South Bank Holdings Investment Appraisal

Introduction

South Bank Holdings is a small UK property company is seeking to diversity its current property portfolio (currently it has assets of approximately £500m) and its portfolio is located mainly in the City and West End of London. It is currently reviewing their long-term investment strategy and are considering the investment potential in mid-town London.

It is understood that South Bank Holdings are looking to place an investment in the region of £10-25m.This appraisal considers the possibility of purchasing an office located a Sutton Yard, 30A Great Sutton Street, London EC1V 0DU.

This report will gather relevant data in order to determine whether investment in this particular building will yield an acceptable profit for the developer. This will cover the market opportunity’s strengths and weaknesses and provide an economic assessment of the locality, before focusing more thoroughly on the office section in midtown London. This will in turn provide the basis and context for a full financial appraisal and risk assessment of the subject property which will be undertaken with relevant and appropriate assumption where necessary, when information or data points are unattainable/unjustifiable.

The collected data aids business decision making. This therefore reduces the risks involved in making these decisions.

Regional Economic Analysis

Introduction

A regional economic analysis determines the highest and best use available for a property and should form the basis for the selection of the particular property and feeds into the accurate valuation providing both positive and negative information about the property.

Location and Demographics

Location and Demographics

Greater London, or London, as it usually referred to is the UK’s capital city. It is technically a county (total area 607 square miles) and incorporates 32 boroughs. The inner London boroughs were defined by the London Government Act 1963, and the definition is used for purposes such as the local government finance system. They correspond to the former area of the County of London and incudes the Borough of Islington. The term ‘Midtown’ London does not have a legal definition or boundary. It was first used around 1990 and is now used in the reports of leading property organisations such as Knight Frank, CBRE and JLL. Having first taken root somewhere around the southern end of Procter Street, it has since expanded in all directions, but especially north-westwards and along major thoroughfares. Some people define Midtown as the whole area between the City and the West End as illustrated in Figure 2.

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Illustration of midtown London

Population

8.8 million people live in London, which is a 16% increase over the last decade, and makes up 13% of the UK population. This growth has been largest in Inner East and South London. London also has far higher proportion of residents aged between 25-34, especially in Inner London where they make up 24% of the population. Net migration into London was almost 60,000 in 2014/2015 (including both international and domestic migration) – the highest figure in four years. This data will not reflect any changes in migration, if any, which have resulted from the Brexit referendum. (Trust for London, 2018). The population for the London Borough of Islington is in the order of 230,000 to 250,000: however, the density of London is so great that boundaries should not be considered as being significant.

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Economy

GDP figures are only provided at a country level. Regional Gross Value Added (GVA) is a productivity measure that measures the value of goods and services produced in a region. GVA per head is a useful way of comparing regions of different sizes. It is not, however, a measure of regional productivity. London has always been a commercial city and today enjoys the status of having one of the largest city economies in the world. The city thrives in trade and commerce and has a vibrant culture seeped in commerce. It has a GDP of over £565 billion, which is about 17 percent of the UK's total GDP. The size of its economy is larger than that of several European nations.. The nature of London's economy has undergone change over the years. While manufacturing industries held the dominant position during the nineteenth century and the early parts of the twentieth century, service industries, especially financial and business services are now the dominant sector. Of the total £37 billion annual export of goods and services, financial and business services account for about £15.5 billion. London is the home to many banks and financial institutions and has the maximum number of foreign banks in any city. The city is also a major centre for forex trade. London trades more US dollars than New York does, and more Euros than all other cities in Europe combined. The service sector employs 3.2 million people in London, which is about 85 percent of all jobs available in London's service industries. Out of this, the financial sector alone employs about 1.25 million people, or about one in every three jobs available. The manufacturing and construction industry, in contrast, employ half a million residents of Greater London, which is about 11 percent of the employable population of Greater London.

Employment

The most recent Business Register and Employment Survey (2018), shows that 513,000 people are employed in the City of London. This represents 10% of Greater London's employment, and 1.6% of the GB's total employment, meaning that over 1 in 58 of the GB's workforce are employed in the City.

Commercial Office Market Analysis

This section will consider the London

Overview

The Greater London commercial property market is rapidly changing and facing highly uncertain times in the face of Brexit. The Greater London commercial property sector has undergone sweeping changes in the past three years. Brexit has provided a shock to the system by knocking valuations, causing a severe slowdown in rental growth and casting a dark cloud over future demand for British property, but longer-term market trends are also reshaping the industry. The EU referendum result and the subsequent fall in the pound has lifted demand for British exports and industrial property while demand for office space has remained resilient - although it is unclear whether this will still be the case when the UK formally leaves the EU, especially if no trade deal is in place. Meanwhile, structural changes have also taken their toll as high streets and shopping centres continue to empty out amid the rise of online shopping.

