PLANTATION PLACE LONDON EC3
4TH FEBRUARY 2009
ON BEHALF OF
N M ROTHSCHILD & SONS LIMITED
CB Richard Ellis Indirect Investment Services Limited Kingsley House Wimpole Street London W1G 0RE
Switchboard 020 7182 2000 Fax No 020 7499 9624 Direct Line 020 7182 2740 [email protected] N M Rothschild & Sons Limited Our Ref Your Ref New Court St Swithin's Lane 4th February 2009 London EC4P 4DU
Attn: Dan Matthews
Dear Sirs
PLANTATION PLACE, LONDON EC3
In accordance with your instruction of 27th January (Appendix I) we have pleasure in providing our investment views regarding the current market value and marketability of Plantation Place, London EC3 (‘The Property’). This advice is subject to our standard terms and conditions as detailed in Appendix II and is solely for the benefit of those parties detailed in your instruction letter.
As such we have provided summaries of the current market conditions in the City’s investment, occupational and development markets and thought has been given to future market forecasts. Consideration has been given to the asset profile and the future performance that this property should provide. Strategic options for a future disposal are discussed as are the estimated net proceeds that such a disposal could generate.
1. City of London Occupational Market
a. Current Conditions
By the end of 2007 the City of London office market had enjoyed four years of rental growth and vacancy rates had reached their lowest point since 2002. This, however, changed dramatically through 2008, City Office take up fell from 5.1m sq ft in 2007 to 3.6m sq ft in 2008 with only 600,000 sq ft of lettings in Q4 2008. This compares to a 10-year average of 4.9m sq ft annually. A marked illustration of the occupational market has been the lack of larger lettings, with the largest deal in Q4 being only 30,200 sq ft.
Rental growth over the last three years in the City market has been substantial. Prime rents grew 19.60% throughout 2006 and 11.50% throughout 2007, but the lack of demand and an increase in supply of space resulted in a year on year prime rental growth of minus 17.69% for 2008. City rental levels thus peaked in mid 2007, with the top headline rental values being in the region of £65.00 per sq ft on new Grade A properties. This is at a similar level to the early 2001 peak, but still less than its peak of the late 1980’s where prime Grade A rents peaked at £72 per sq ft. On any inflation adjusted measurement, rental growth measured on a peak-to- peak basis has been negative for approaching 30 years.
Registered in England No 02535405 Registered office St. Martin’s Court 10 Paternoster Row London EC4M 7HP CB Richard Ellis Indirect Investment Services Limited is authorised and regulated by the Financial Services Authority CB Richard Ellis Indirect Investment Services Limited, a part of CB Richard Ellis Limited. - 2 -
City Office availability increased consistently throughout 2008. From a low point of approximately 6% in December 2007 availability rose to 8% by the end of 2008.
City Office Availability Q4 2008
Secondhand New Completed New U/C
14.0
12.0
10.0 8.0 8.0 7.8
6.0 million sq ft million
4.0
2.0
0.0 2002 Q1 2002 Q2 2002 Q3 2002 Q4 2003 Q1 2003 Q2 2003 Q3 2003 Q4 2004 Q1 2004 Q2 2004 Q3 2004 Q4 2005 Q1 2005 Q2 2005 Q3 2005 Q4 2006 Q1 2006 Q2 2006 Q3 2006 Q4 2007 Q1 2007 Q2 2007 Q3 2007 Q4 2008 Q1 2008 Q2 2008 Q3 2008 Q4
Source: CB Richard Ellis CB Richard Ellis | Page 26
Prime City rental values1 currently stand at £53.50 per sq ft having fallen from their peak at the start of 2008 of £65.00 per sq ft. However, evidence is apparent that rents are now falling.
Coupled with falling headline rents, the occupational market has seen an increase in overall incentives or other forms of inducement offered to prospective tenants. As such, the current total rent free period (or other equivalent incentive) granted on a new 10-year lease is now in the region of 24-months, whilst a 15-year lease would have the benefit of up to 36-months rent free. For reference in 2007, rent free periods (or other incentives) were 12-months on a 10-year term and 24-months on a 15-year letting. As a result, net effective rental values in the city have fallen considerably during the last 6 months. These incentives are continuing to increase as competition between landlords increases.
There is now evidence that whilst headline rents for smaller units remain relatively stable, lettings for large units say in excess of 100,000 sq ft are being negotiated at heavy discounts.
