for the foreseeable future?




Euro-zone :


-       In the Eurozone : consumer prices are falling at the fastest pace ever recorded ( December 2013 – January 2014 ) . Of the major Euro-land economies Germany has the highest inflation rate at 1% , with France @ 0.8% , Italy @ 0.6% , Spain 0.3% . Cyprus and Greece are already in the midst of deflation ;

-       If Germany starts to deflate then the prospects for the rest of the struggling Euro-land are very grim indeed . It will mean that these economies cannot make themselves more competitive other than by even faster falling prices and wages ;

-       This is starting to happen in France where core inflation dropped from 0.6% in December 2013  to 0.1% in January 2014 ;

-       These numbers are starting to look horribly like Japan in the 1990s when the economy got used to negative inflation and no growth . This meant Japan could not pay down its debts and employment was only kept from dropping by huge infrastructure projects that funnelled massive amounts of public money , via construction firms , to the workforce ;

-       The over –borrowed Eurozone economies do not have this option  meaning that the ECB and loose(r) monetary policy  is the only route to economic growth and reduced unemployment levels  ;

-       Whether or not the ECB can deliver something like  QE and/or other unconventional monetary policies is legally and administratively doubtful ;

-       With unemployment , and in particular youth unemployment levels at record levels , the domestic political consensus in some countries in favour of the Euro is likely to be challenged over the next few years ;

-       We think that France will be the key flashpoint as , over the next few years , the party of Madame LePen start to win votes on an anti-Euro platform in Local , Assembly , European and , ultimately , Presidential elections . Once France starts to back away from the Euro-consensus all bets will be off and Germany will stop financial support ;

-        In short , over the next 5-10 years , the prospect for the Euro-land is one of huge policy uncertainty and increasing questions about the sustainability of the Euro-project ;

-       This economic and political volatility on the UK’s borders may not be great news for UK exporters but it is likely to continue to feed demand for safe PCL assets ;



Greece :


-       For a while now Greece has been off the front pages but , during the last crisis there , large amounts of capital flew into London and London real assets ;

-       Against the wider deflationary background ( see above ) Greece’s finances have started to deteriorate again and it looks an absolute certainty that another bail-out will be needed later this year ;

-       It has been reported that the Troika ( IMF , ECB , European Commission ) think that Greek banks require 20 billion euros of fresh capital ;

-       OECD forecast is for Greek debt to GDP to stabilise at 160% in 2020 , versus the arithmetic for the current Troika bailout being based on 124% ;


The crunch question will be : what will Germany require of Greece ( and others in the Euro-area in a similarly dire position of not being able to work off their debts through inflation ) before it commits to a further bailout ?


-       One answer could well be the introduction of  dramatic and immediate wealth taxes ;

-       Indeed this is precisely what the Bundesbank has already argued will need to happen before the German tax payer money will be further available for bailouts of countries within the Eurozone that need to improve their national finances – source : FT January 28th 2013   ;

-       Given the precedents of (a) Cyprus last year when bank accounts were suddenly and immediately frozen and raided for money to help the Cypriot Government finances , and (b) a similar trick pulled by the Amato Government in Italy in 1992 when the Government took out 0.6% of all Italian bank accounts overnight  we would expect many European HNWs to start to move  capital out of the Euro land and into sterling , and the dollar , and then , when the interest rates on these deposits becomes too much to bear , some of it will find its way into safe AAA real assets


Japan :


-       Wages continue to fall and have been doing so in real terms since the 1990s ;

-       There appears to be a correlation between the decline in the working age population of a country and deflation ;

-        According to a study by Masaaki Shirawaka , former Governor of the BOJ , during the 2000s population growth rate and inflation correlated positively across 24 advanced countries . This is because a retiring population uses up savings for its own consumption , thus reducing capital for productive investment . Retirees also consume less ;

-        This is a further long term demographic sign that deflation should be the main fear for those  overseeing policy in Euro land and Japan ( whereas the population of London has grown over the last ten years and is forecast to grow further over the next ten – see below )


-       JP Morgan think that real wages in Japan will drop by 1.4% during 2014 , the largest drop since the big recessions of the 1980s ;

-       GDP fell to 1% in the 3rd and 4th quarters of 2013 as the initial effects of the yen devaluation fell away ;