Occupier Focus

The offices provide open plan spaces. Open plan is the generic term used in architectural and interior design for any floor plan which makes use of large, open spaces and minimses the use of small, enclosed rooms such as private offices. Albeit these smaller areas can be carved of the open plan areas. The openness may improve communication and collaboration among your workers, but it also may reduce concentration and productivity. A lack of walls or other physical barriers in open-plan office spaces makes it easier for employees to interact with each other on a regular basis.

Investment Focus

Office buildings are categorised based on a combination of physical characteristics and location. A Grade-An office space is described as the highest quality of office space available. Savills suggests that new London office development opportunities coming to the market in the next 12 months could be a wise move, given forecasts that the city is set to suffer a severe undersupply of Grade A office space beyond 2021 (Savills, 2019).

Spotlight on the Midtown London Office Market

Midtown London Economic Overview

Midtown is also poised to benefit from the impact of the Crossrail high-speed train link running through its northern area. Knight Frank research shows that commercial property located within a 10-minute walk of a Crossrail station will outperform wider price growth in the area by 1% until the route opens in 2019. In terms of residential since the financial crash, foreign students have been attracted to Midtown. They are able to walk to the London School of Economics, King’s College, University College London, Birkbeck College and the School of Oriental and African Studies as well as being near to bulk London University accommodation in Bloomsbury.

Occupier Market

Midtown offers a full range of office accommodation from the "Grade-A" to the "Cheap-and-Cheerful", and from large headquarters-style buildings to small, self-contained office suites. West End and City office rents are higher than in the Midtown area, which benefits from a 20%-30% saving in office occupational costs compared with these. This suits many companies, who wish to be located in the area in any event, to save on travel time when they flit between meetings, although there are certainly cheaper locations for the office occupier to consider outside of the London Midtown area. London Midtown is home to the country's Legal profession, with the Royal Courts of Justice and the Inns of Court being located just to the north of Fleet Street. Fleet Street itself is still the spiritual home for the news and publishing sectors, although the presses have long since gone. Large corporate occupiers in Midtown include BAT, Pearson Group, Goldman Sachs, Sainsbury PLC, Towers & Perrins, Olswang solicitors, Covington & Burling, The Food Standards Agency, Manches Solicitors, the BBC and Reuters.

Pipeline

With reference to Figure 3 a check of the Borough of Islingtons’s planning portal found that only 2 other applications had been made for similar type developments had been applied for in the last 12 months.

Extract from Borough of Islington Planning Portal

Furthermore the trend amongst the planning applications was for converting commercial property into residential.

Proposed Investment Property

Property Description

Sutton Yard is a a modern Grade A mixed used development compromising commercial office space over Lower Ground, Ground & 3 upper floors along with an additional 12 sold-off residential apartments leased for a term of 124 years from 24th June 2007 and producing a ground rent of £600 per annum, doubling every 25 years.

Interior view

70 cycle spaces

8 Showers with 31 lockers

Large central reception area with entrances from the courtyard off Goswell Road and Northburgh Street

4 new 13 person passenger lifts

Dedicated courtyard served by a contemporary new restaurant providing an ‘all day’ offering

Excellent natural light with glazing to all elevations and panoramic views from the newly constructed 5th and 6th floors

Roof terrace at 5th floor

VRF heat recovery system with central network controls to provide flexible heating and cooling

Mix mode natural and mechanical ventilation

Suspended lighting (direct and indirect) with Simmtronic DALI dimmable system

Raised access floor

Potential for a 200 amp 3 phase supplementary supply for additional capacity

Energy efficient building with an EPC asset rating of A

BT fibre and copper connectivity with additional ducts in place for connection to alternative providers

Access control and CCTV to common parts

The Ground and Lower Ground comprises a self-contained space measuring 9,201 Ft2 with its own front door from the street, which can enable the premises to be used as a self-contained office or showroom unit. The showroom occupiers based in and around Great Sutton Street have consistently demonstrated a desire to be in the area, and this has resulted in a fantastic array of showroom tenants. Showroom occupiers include Vitra, Knoll, Modus and Havwoods. Office occupiers include Kurt Geiger, Agent Provocateur, Alexander McQueen, Airbnb and WPP.

Property Situation and Location

Great Sutton Street has a beautiful range of former warehouse buildings, most of which are occupied by a wide variety of creative businesses. Clerkenwell Green retains a village feel steeped in history while Brewhouse Yard and St John Street provide a fantastic mix of old and new. Sutton Yard combines impressive and expansive workspace with an enviable location in the heart of one of London’s most characterful, unique and well-connected neighbourhoods.

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Current Tenancy

Showroom occupiers include Vitra, Knoll, Modus and Havwoods. Office occupiers include Kurt Geiger, Agent Provocateur, Alexander McQueen, Airbnb and WPP.

