The Sentiment Discount

This is not research

This is not a survey, and I have not been commissioned to write it.

These are my own views, formed from transactions in markets where my own capital, and the capital of others, has been committed.

You are entirely at liberty to disagree with them.

A note on position

We hold no stock, we act for no party that is selling, and there is nothing here that anybody needs to buy.

That is the only reason this paper can be written the way it is. An argument is worth exactly as much as the independence of the person making it, and a reader is entitled to establish that before going further.

You are entitled to disagree with everything that follows. Several people whose judgement I respect do.

Introduction

For more than a decade Prime Central London has underperformed the expectations placed upon it.

That statement will surprise some readers. London spent years being treated as something approaching a one-way proposition: international capital, constrained supply, and a price trajectory that appeared incapable of reversing. The record is less flattering. Since the middle of the last decade the market has undergone a prolonged repricing, driven by taxation, regulatory intervention, altered international capital flows, political uncertainty, and latterly the most aggressive global interest-rate cycle in a generation. In many instances values remain materially below previous highs.

Over the same period, rents have risen substantially.

It is tempting to conclude from this that London has become a fundamentally different market. I do not believe it has. Supply remains constrained. Demand remains substantial. Rental demand is arguably stronger than at any point I have observed. The characteristics that allowed this market to function a decade ago appear, as far as I can determine, to remain largely intact.

What has changed is the price. And the mood.

That is a very different proposition from a broken market, and it is why this paper exists.

Where we are in the cycle

Every cycle authors its own narrative.

At the peak of the previous one the narrative was uncomplicated. London was a safe haven, capital moved freely, debt was cheap and abundant, and investors accepted yields that would once have been regarded as indefensible on the assumption that future capital growth was inevitable. The prevailing mood was optimism.

Today it is almost perfectly inverted. Borrowing costs have compressed affordability. Property has fallen out of favour relative to financial assets. Political uncertainty has discouraged part of the international investor base. The prevailing mood is scepticism.

Yet sentiment and fundamentals are different things. They are not required to move together.

Indeed, many of the best investment opportunities in history have emerged precisely when they diverge.

A market that has already corrected

Investors devote considerable effort to finding value in markets that have never actually fallen.

Prime Central London does not belong in that category. It has already endured a prolonged adjustment, and assets acquired at peak valuations ten years ago now trade, in many cases, materially below those levels.

To put a figure on it, and to be clear that this is my own observation rather than an index, I frequently see values approximately twenty-five per cent below prior highs. An apartment that changed hands for £2 million may today trade for approximately £1.5 million.

That is not a forecast. It has already happened.

It is also the most important fact in this paper. Everything that follows, income growth, replacement cost, supply constraint, currency and sentiment, is being applied to assets that have already undergone their correction. The reader is not being asked to position before the fall. The reader is being offered the position after it.

The investor of 2014 paid a premium for certainty. The investor of today is being offered a discount for uncertainty.

In my experience, the latter is generally the more attractive proposition.

The mistake of anchoring

An apartment that traded for £2 million ten years ago may be worth £1.5 million today.

Most observers interpret this as evidence of loss.

The market does not.

Markets possess neither memory nor emotion. The previous transaction matters only to the individual who conducted it. The investment decision facing a new buyer is not whether £2 million was a sensible price. That question has already been answered. The decision is whether £1.5 million represents value today.

Investors regularly anchor themselves to historical prices and then mistake a comparison for an analysis.

The market has no knowledge of what an apartment once sold for. Nor does it care. It knows only the price at which willing buyers and willing sellers are prepared to transact today.

Those are entirely different questions.

Am I calling the bottom?

Not precisely. I would be cautious of anyone claiming otherwise. Markets are not clocks; they do not ring a bell when they turn.

What I will say is this.

I believe values are at, or near, cyclical lows. The correction has happened. Income has improved materially. Replacement cost exceeds transaction value. Supply is contracting. Sentiment is exceptionally poor.

Those conditions rarely coexist at the top of a market.

The income story nobody is discussing

The conversation remains fixated on capital values. That is understandable, investors naturally anchor to historic prices. Yet in doing so they overlook the most significant development of the past decade.

Income.

Values have fallen. Rents have risen, and in many instances they have risen materially. The result is simple: the same asset can now frequently be purchased with less capital while producing greater income. What once relied almost entirely upon capital appreciation has become considerably more capable of paying its owner while they wait.

That is a better investment proposition than the one available at the previous peak.

The capital figures below are rounded, and representative rather than drawn from any single transaction. The yields are not. Those are the numbers that matter here, and they reflect what I actually observe in this market.

