April 25, 2014 7:33 pm

Why developers in London are building on unsteady ground

The city’s increasingly commodified real estate market is dominated by speculative foreign buyers
London Perspective, illustration by Clare Mallison©Clare Mallison

Move over St Paul’s Cathedral and the London Eye. The dome and big wheel are no longer the defining architectural features of the London skyline. Slowly but surely, they’ve been replaced by a sprawling canopy of cranes. The question is: to what degree is this choppy panorama representative of a building boom that’s gone haywire and about to engulf the capital with more supply than it can handle at current prices?

The standard narrative, of course, is that the development rush is more than justified. London asking prices, as tracked by Rightmove, have outperformed the national average by 30 per cent over the past five years, reflecting a chronic shortage of housing in the UK capital. What is more, almost every sector specialist predicts that the market will stay woefully undersupplied for years.

Analysts at Barclays noted recently that the 20,000 new units of supply being added to the market every year isn’t nearly enough to compensate for the demand being spurred by low interest rates and a rising urban population. That, the Barclays analysts said, did not account for foreign buyers, whose pursuit of real estate as a safe store of values rather than as living space is crowding out London’s prime markets at glaring rates.

The figures in that respect are stark. According to developers’ own stats, as cited by Barclays, up to two-thirds of off-plan London home sales are being sold to southeast Asian buyers direct.

In the short term it’s a clear-cut boon for London developers, especially those with strong pipelines of identikit, high-end flats, which appeal to foreign buyers due to their standardised and neutral form, making them extremely liquid investment vehicles.

In the long term it represents a brave new commoditised real estate world in which generic flats have become equal to gold, property developers the equivalent of gold miners, and London the Klondike territory. However, as with most commodities, be careful what you wish for because there’s nothing like a rush to kill a rush.

The reasoning for this is simple. High prices make investing and prospecting for new supply economically viable, which leads to more supply, which corrects the market imbalance, which eventually sees prices fall. If more supply is not available for any reason, high prices then lead to demand destruction or substitution.

Either way, prices will correct eventually. How smoothly or disruptively they do so depends on how effective the market signals have been about forthcoming demand and supply. Sometimes – in a telling sign that prices may have been out of whack with actual consumption demand – the supply attracted to the market can end up overcompensating for demand so much that prices have no choice but to fall below the break-even rates of new entrants.

When that happens, there can be disruptive consequences for the sector’s oldest and least technologically efficient producers, who – unable to compete with more efficient newcomers – are forced to reduce capacity or leave the market entirely. This is when bankruptcies and defaults happen.

Luckily, commodities benefit from large, liquid futures markets which can help both investors and consumers to signal new supply or demand to the market efficiently.

Producers – ever mindful of price declines – do so by selling planned supply forward, in a way that guarantees them a break-even rate on their investment. Consumers who are mindful of price rises do so by reserving a right to buy tomorrow’s supply at today’s prices.

Miss-assessment can occur, however, if investors or consumers decide to abstain from the hedging process entirely – perhaps due to the fear of missing out on a bull or bear run – or if speculators, who don’t have physical needs, enter the market in large sums skewing the signals from real buyers and sellers.

Developers take on most of the risk of price reversals in a framework where only a small deposit stops buyers from walking away when things get tough

Which raises the question: could the increasingly commodified London real estate market be experiencing a similar problem? After all, London real estate does not benefit from a liquid futures market to forecast its future supply needs. Developers base their investment decisions on other variables such as funding costs, current market prices, and handcrafted projections about future demand. Supply-side figures, meanwhile, are estimated using public approval data or the tracking of competitor activity.

Yet, speak to local authorities and they struggle to shed light on how much volume is really coming to market, because approvals don’t equate to guaranteed supply, and developments can take an indeterminate number of years to come to market. As for demand, their figures represent local needs at best and say little about wider demand destruction factors.

That means the nearest thing to a projection market is the one for pre-selling developer inventory, which by developers’ own admission is dominated by foreign speculative buyers rather than the domestic, dependable sort.

Thus, there are two things to keep in mind. First, the act of pre-selling can see developers miss out on the full fortitude of bull markets, a factor that might encourage them to overbuild if and when prices keep rising, rather than to renege on unfavourable contract terms when delivery dates arrive. Second, it sees the developers taking on most of the risk of price reversals in a framework where only a small deposit stops buyers from walking away when things get tough.

To what degree this is obscuring the supply-and-demand picture is hard to estimate. Generally speaking, however, when two-thirds of your “futures” market is dominated by speculative flows, and new supply is almost entirely catering for it, it’s probably wise to start factoring things like crane count into your housing market view.

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Izabella Kaminska is an FT Alphaville reporter

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