Investors should fear the London property bubble

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EVERYONE wants to own a property in London. Over the last 12 months, prices have increased by 8 per cent, and since 2009, prices have increased by 57 per cent. Has everyone forgotten the property bubble of the late 1980s?

Owning a property in London has become a status symbol for the wealthy. It’s not just about employment prospects, culture, the vibrant lifestyle, the world’s best schools, a trusted legal system and the English language. Property in London, despite its illiquidity, continues to be seen as an ultimate safe haven during uncertain economic times.

Limited bank lending and the 7 per cent rate of stamp duty for properties worth over £2m have not helped the market, yet capital values continue to increase. To an investor, this makes little sense. While property prices have increased by 8 per cent over the last 12 months, rental yields have struggled and have dropped by 3 per cent.

From an investment perspective, the comparative benchmark would be investing in government ten year gilts, currently yielding 2.54 per cent, or the likes of the Swiss Franc or even gold. These financial assets are all significantly overvalued. And the longer-term risks to London property prices are numerous: a change to UK tax policy post-election, changes to the regulatory environment driving jobs out of the City, and geopolitical events impacting on bank lending. In addition, the domestic economic recovery poses a threat to London’s real estate.

London property prices have increased primarily on the back of cautious international buyers. Investors – sensitive to ongoing geopolitical events, volatility in the financial markets, low interest rates, and more recently, weakness in sterling – have been gradually increasing their allocation to London property.

While the market has traditionally been supported by lack of supply and international buyers, domestic buyers have contributed significantly towards demand, particularly in the buy-to-let rental market. But with significant domestic unemployment, and concerns around job security, demand from domestic professionals (and thus rental yields) has started to decline. International buyers have picked up some of the slack, but their impact on rental yields – as opposed to capital appreciation – is minimal.

So can property prices continue to rise despite the longer-term risks and declining rental yields? As long as there is a supply shortage, market uncertainty, and sterling remains relatively weak, the answer is a cautious yes.

But on a fundamental basis, property valuations and risk relative to other financial asset classes – like equities, bonds and commodities – look expensive. Property valuation compared to other major international cities around the world does, however, look reasonable. Our long-term rental forecast for London property is around 4 per cent per annum. This compares favourably to ten year UK gilts, but less favourably to UK equity markets – where forward price-to-earnings ratios are fairly valued at 11.8, and dividend yields at a respectable 3.8 per cent.

Despite the current property bubble, London still retains a strong appeal to international buyers. From a wealth management perspective, we advocate diversification across all financial asset classes and we would not be allocating significant new funds to London property at current prices and rental yields. We would encourage investors to look at London property exposure relative to more liquid government bonds and large cap equities paying good dividend yields. As the economic environment improves, the property bubble, despite current valuations, is unlikely to burst. But prices and rental yields will remain range-bound, as equities trade higher and government bonds sell off.

Investors need to remain wise to the illiquidity risk of holding property. A more positive economic environment and improving corporate earnings would support equities trading higher, not London property prices. If you do decide to buy property, understand that it is in bubble territory. Consider the location and your time frame, and be sensitive to illiquidity. Recognise that you are buying at what could be the top of the market, and understand that investing in property is a long-term game. As investment managers, we cannot help but think that the easy money in the London property market was made a long time ago.

Yogi Dewan is chief executive at Hassium Asset Management.