The capital figures vary from case to case. The pattern does not.

Lower prices. Higher rents. And an asset that has moved from yielding under three per cent to yielding around five, which is the entire point, and the part of this that is not an approximation.

What a market price actually is

There is a distinction between an asking price and a market price which much of the industry appears reluctant to acknowledge.

An asking price is an opinion, frequently one held by a party with a direct financial interest in maintaining it. A market price is what sufficient buyers have demonstrated a willingness to pay.

One is aspiration. The other is evidence.

Where fifty comparable apartments have transacted between £1.4 million and £1.5 million, that range represents the market. It is not displaced by an individual listing at £2.2 million. Nor is it displaced by a single buyer who overpays.

This distinction matters. A significant amount of commentary references asking prices as though they constitute evidence.

They do not. Nobody has paid them.

The comparable evidence we work from is drawn exclusively from completed and registered transactions. Asking prices appear nowhere. They are evidence only of ambition.

Sentiment and those who shape it

A decade ago, market commentary was produced predominantly by participants.

Today it is increasingly produced by observers.

The two groups may arrive at identical conclusions. Only one bears the cost of being wrong.

Modern media rewards conviction over accuracy. A thirty-second video forecasting disaster will frequently attract more attention than considered analysis developed through years of direct market participation.

That dynamic matters because opinion now travels globally in minutes. Real estate does not. Property responds to planning frameworks, construction pipelines, demographics, replacement costs and capital flows, and those variables evolve over years.

Sentiment reprices in an afternoon.

The gap between those two speeds is not a problem for a patient investor. It is often the opportunity itself.

Incentives, and the lesson of Dubai

There is a structural reason the commentary is delivered with such confidence.

In most major cities the commissions available in real estate are sufficient that an individual may earn a great deal of money without knowing a great deal. This is not a moral observation but an economic one. Where the reward for transacting is substantial and the penalty for error is nil, advice migrates toward the interest of the adviser rather than that of the investor.

Dubai furnishes the clearest illustration I have encountered.

Buyers were sold an eight per cent yield as though it were a characteristic of the city rather than of a moment. It held for the first several units. It did not hold for the subsequent five hundred. Supply arrived, the arithmetic altered, and a considerable number of purchasers are, by my observation, carrying losses in the order of thirty to forty per cent against a promise that was never capable of being delivered.

None of this required foresight. The supply pipeline was published. The population figures were published. Five units achieving eight per cent does not establish that five hundred more will. That is not analysis, it is arithmetic.

It was sold regardless, and enthusiastically, by a very large number of people who were remunerated on the day of exchange.

The same structure recurs wherever the fees are large enough. One need only consider the volume of consultancy work attaching to announced mega-developments across the Gulf. The consultant is paid upon appointment. Whether the scheme is ever delivered is, financially speaking, somebody else's difficulty.

I do not write this to disparage an industry in which I work. I write it because the identical instinct is now being applied to London in the opposite direction.

Those informing you that this market is finished are, broadly, the same constituency who assured you the previous one could not fail.

The supply problem

Real estate returns, always, to supply. Every cycle, every market, every asset class. And the question is invariably the same: can sufficient new product be delivered to meet future demand?

In Prime Central London the answer appears increasingly to be no. Construction costs have risen materially. Development finance is considerably more expensive. Regulatory requirements continue to expand. Planning constraints are severe. Land is exceptionally scarce.

In many cases replacement cost now exceeds transaction value. It costs more to build the thing than to buy the thing.

Where developers cannot generate a return, supply contracts. Existing assets appreciate in relative terms for no reason other than that fewer alternatives are being created.

Markets are slow to acknowledge this while it is happening. They acknowledge it eventually, without exception.

Currency

I will advance a proposition unfashionable among property people. I am frequently more interested in the currency than in the building.

An international buyer is not acquiring an apartment. They are acquiring a sterling-denominated asset at a sterling price. These are two separate decisions, and most buyers consciously take only one of them.

There have been extended periods in which London appeared expensive against every domestic measure while being, to an overseas purchaser, ten to fifteen per cent cheaper than the headline implied, for no reason beyond where the exchange rate happened to sit. That advantage appears in no valuation, no brochure and no agent's presentation. It is nonetheless real money, and I have watched it determine transactions that the property alone would not have.

Sterling remains beneath its historic range on most long-run measures. My own view, and it is a view rather than a forecast, is that it strengthens as political uncertainty resolves.

An international buyer acting today acquires that potential movement alongside the asset, at no additional cost.