1 Units of 15,000 sq ft of Grade A accommodation let for a term of 15 years.
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City Top Prime Rents vs Rent Free Periods Q4 2008
Rent Free Periods Rent (RHS) Net Rent (RHS) 35 70 65 30 60 25 55 Rents £ psf
20 50 45 15 40 10 35
Rent Free Period Months Period Free Rent 30 5 25 0 20 1994 Q2 1994 Q4 1995 Q2 1995 Q4 1996 Q2 1996 Q4 1997 Q2 1997 Q4 1998 Q2 1998 Q4 1999 Q2 1999 Q4 2000 Q2 2000 Q4 2001 Q2 2001 Q4 2002 Q2 2002 Q4 2003 Q2 2003 Q4 2004 Q2 2004 Q4 2005 Q2 2005 Q4 2006 Q2 2006 Q4 2007 Q2 2007 Q4 2008 Q2 2008 Q4
Note: The net effective rent is calculated using a DCF over 10 years @7% and assumes a 3 month fitting out period Source: CB Richard Ellis CB Richard Ellis | Page 27
b. City Development Pipeline
Development completions are set to peak in 2008, with 12 of the 15 largest Central London schemes being located in the City market. However a number of large schemes are also currently under construction and will be delivered in 2009, such as Watermark Place, Ropemaker Place and The Walbrook, all of which will each provide over 400,000 sq ft of new Grade A accommodation.
The total level of supply of new Grade A office space in 2008 was 4.0 million sq ft, with 2.4 million sq ft of space in 2009 and 2.0 million sq ft of space in 2010 being delivered. There are very few schemes which are being proposed for 2011 onwards at this time with only 1.0 million sq ft estimated to be completed during 2011 of which the Heron Tower accounts for approximately half of the 2011 total supply.
Not surprisingly, a number of high profile UK developers and property companies have put on hold plans for development activity in the City market which could lead to a shortage of newly completed stock in the City after 2010. Several high profile, proposed schemes such as Arab Investment’s ‘The Pinnacle’, British Land’s The Leadenhall Building and Land Securities’ 20 Fenchurch Street have all been put on hold whilst the date of completion for schemes such as Metrovecesa’s Walbrook Square is currently unconfirmed.
The graph below provides a guide of developments currently forecast to be completed up to 2011, and highlights City development completions back to 1985. This graph highlights the peak of development completions during previous cycles which includes in excess of 5.8 million sq ft delivered in 1991 and 3.3 million sq ft delivered in 2003.
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City Developments 1985 - 2011
Completed U/C Let/Under Offer U/C Available Proposed Let/Under Offer Proposed Available 7.0
6.0
5.0
4.0
3.0 million sq ft
2.0
1.0
0.0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: CB Richard Ellis, December, 15/01/2009 CB Richard Ellis | Page 28 c. Market Rental Forecasts
The implications of recent events in the banking and finance sector will undoubtedly have a major impact on the City occupational market. It is expected that the levels of supply of second hand or Grade B space could increase dramatically either as a result of business failure or consolidation of banks and other financial institutions. For example, following the takeover of both HBOS and Merrill Lynch by Lloyds TSB and Bank of America respectively, it is expected that some of their existing office accommodation will be surplus to requirements and that they may seek to co-locate in the medium term. This could increase the level of availability going forward, having a further short term negative affect on rental levels in the City.
In an economic scenario dominated by progressive de-leveraging in credit and financial markets, business activity in Central London is likely to be severely impacted. The City of London, as one of the key global financial centres, with a high degree of specialisation in finance and business services is highly exposed to this current trend.
On the occupational demand side, the most likely effect will come through weaker take up throughout 2009 and potentially into 2010. In the short term, the increased market uncertainty and weaker economic growth will inevitably produce greater caution and reluctance to make significant leasing commitments.
Recent announcements of job losses at a number of major investment and clearing banks combined with general consolidation across the Financial Services sector have lead to forecasts of approximately 63,000 job losses in the City spread over 2008 to 2010. This reflects an approximate 10% reduction in City employment from the 2007 peak. It is anticipated by many observers that total job losses will peak in 2009, with 33,000 jobs forecast to be lost.
The combination of increased short term availability through development completions and sub let space and lower demand will produce weaker rental growth than previous envisaged. In addition, owing to the expectation of higher availability the recovery in rental growth previously anticipated in 2010 is now expected to be delayed until 2011. As such, City rental levels are likely to take longer to bottom out, probably taking place some time in 2010, and are unlikely to regain their 2007 levels until 2014 at the earliest.
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Although the market is currently less threatened by over-supply from new development completions than in the early 1990s, the greater threat currently to rental values in the City is from weaker demand. Availability levels may therefore revisit the levels at the start of this decade rather than the peaks of the early 1990s. However rental values will nonetheless be under significant downward pressure that may witness levels fall to values comparable to that of 2001 – 2004.
