Andrew Baum and David Hartzell, Global Property Investment, 2011 The L&G case: London office purchase 1992 / 2006

Andrew Baum and David Hartzell, Global Property Investment, 2011Andrew Baum and David Hartzell, Global Property Investment, 2011

The L&G case: London office purchase 1992 / 2006

Andrew Baum and David Hartzell, Global Property Investment, 2011

Case study

London office sale by UK insurance company, 1992 1990 development 1991 25 year lease with 5-yearly reviews to market rents, upward only Let to partnership of lawyers End 1992: lease rent £760,000 (£50psf); market rent £296,000 - £370,000

(£20-25psf) January 1993 sale – at what price?


Why the UK won’t join the Euro - yet


Appraisal issues: the UK view

• Interest rates raised from 10 to 15 per cent • UK formal decision to quit ERM, rate rise reversed• In two days, $30 billion sold from UK reserves• £ set to slide in value• Gilt and interest rates set to fall

• Canary Wharf bust • Sunday newspapers full of ‘negative equity’• No office tenants!


Sterling/$, 1985-1993 – Black Wednesday


Rental values and growth 1988-1993 - collapsing

-20

-10

0

10

20

30

40

50

60

70

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Source: IPD, PFR 2006

Lease signed

Sale date

… and these are appraised values…


Appraisal 1: Summary

Cash flow (fixed) £760,000

Term: 23 years

Long gilt: 8.4%

Risk premium: ?%

Required return: ?%

Value: £?m


Valuation: December 1992

Term:Rent passing £760,000PV pa, 23 years @ 10.00% 8.88Capital value £6,751,246Reversion:ERV £370,125PV pa, perp @ 10.00% 10PV, 23 years@ 10.00% 0.11Capital value £413,349Valuation £7,164,595


Appraisal issues: the UK view

• Cash flow– Rental value?– Rental growth forecasts?– Rental growth net of depreciation

• Discount rate– Risk of default – Rental value protection? – Risk premium over gilts?

• Exit price• Holding period return?


Appraisal 2: Summary

Long gilt: 8.4%

Risk premium: 2.0%

Required return: 10.4%

Value: £7.8m


The German view: five key points

• The cash flow is effectively fixed for 23 years – there is no upside but also no risk

• The local risk free rate is lower so the discount rate, all things being equal, could be lower than a UK buyer’s

• Default risk is tiny, the currency looks as if it has fallen a long way already and the buyer has a long term perspective – so illiquidity is unimportant and the risk could be seen to be low

• Germany is a low return market, so this asset might add a lot to the fund’s returns

• UK property – this is a new building in the City - looks cheap compared to recent prices especially after the £ collapse


Appraisal 3: the German view

Long gilt: 6.9%

Risk premium: 2.0%

Required return: 8.9%

Value: £8.9m


Sterling/DM, 1992-2001


The outcome

• Property bought for £8m• Property sold 2001 for £12.5m with 15 years remaining;

ERV now £40psf• Running yield 9.25%• German market returns 5% every year • IRR 13.1% in local currency • IRR 17.5% in DM• ERV in 2003: £25psf?


2006

• The same property is now on the market again. The 2001 buyer is making the most of recent price rises and cashing in

• Rental values have recovered in the City but the property is now 15 years old with exactly 10 years to run on its lease

• The lawyers want to vacate the property but remain liable for the rent

• What is it now worth?


Source: IPD, Datastream 2006

Property and gilt yields appear related…

4

5

6

7

8

9

10

11

12

(%) 10 year gilt yield Property equivalent yield


2006

• Bidders include three sub-groups– a German open–ended fund– a private equity (opportunity) fund– a UK pension fund

• What price will be paid?• Which buyer type will win?


Appraisal 4: summary

Net exit value £5,980,559

Base value £5,503,736

Froth value £705,291

Total value £12,189,585


Appraisal 4

Annual rent 760,000 Long gilt 4.50%

Annual ERV psf 37.50

Total ERV 555,188 Base prem 1.50%

Inflation 2.50% Froth prem 2.50%

Prop prem 2.50%

Growth real nominal

Growth 1 10.00% 12.75% Reqd ret qtrly annual

Growth 2 5.00% 7.62% Base 1.47% 6.00%

Growth 3 0.00% 2.50% Froth 1.71% 7.00%

Growth 4 0.00% 2.50% Prop 1.71% 7.00%

Growth 5 0.00% 2.50%

Growth long 1.00% 3.53% Net exit value 5,980,559

Base value 5,503,736

Depreciation pa 1.50% Froth value 705,291

Depreciation pq 0.37%

Exit yield 6.00%

Review costs 2.50% Total value 12,189,585


Performance 2001-6

Year end Capital Costs Rent Net cash flow2001 -£12,500,000 -£593,750 -£13,093,7502002 £760,000 £760,0002003 £760,000 £760,0002004 £760,000 £760,0002005 £760,000 £760,0002006 £12,190,000 -£213,325 £760,000 £12,736,675

IRR 4.237%Running yield 5.804%Capital gain -£1,117,075


Where will the highest bid come from?

• German open–ended fund? – risk free rate advantage?– Germany and its relative attractions– UK property cheap? – currency advantage?

• UK pension fund – appealing in 2006?• Private equity (opportunity) fund: options?


Private equity (opportunity) fund: options

• Gear highly and boost IRR on equity• Obtain possession, get payment from law firm

– develop if profitable– if not profitable, take rent and wait until it is

• Worst case: no profit in immediate development: collect 6% + income yield, geared if profitable, and wait

• Re-negotiate lease with tenant: surrender and renewal for 15 years at a lower rent, sell to UK pension fund at 4.5% cap rate

Documents

Andrew Baum and David Hartzell, Global Property Investment, 2011 The L&G case: London office purchase 1992 / 2006