by Russell Schiller
The reign of the institutions as the kings of property investment seems to be over for good. Their place has been taken by developers, financed by debt, and short of some global catastrophe this new order is here to stay. It means new thinking for a generation of property professionals who have grown up on the convention of forward-funding developments, with the institutional buyer in place before construction starts.
The decline of the institutions was vividly shown by the Government statistics for the second quarter of 1989. At a time when development was running at a pace so rapid that it provoked the Governor of the Bank of England to issue a warning, the institutions were actually reducing their holdings by £225m.
The chart below shows how violently the pendulum has swung from debt to equity and then back to debt in the past 15 years. Debt had always been the principal form of property investment before 1974, and it now looks as if the basic pattern has returned. The 1975-1985 decade, when the institutions pumped equity investment into property, appears abnormal in retrospect, and anything but the permanent change which many thought had occurred.
Foreign money
What has transformed the situation is the arrival of foreign money, both equity and debt. Five years ago there was no modern office development in London of over 1m sq ft, the biggest being the NatWest tower at 800,000 sq ft. Now we have three schemes of over 2m sq ft, all involving foreign investment. The three are London Bridge City (Kuwaiti), Broadgate (British, but funded largely by Japanese banks) and Canary Wharf (North American). Another indication is that over half the transactions in the City now involve a foreign buyer.
The scale of the change is so great that it is difficult to grasp. Cross-border flows of property investment are growing at a quite extraordinary rate, and the phenomenon itself is also new having appeared on a significant scale only since 1985.
The cause of the change was the removal in the early 1980s of most of the controls on exporting capital in three key countries — the USA, Japan and Britain. There followed explosive growth in cross-border investment in equities, and particularly bonds, with property following a few years behind. A few figures will give an idea of what happened. Between 1980 and 1985 Japanese investments in foreign stocks and bonds grew 14 times. Pension fund assets worldwide grew nearly fivefold between 1980 and 1987, but the amount held by funds outside their home country rose nine times.
History
This new era of freedom for international investment follows a period of restriction which has lasted for 75 years. The first world war was a massive blow to confidence. Recovery had barely started in the 1920s before the slump of the 1930s caused limitations to capital flows which survived for decades.
The modern international market began with the development of off-shore finance, particularly Eurobonds, in the 1960s. The 1970s saw the appearance of the sovereign funds of mostly small oil-rich states like Saudi Arabia, Kuwait, Brunei and Singapore. These funds were forced to invest abroad because the home country was far too small to accommodate them. In 1973 we saw the ending of fixed foreign exchange rates and the ending of the Bretton Woods era, which has lasted since 1943. The three factors of offshore finance, oil-surplus funds and free exchange rates created the pressure for the removal of barriers to the cross-border flow of capital which followed in 1980-83.
There are parallels between the 1980s and the 20 years pre-1914, when there was an outflow of investment from Europe, particularly Britain, to build railways and ports for the rest of the world. In proportion to the size of the main economies the scale of international investment was as high then as it is today.
It is sobering to remember how vulnerable international investment was to a calamity like the first world war, and how long it took the financial world to recover. The vulnerability remains, although the recovery time ought to be shorter if another catastrophe occurs.
Property
The story of international property investment is led by the Japanese, whose financial muscle is so strong that it dominates the market. Our estimate at Hillier Parker Research is that 55% of non-European investment in direct property in the UK and the Continent is accounted for by Japan.
Japanese direct investment in European property was $1.1bn in the year to March 1989, with the UK taking 69% — 13 times the level of 1987. Most commentators agree that Japanese investment is still in its preliminary stages and that investment in Europe will clearly rise considerably.
Despite this, the Japanese share of the total could well fall as the Americans, Koreans and other countries follow suit.
It is easy to be dazzled by the arrival of foreign money buying British freeholds, but it is likely that direct investment in property will remain tiny when compared with international investment in bonds. For every £100m available for equity, there is likely to be well over £1,000m available for property debt.
The reason for this lies in the reluctance of the institutional investor to take unnecessary risks in an unfamiliar market. The main reason for investing abroad is to spread risk by diversification. Growth is secondary to this. Certainly it is difficult to see why, if the objective is growth, a Japanese investor would convert yen into assets in a currency which has consistently depreciated against the yen.
It is easy to see why a foreign investor would prefer to buy property debt rather than property equity. Investing in a freehold in a strange country must appear risky and full of potential management troubles. By contrast, a bond secured on 70% of the value of a property offers a known level of return, security of income, liquidity, and a quiet life. Once we accept that the overseas investor prefers security to growth, then the picture changes. The taste for low-yielding “trophy” offices in the City becomes explicable. The UK investor currently shuns the City and prefers opportunities elsewhere — but then the UK investor is not operating a global diversification strategy.
For the British property adviser the message is that it is perhaps less important to sell growth prospects than stability. Forecasts of rental growth — which may not be believed — become less important than void rates, covenant strength, and pictures of Beefeaters at the Tower of London.
Bonds
The story of international investment has been the story of bonds. Japanese investment in foreign bonds was at a rate 50 times greater than investment in foreign equities through most of the 1980s. Bonds are replacing bank loans as the principal source of debt in many markets, particularly the USA. They have enormous flexibility and can be packaged to the particular requirement of the buyer; they can be off-shore; they can offer stepped interest payments; deep discounts; and low-or zero-coupon rates. As such, they have some of the attractions of equities. Above all, however, they are tradeable in a way that bank debt is not.
Of course, debt in any form raises gearing and high gearing is particularly vulnerable if the market turns down. We need to watch closely that the burden of debt does not do for property what junk bonds are doing for some American equities.
At the moment there are few examples of property-backed bonds (or securitisation) in Britain, but the potential is enormous. Most property debt still takes the form of bank loans, often syndicated for big schemes, a situation that has effectively reduced the demand for unitisation. Unitisation offers equity in small packets. High-value buildings used to be valued at a discount because they were eggs too big for most baskets. With the arrival of foreign investors and their deep pockets this discount has virtually gone, as the above chart shows. It is no longer necessary to break up the equity of big developments. Debt, in one form or another, can take care of 80% of even the biggest projects. Tax transparency makes unitisation attractive for some investors, but the potential for securitised equity looks small compared with the opportunities for securitised debt or bonds.
Implications for Britain
International investment is growing fast, and international investors have an appetite for bonds. This offers an almost limitless pool of money to the British property industry. One effect of this is to solve the problem of who will “take out” the large amount of development now in the pipeline. In the past, the institutions have bought completed developments, enabling the developer to pay off his construction loan, usually financed up to five years. With the institutions unenthusiastic, this has been seen as a worry, but what looks certain to happen now is that most of the debt will be packaged in the form of bonds, with the developer keeping the freehold.
Another consequence of the growth of bonds is that it holds out the prospects of a split between the growth and the income parts of an investment. This has been advocated for some years and it makes sense. It gives both the developer and the international investor what they want. The developer wants to exploit his expertise and market knowledge to get growth, and for this he needs the freehold and full management control. The international investor is less interested in growth, but wants security, diversification, a secure income, and no headaches. Property-backed bonds thus satisfy both players. There is still some way to go to bring about this state of affairs but it is surely coming — and debt is the key to it. In the long run it will be far more important to the British property scene than the arrival of foreigners in the direct market.
