London’s residential sector has been in the news a lot recently. Depending on what you read it is either destined for a major boom or a major correction. Contradictory messaging reflects the sector’s diversity with market dynamics varying significantly by location and product.
The sector has undoubtedly slowed over the last 18 months. Deal volumes are down. Price growth has decelerated and in some cases reversed. However the market is a curate’s egg – good in parts. Some segments are under pressure but others are still going strong. For example whilst central London prime prices fell by 6.8% over the year to June 2017 according to Savills, mainstream prices in the East of England grew by 7.3% according to the Office of National Statistics.
Three drivers define current London residential performance. We believe these drivers will determine market outperformance in the short to medium term.
1) Affordability constraints
Savills estimates that London’s earnings to house price ratio presently stands at 12.0x. It was 7.9x a decade ago. Buyers, particularly first time buyers, must borrow more to afford a house. Lending is at the limits of current mortgage regulation and we believe that the earnings to house price ratio has little further to go. Stretched affordability will limit the scope for the levels of price growth we have seen over the last few years. At the same time it will prevent a sizeable correction. Moderation in pricing is likely to cause the large number of households currently priced-out of home-ownership to enter the market, thus acting as a brake for further falls.
2) Lack of suitable stock
The Mayor of London estimates that at least 42,000 new homes a year are needed for the next decade just to meet demand. Last year 41,000 homes were built. This was the highest annual number of completions since the 1930s but still well below need. Supply is also weighted towards certain locations, such as Nine Elms, and certain product, such as prime central London. It is not aligned to demand.
Further analysis by Savills shows that around 58% of anticipated demand over the next five years is priced below £450 per square foot (psf). Only 15% of pipeline supply is priced at this level as shown in Figure 1.
Figure 1 - London residential completions (forecast annual average completions 2017-2021)
Source: Savills/ Mayfair Capital
* Includes net affordable rent and intermediate housing completions for properties under £450psf which account for approx. 70% of completions in this price bracket
London’s residential supply pipeline will peak this year. It will fall away abruptly thereafter as developers curtail new starts given lower transactional activity. This will worsen the supply/ demand imbalance meaning a lot of unmet demand for mainstream product.
3) Flight to the commuter belt
Traditionally households have moved further away from central London as their lifestyle changes and they want to access more affordable, spacious stock. With housing affordability now being challenged over an increasingly large area within the M25, more Londoners are electing to leave the capital altogether. Last year there was a net loss of 93,000 residents from London, an 80% increase on five years ago.
Public transport infrastructure has made relocating to more affordable towns within a 1-hour commute of London more viable. Improvements in technology and greater workplace flexibility enable employees to work remotely more frequently too. The appeal of liveable, cheaper locations offering greater housing choice has gown. This driver has supported strong house price outperformance in places like Brighton, Thurrock and Medway.
We believe that these three drivers will support the ongoing success of mainstream residential product in outer London and the commuter belt. We predict that the best opportunities will be focused on locations that are well connected to public transport, which have excellent local amenity and a favourable supply/ demand imbalance.
Mayfair Capital Residential 2 ("MCR2”) is our residential debt fund which provides mezzanine finance for developers. Through this vehicle we are actively pursuing opportunities that capitalise on the three drivers outlined here.
By Tom Duncan
Senior Analyst - Investment Strategy and Risk