With the current prime headline City rent having already fallen 17.69% during 2008 to its current level of £53.50 it is expected that rents will continue to fall as increased levels of supply outweigh tenant demand. The forecast drop in rental levels in the City going forward is largely uncertain and there is no consistency of opinion as to the rate of decline amongst researchers at this stage. However many believe that rental values will continue to fall during 2009 and part of 2010, before we witness a strong recovery in 2011 if (and it is not certain) we see low levels of development supply at a point where there is increased occupational demand as the general global economy recovers.
The most recent CB Richard Ellis forecast (Oct 2008) is for prime City rents to bottom out at approximately £45.00 per sq ft before any recovery takes place. However, the speed of the recovery in 2011 and thereafter was expected to be in line with the spike in rental values witnessed in 2006 and early 2007 where prime rents rose 30% from £50.00 per sq ft to £65.00-67.50 per sq ft during an 18 month period.
Whilst this scenario represents CB Richard Ellis’s main forecast for City rents the uncertainty around the economic outlook creates a high degree of variability around the base case. If the loss of employment in the financial sector is greater than anticipated in the short term, or the pick up in employment from 2010 onwards proves more gradual than anticipated then under these conditions, the possibility that rents might fall more steeply to less than £45 at their lowest and rebound more slowly thereafter would be a likelihood. CB Richard Ellis are presently reviewing their forecast in light of the size of contraction in Q4 2008. These figures are not yet available.
City Prime Rents: 1984 – 2013 Q3 2008
City Main case Downside 80 FORECAST
70
60
50
£ per£ sq ft 40
30
20 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: CB Richard Ellis CB Richard Ellis | Page 57
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2. City of London Investment Market
a. Current Conditions
A total of £2.8 billion of City Office Investments were transacted in 2008. This contrasts to a ten year average of £4.4 billion. The 2008 number also, arguably, overstates true volume as it includes the repurchase by HSBC of their tower at Canary Wharf for £838 million following a loan default by Metrovesa to which they were the sole creditor.
The market has also witnessed a significant drop in the number of investment transactions over £100 million where there have been a limited numbers of buyers. If one excludes the HSBC tower, the largest deal of the year was the purchase by St Martin’s Property Corporation of the Willis Building which was developed and completed by British Land in late 2007. The property was sold in May 2008 for £400 million reflecting a net initial yield of 5.75%.
The only other transaction over £200 million that did not involve the occupational tenant was the purchase by Deka of Moor House, 119 London Wall. The then rack-rented property was built in 2004, is held long leasehold from the City Corporation with a 3.50% ground rent and is multi-let with occupiers including HVB Group and Macquarie Bank. The price achieved was £230 million which reflects a net initial yield of circa 6.50%. The length of secure income is an average of nine years, and the sale was completed in Q3 2008.
Although no large lot size transactions were concluded in the City (excluding HSBC) in the fourth Quarter of 2008, there was a spate of activity in the £50-£100 million category, some of which have still not completed and demonstrates the further re-rating of City Office yields.
Of particular note are:
1 Fleet Place EC4
Sold by Legal & General to London & Stamford for £75 million, the building is let to Denton Wilde Sapte for 16 years at a rent of £36 per sq ft, the initial yield achieved was 7.75%.
11 Pilgrim Street EC4
Let to Bechtel and Mayer Bro for a further 12 years at an average rent of around £45 per sq ft, sold by UBS to Pramerica for £53.5 million, 7.5%.
1 Plough Street EC4
Let to New Opportunities Fund for 12-years, sold by New Star to German Fund Union for £36.25 million, 7.3%.
It is also worthy of note that CB Richard Ellis are currently offering for sale the new Allen & Overy building at Bishops Square E1 on behalf of Hammerson. The building is let for a term certain of 18 years at an overall rent of £45 per sq ft. The building is being offered at £490 million, an initial yield of 7%, with the benefit of an existing £395 million, four year loan at a fixed rate of 6.27%. The availability of a debt package at a relatively high loan-to-value (75% at the quoting price) and no loan-to-value covenant is proving to be a significant factor in attracting investor interest.
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In summary City Office Yields have, and continue to, weaken at an accelerating rate. This is a function of weakness in capital and occupational markets; a re-evaluation of credit risk; and a general widening in the risk premium. The effects are most pronounced for large lot size investments where investors seek additional compensation for the increase in specific and liquidity risk, and is not aided by the virtual absence of debt.
Conditions within the debt markets have also become significantly more challenging over the last few months, and as such the number of active leveraged buyers in the market has vastly reduced. Coupled with this, a number of highly leveraged transactions which were completed during 2006 and 2007 are now showing stress under breach of loan covenants, which in some cases is leading to distressed sales.