Investment Analysis

The economic assessment should be used to provide the criteria for the selection of a particular property for appraisal. The property does not necessarily have to be on the market but it may be easier if it is. A full financial appraisal of the property is required to establish it’s worth using a discounted cash flow approach. The assumptions behind your key variables need to be clearly identified and stated. The full DCF and assumptions for the DCF MUST be supplied within the submitted coursework. A full risk assessment needs to be undertaken and it is suggested that you consider one of the following approaches: sensitivity analysis, scenarios, probability, Monte Carlo simulation etc. Whichever approach is used a clear statement of the rationale for the figures used needs to be clearly stated.

Holding period

South Bank Holdings that holding period of 10 years is assumed. This being the amount of time the investment is held by an investor or the period between the purchase and sale of a security i.e the time between an asset's purchase and its sale. None of the current tenants lease agreements last for 10 years, but given the relative covenant strength of each tenant and that the leasing it not reliant on a single non-renewing tenant full occupancy of the building may never be achieved.

Inflation

Inflation is defined as a rise in the general level of prices of goods and services in an economy over a period of time. When prices rise, each unit of currency buys fewer goods and services, eroding real consumer purchasing power. Although deflation also is a risk to the economy, moderate inflation is much more prevalent over the course of modern history.

History of inflation rates in the UK Prevailing CPI

Rental Growth Rate

Investors widely consider commercial property an asset class that can help offset the impact of inflation over the long term. In fact, that benefit is regularly cited as one of the advantages of adding commercial property to a mixed-asset portfolio of investments. Academic literature on the inflation-hedging benefits of real estate are mixed, but generally agree that private real estate is at least a partial hedge against inflation. The ability to adjust rents over time is typically credited for commercial properties inflation-hedging benefits. Typically, robust economic growth should result in higher inflation, and therefore stronger rent growth.

Impact of Lehman Brothers collapse

Risk Premium

The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. In theory, the risk-free rate is the minimum return an investor expects for any investment because he will not accept additional risk unless the potential rate of return is greater than the risk-free rate. In practice, however, the risk-free rate does not exist because even the safest investments carry a very small amount of risk.

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Total return forecast

Forecasts for the rental growth to 2021

This graph covers a 4 year period with an average growth for offices of 1.5%. Therefore for a 10 year period the average growth will be assumed to the 1.5 x 2.5 = 4.5% per annum

Risk Premium

A risk premium is the return in excess of the risk-free rate of return an investment is expected to yield; an asset's risk premium is a form of compensation for investors who tolerate the extra risk, compared to that of a risk-free asset, in a given investment. The following formula applies:

Total return forecast + Inflation forecast (CPI) – risk free rate

In this case

4.5 + 1.8 -1.02 = 5.28%

Target rate of return/discount rate

Target rate of return pricing is a pricing method used almost exclusively by market leaders or monopolists. You start with a rate of return objective, like 5% of invested capital, or 10% of sales revenue. Then you arrange your price structure so as to achieve these target rates of return.

This is estimated as follows:

Risk free rate + Risk Premium = 5.28 + 10 = 15.28%

Thus if South Bank holdings proceeded with this investment they would receive a strong return of 15.28%. This figure represents a high risk investement which will have a significant impact on the Net Present Value

Exit yield

Exit yield is the value applied to the projected income on the assumed sale date of the investment. According to Knight Frank (2018) a figure of 4.00 to 4.25% with a stable outlook is proposed.

Tenancy Assumptions

It is assumed that the past mix and longevity of tenants will continue. There are no radical shift of occupancy patterns anticipated, but occasionally in the history of commercial markets radical shifts can occur. The outcome to the Brexit being seen as the biggest risk to tenant patterns.

Acquisition and Disposal Fees

Table 1 summarises the assumed costs (based on averaging the costs obtained verbally from a range of solicitors and agents working in Midtown London

1Associated professional fees

Discounted Cash Flow Calculations

Discounted Cash Flow Analysis (“DCF”) is the foundation for valuing all financial assets, including commercial property. The basic concept is simple: the value of money today is worth more than money in the future. The value of an asset is simply the sum of all future cash flows that are discounted for risk. Assuming South Bank Holdings pays the asking price of GBP 25 Million the NPV of the investments is GBP 25 Million. Assuming the building is held for 10 years the following figures are calculated:

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Gross Initial Yield – 3.58%

Net initial Yield – 4.43%

GPV (taking into account the acquisition and disposal fees) = GBP 26,107,500

This does not represent a good enough return on investment.

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Risk Assessment

All the calculations are based on projected figures and intelligent reports from ‘experts’ in the market place: however, these are always caveated that they are to be used with care.

Conclusion

The trend in midtown London is for more residential than commercial property, however it is anticipated that in 2019 real estate investors zero in on the fundamentals of supply and demand in the UK market to support secure income streams, placing greater reliance on rental growth to deliver capital appreciation, to reflect the uncertainty surrounding the UK’s economic and political environment, particularly in connection with Brexit.

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