-       The only option is for the Bank of Japan to stick with easy money policies and trying to keep the yen low ;

-       A weak yen ( it has fallen 25% on trade weighted basis since Prime Minister Abe took office )  is starting to have an impact on the wider Asian region , and China especially ;

-       A Japan that shows no sign of growing again is a further deflationary downward pressure on the world economy ;



            China :


-       Chinese economic growth has , over the last 35 years , averaged 9.7 % p/a  . The ex-Chief economist of the World Bank has described this performance as “ a miracle unprecedented in human history “ ;

-       Many commentators think that the Chinese economy will follow the precedents of  earlier Asian growth stories like South Korea  , Japan , Taiwan and Hong Kong where  growth was initially driven by investment in cheap manufacturing for export that then evolved into credit-intensive domestic investment ( real estate ) before slowing down ;

-       Concerns about growth falling to 7.4% ( official forecast ) or 6% ( IMF ) might explain in part why the currency has weakened this year ;

-       At the end of February 2014 the renminbi had its biggest five day decline since the devaluation of 1994 and the start of the great Chinese export phenomenon ;

-       Although Chinese official policy is to rebalance the domestic economy away from exports towards domestic consumption this devaluation suggested that the authorities are concerned about losing competitiveness , particularly against a weaker yen ( see above ) ;

-       The Chinese Government has indicated that top of its list of reforms is a reduction in the domestic debt levels ( risen from 130% of GDP in 2008 to 200% of GDP by 2012 ) ;

-       Investors were frightened earlier in the year when the frailties of the Chinese shadow banking sector were highlighted .  A large Chinese Fund , distributed to investors via ICBC China’s largest Bank ,  avoided default only through the intervention of the authorities . Since then another has defaulted  ;

-       An official emphasis on deleveraging could lead to a softening of real estate values and the fragility of much of the shadow banking sector may well encourage mainland Chinese HNWs to look at diversifying their wealth ;

-        London  , due to the attractions of the education system , would benefit from this asset re-allocation trend from mainland Chinese ;

-       This  is happening already but it is the “ insiders “ who are able to get around existing capital controls . Net capital outflows from China  were about $500 billion in the 18 months to the end of 2012 source : FT September 13 the 2013 ;

-       It is possible that , in order to encourage further devaluation of the renminbi , capital controls might be relaxed thus  moving closer to the policy aim of a internationalised , convertible currency ;

-       If this was to happen it would be a hugely significant moment as Chinese annual savings are about $4.5 trillion ( compared to the US $2.25 trillion ) . If even a small portion of this was allowed to escape from China  then it would likely mean a big boost for the world’s AAA real estate markets with London benefitting disproportionately  ;



         Russia :


-       Before the spat in Ukraine Russia had suffered net capital outflows during 2013 ;

-       About $65 billion went out of Russia in 2013 , up from $55 billion in 2012 ;

-       Events of the last few weeks are likely to mean that 2014 will be another year of wealth leaving Russia and ending parked in £ or $ accounts , and then real estate .




-       After the initial boost given  by QE US house price growth is slowing , consumer confidence is also falling ( the two may be related ) ;

-       Election of new NYC Mayor makes higher Manhattan property taxes more likely increasing London’s attractiveness to global HNWs

-       New Fed Chairman Janet Yellen has indicated that the soft data that has come out of the US in recent months could mean that the policy of tapering ( i.e. reducing ) bond purchases might have to be revisited ;

-       In December 2013 the Fed reduced its asset purchases by $10 billion from $ 75 billion to $65 billion every month but the weaker data might well mean that , at the very least , no further reductions are planned ;

-       Again , our view is that the US authorities will keep in place the QE policy of asset purchases for the foreseeable future stopping the US$ rising too far and keeping a floor under US asset prices .




The UK and it’s London City state :



One of the key themes we have hammered away at since 2006/07 is that the “ right” Bank of England UK interest rate will almost always be the  “wrong” ( i.e. too low and thus inflationary  ) interest rate for Inner London . The scale of this “London-loose”  monetary policy is getting greater each year as the London economy thrives and the rest of the UK suffers from the deflationary / low growth environment of other developed economies ( see above ) . At the heart of our view that PCL assets will continue to rise in value is the extent to which this London-loose monetary policy bias will be entrenched for years to come.