Stamp duty, and the cost of waiting

The country has a new Prime Minister and, in all likelihood, faces a change of party at the next general election. Whatever one's politics, there is broad agreement across it that business and investment in this country require reanimating.

My expectation, and I will identify it as speculation because that is what it is, is that stamp duty land tax will be among the earlier things addressed. It is set too high and it is visibly suppressing transaction volume.

Here is the consideration worth weighing carefully. The instinctive response is to wait and purchase afterwards.

I would suggest that is precisely inverted. Should stamp duty be reduced, the saving will not remain with the buyer. It will pass into the price, and it will do so rapidly. I would anticipate a movement in the order of ten per cent, and quickly. The purchaser would acquire the identical asset with the discount removed, paying less tax upon a larger number.

The event being waited for is the event that terminates the opportunity.

The alternative to selling

Selling is the reflex. It is seldom the only option, and in a market that has already absorbed a twenty-five per cent correction it is frequently the least attractive one. To crystallise that loss permanently, in exchange for liquidity an owner may have no superior use for, is a decision warranting rather more scrutiny than it customarily receives.

Approached as a strategy question, the place to begin is the capital structure rather than the asset. Refinance. Accept that a portfolio may do little beyond servicing its own costs for two or three years, and hold it into the cycle this paper describes.

If the analysis is correct, the owner retains the recovery. If it is wrong and the market does nothing for three years, the owner has forfeited very little. The costs were met and the asset is still owned. Set against a permanent twenty-five per cent reduction taken today, the asymmetry is not subtle.

Where liquidity is genuinely required, the choice is not binary. Co-investment placement sits comfortably between holding everything and selling everything, and it is neither exotic nor difficult to execute. Upon a six-million-pound portfolio, an owner requiring cash but facing a difficult market for the whole might place half and remain invested alongside the incoming buyer in the remainder.

The elegance of that structure is that it resolves two problems with a single instrument. The seller achieves partial liquidity without capitulating on the entire position. The buyer receives something considerably more persuasive than a discount: the vendor's own capital positioned alongside their own, which remains the only expression of confidence in this industry that costs the person making it anything.

Nor need the income split be even. Weighting it toward the incoming buyer through the early years, seventy-five against twenty-five, acknowledges that they carry the harder end of the risk while the market turns. In my experience it is often the difference between a structure that is admired and one that is signed.

Owners rarely reject these arrangements. More commonly they are unaware of them, or reluctant to restructure at precisely the moment restructuring carries its greatest value, and disposal presents itself as the straightforward course.

It is straightforward. That is not the same thing as being right.

What would make this wrong

I would not trust a paper that advanced nine arguments and conceded nothing, so here is the other side of it.

Sterling recovers before you act. The currency advantage is real, and it is temporary by definition. Should the pound strengthen materially before an international buyer transacts, a meaningful portion of the case evaporates, and it is the portion I personally weight most heavily.

Rates remain higher for longer. Everything above presumes borrowing costs normalise across a reasonable horizon. If they do not, affordability stays compressed and any recovery in values is slower and shallower than this paper implies.

Taxation moves the other way. I have argued that stamp duty is likely to be cut. Governments under fiscal pressure have historically found property a convenient target, and it could as readily move in the opposite direction, in which case the transaction market deteriorates before it improves.

I am simply early. Markets are entirely capable of remaining disconnected from their fundamentals for longer than most investors' patience, and considerably longer than most investors' financing.

None of these constitute reasons for inaction. They are the reasons this is a long-term position rather than a trade.

Why this is not a trade

Among the more expensive errors an investor can make is to treat property as though it were a financial asset. It is not one, and it does not behave as one.

Real estate rewards patience. What is described here is not a twelve-month proposition, and it is not intended for momentum investors. It is intended for those attempting to preserve and compound capital across a period measured in years.

The largest returns in this asset class have historically accrued not to those who traded frequently, but to those who acquired well and then did remarkably little.

Conclusion

The case for Prime Central London today does not rest upon optimism. It rests upon arithmetic.

Lower prices. Higher income. Constrained future supply. Replacement costs exceeding transaction values. A currency beneath its long-run range. Negative sentiment, a good deal of it manufactured by people carrying no exposure to being wrong. And beneath all of it, a globally significant city with a stable legal framework, a freely tradable currency, and genuine liquidity.

No single one of these guarantees an outcome. Collectively they describe a risk-and-reward profile appearing considerably more attractive than the one available at the previous peak.

The question is not whether Prime Central London outperforms across the next twelve months.

The question is whether, a decade from now, this will be recognised as a period in which the opportunity to acquire scarce assets in one of the world's most desirable cities was rather more apparent than it appeared at the time.