Low inflation/wage growth and future fiscal tightening will keep a lid on UK interest rates:


-       The interest rate market is assuming the first rate rise in the UK is 2015, with some economists forecasting that the first rise will be by the end of this year ;

-       Our view is that  due to further fiscal tightening for the next five years at least, the global deflationary environment, little pricing power amongst UK retailers and  very weak real wage increase , UK rates will stay lower for longer than the market currently predicts ;

-       Yields on Gilts are now very closely correlated to what happens to US Treasuries. The gap between the two has averaged about 7 basis points since the start of the year. This is the smallest gap between the two benchmark bonds since the 1980s and it reinforces the point that UK asset prices are driven by global events to a greater extent than for many years (there is a similar relationship between the FTSE 100 and the S&P 500 which have tracked each other and the differing perceptions of future US monetary policy very closely since  May 2013 when Ben Bernanke indicated tapering of bond purchases was imminent) ;

-       The UK economy , based as it is on trade of goods and services , is very sensitive to global economic and financial developments hence the close correlation between UK financial assets and the assets of the biggest consumer economy of the lot , the USA ;


-       UK fiscal tightening is set to continue for some years, irrespective of which party wins UK General Election in 2015  ;

-       On current projections ( Autumn Statement 2013 ) only about 30% of the spending reductions planned to bring the UK back to a balanced budget have been implemented ;

-       The pace of fiscal tightening will pick up after the 2015 General Election ;

-        After 2016 annual real reductions in government spending are set to increase from current 2.3% p/a to 3.7% p/a ;

-       As of the end of 2013 the UK is  about halfway through the fiscal tightening required to eliminate the budget deficit with a reduction of about 4.4% of GDP so far achieved but with further tightening of 6% required over the next five years source : IFS  ;


A rising house market is important to this budget deficit reduction plan   :


-       Increased revenue from housing will play an important part in that fiscal tightening process . In the 2013 Autumn statement the Government forecast that revenues from stamp duty would rise from £6.9 billion in 2012 to £16.8 billion in 2018/19 ;

-       Part of that increase in revenue will come from rising house prices . Again in that 2013 Autumn Statement official forecasts were that  UK house prices would rise 5.2% in 2014-15 , and then 7.2% in 2015/16 ;

-       Bank of England has indicated that any pre-emptive action to prevent a housing bubble would be via conditions attached to mortgage lending overseen by the Prudential Regulatory Authority ( PRA ) and not higher interest rates unless the wider economy warranted them ;



UK Banks , encouraged by the regulators , will seek to re-balance their businesses by increasing their lending  on residential  property , and particularly London residential property :


-       UK Banks appear to have learnt the lesson of 2008/09 that it was not their domestic loan book , secured against UK house prices, that  defaulted but their overseas exposure ;

-       The Bank of England ‘s MPC voting member Ben Broadbent has made this point in a number of speeches that give an indication of what the Bank of England would like the domestic banks to concentrate on  ;

-       In 2009 64% of all UK bank lending was for residential mortgages , 13% for commercial property and 12% for unsecured lending  ;


-       Yet between 2007 and 2013 only 4.4% of the £80 billion of write-offs by UK banks and building societies was on loans to individuals secured on their houses ;


-       The Banks credit teams and the regulator would therefore be happy if UK Banks stuck to these safe loans secured against UK residential property during this next  cycle ;


-       Lending on London residential property has proved a much safer bet than in other UK regions . As at March 1st 2014 only 1% of the UK’s homes in negative equity were in London source : HML ;

-       Accordingly ,  those domestic banks ,  re-entering the UK mortgage market , are likely to want to lend on London residential property above all other regions   ;


UK savers : the great rotation ….cash to real estate


-       Amongst UK savers/investors there has been a great “ rotation “ from cash to real estate during 2013 . Buy-to-let lending increased by 18% during 2013 – source : Council of Mortgage Lenders;

-       The “ low “ savings rates that many berate the UK consumer with do not take account of the financial reality that for most homeowners mortgage payments are  part “ rent “ and part “ saving “  ;

- At the end of 2010 UK households’ total wealth , including housing , was worth eight times annual disposable income . This compares with a post-1987 average multiple of seven : source Ben Broadbent Speech “ Deleveraging “ 15-0312



         London , the City-state , is starting to boom  :


-       London has a  current account surplus of 8% of its GDP , the sixth largest in the World ;

-       80% of UK’s private sector job growth between 2010-2012 was  in London -Source : Centre for Cities Research February 2014 ;

-       London raised £2 billion in stamp duty in the year to April 2013 , 40% of the amount raised across the UK nationally ;

-       London has more people ( 1.5m ) employed in highly skilled sectors than any other city in the world , NYC ( 1.2m ) –source Deloittes ;

-       300,000 further jobs in these sectors forecast to be created in London by 2020 –source ibid ;

-       During 2010-2012 216,000 private sector jobs created in London versus 7,800 lost in Glasgow source : ibid ;

-       London’s share of nation output has risen every year since 2006 and is now 22.4% ;

-       London boroughs are the top nine places in the UK competitiveness Index –source Cardiff and Nottingham Universities ;

-       London has more world class universities in the top 40 than any other city in the world ;

-       55% of London businesses are planning to take on employees , compared to 38% across the UK : PWC survey February 2014 ;

-       The City is creating new jobs ( 27,915 in 2013 and 35,115 in 2012 ) ;

-       With job creation and rising wages in London rents are starting to rise too .

-       London takes 45% of all UK Foreign direct investment –source : Ernst and Young 2012 ;





Policy risk  overhanging PCL ? Will a Labour/Liberal democrat Government in 2015 bring in a 1% wealth / Mansion tax on high value residential properties ?


-       A couple of weeks ago we  had a useful meeting with key Labour “ sources “ ;

-       The impression we got was that Labour  was considering the advantages of using an existing tax ( Council tax ) rather than introducing a new one ( Mansion tax ) ;

-       We were also told that there would be no revenue target for any new tax  implying that the money for any new 10p income tax band would not have to come 100% from the rise in taxes on high value residential properties ;

-       Within the Labour party there are powerful voices lined up against a Mansion/Wealth tax . The leading Labour  candidate for London Mayor ( Tessa Jowell ) supports higher council tax bands ( as does the current Conservative Mayor , Boris Johnson )  .


We think that a cross-party ( bar the Liberals ) consensus is emerging that the easiest and most effective way to raise extra revenue from  “ high value “ residential property is via new Council tax bands .


-       Policy makers understand the link between foreign wealth investing in London real estate and the creation of new homes  . CBRE published a report recently that demonstrated that developers from China , Singapore , Malaysia and Qatar hold current  permissions to build over 33,000 homes in London ;

-       In a world of less debt and global capital all governments would love to be able to  capture some of that capital in illiquid assets situated in their  own country because  it produces tax revenue and ancillary economic benefits ( report by Ramidus Consulting concluded that global super-rich spent about £4 billion on UK goods and services in 2013 ) ;

-       There is a general recognition amongst the investor community that sensibly higher Council Tax increases ( perhaps with a premium for empty properties )  , which are met by the occupier/tenant , would be unlikely to discourage global investment in to the UK residential asset class at all points of the value chain ;

-       At the moment fear of the Liberal version of the Mansion tax is skewing demand towards  the sub-£2m assets ;

-       For the reasons given above we think value lies in the £2m-£4m price range ( this is a sector that we do not think would be adversely affected even if a 1% Mansion tax was introduced ) .




         PCL 10 year outlook:


-       Global demand will remain strong for AAA UK, and especially PCL, real estate assets;

-       Global cyclical and long term deflationary pressures will keep monetary policy too loose for London for the foreseeable future, driving up asset prices;

-       Prices on some new build stock look vulnerable particularly as some major UK lenders have tougher LTVs and covenants on new build to secondary stock;

-       Policy risk on PCL assets in the £2m and above category will lift after the May 2015 GE;

-       Current value within PCL market lies in the £2m-£4m range;

-       PCL rents for properties in £1m-£4m range will rise in line with UK RPI but underperform capital rises;

-       PCL values will double over the next 10 years and gross yields will fall below 1% (This is where gross yields on AAA UK farm land are now) .