A number of institutional investors such as New Star, M&G/ Prudential, ING, Legal & General and Standard Life have witnessed significant withdrawals from their retail funds during the second half of 2007 and throughout 2008. With an urgency to raise cash for redemptions, a number of City assets have been sold at significant losses to meet cash demands. The distressed nature of a number of these sales has lead to properties being sold below valuation levels. With cash pressures increasing on these funds again during the third quarter of 2008, city values continue to be driven down by effectively pressurised vendors.
Transactional timescales have also extended considerably during the last 12 months, with most property disposals taking between 3 – 6 months from the commencement of marketing, compared to 1 - 3 months in 2007. b. Historic Market Trends
The City market has historically shown high levels of pricing volatility which tend to be correlated to the UK economy. Since 1980, City yields have ranged from 4.00% to 6.50% (off the then current rack rent) at various different points in the cycle. As at 31 December CB Richard Ellis’s prime rack-rented City office yield was 6.65%, the highest yield we have recorded since commencing measurement in 1979 – the trend continues to weaken.
Nominal yields have often been significantly higher, a function of falling rental values and consequent over-renting during periods of economic weakness. In 1993, income yields across the City market rose to 10.92% (Source: IPD) as rents fell to approximately 50% of previous highs. In such periods income in excess of the rack rent is capitalised at a non-growth rate for a term limited to the length of the lease or for such lesser period as maybe deemed prudent, by the credit quality of the tenant.
The key to stabilization and recovery of the City investment market has historically been the occupational market. With average lease lengths in the IPD index having fallen from in excess of 18-years in 1993 to a little over 9-years today (source IPD) occupier confidence is likely to a be a pre-requisite of any investment market recovery this time round as void risk has clearly increased. c. Market Forecasts
The outlook for the city investment market is extremely uncertain at present given the general economic uncertainty surrounding the financial and banking sectors. As a result, transactional volumes are extremely subdued as property values continue to fall and the total number of active buyers in the market has contracted. The lack of debt financing available to leveraged buyers has reduced investment demand and with concerns regarding short term occupational supply and demand, investment values continue to trend weaker.
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Since mid 2007, City property prices have witnessed a 30% – 35%% fall in values. Prime City yields are now in excess of 6.50% with the most recent transactional evidence of deals having completed at yields in excess of 7%. With economic conditions continuing to deteriorate, it is expected that prime city yields in the short to medium term will continue to weaken driven by the worsening conditions in occupational markets, a continued lack of debt available for leveraged buyers, and a general hesitation by investors to act in such volatile conditions.
A key driver of investment yields in previous cycles has been the expectation of rental growth to enhance asset performance. For instance, the sharp yield compression witnessed from 2005 through to mid 2007 was to a large extent driven by expectations of rental growth in the City. Given the current negative forecasts for rental values in the City market, limited investment performance is expected in the short to medium term unless assets are significantly reversionary.
Levels of supply of investment property in the City are also currently high, driven by UK institutions who continue to seek to raise capital to meet fund redemptions; and funds and listed companies who are seeking to realise equity to stay within loan covenants. Market perception is that investors selling property in current market conditions are on the whole distressed and active buyers are using this to their advantage.
The graph below illustrates CB Richard Ellis’s forecast for prime City yields as at October 2008 and only apply to lot sizes up to £100m. The central forecast was that prime city yields would find a plateau at approximately 7% by the middle to end of 2009 (that is 7% of the rack rent at that time, forecast at £45 per sq ft, buildings like Plantation Place that are let at higher rentals would be perceived as over rented and would be expected to trade at a higher yield). The sharp compression in City yields projected from 2011 represents investor anticipation of a rebound in rental values coinciding with the recovery in the wider economy, but most notably London’s financial and business services, assisted by tight levels of supply with limited development activity from 2010 onwards. With investors attracted by the historically high City office yields, and the prospect of double digit rental growth, it is expected that prime City yields will harden back to circa 5%, its long term trend level. However, this is dependent on the global economy recovering and the timing of the recovery is unclear and thus subject to a high degree of risk.
Although these forecasts were produced a little over 3-months ago, the severe contraction experienced in Q4 of 2008 is likely to result in a deeper trough and a deferment of any recovery. Updated forecasts will be available by the end of February.
The one potential “silver lining” for the City office investment market is the current price of Sterling. The city market is a global market; indeed most investment sources its capital outside the UK. With sterling having fallen so significantly in the latter half of 2008, particularly against the Euro and Japanese Yen, we could see global funds investing in the City earlier than predicted for reasons that are not strictly related to the asset class itself.
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Prime City Office Yield Forecast
Prime City Yield IPD City All Property 12 Finishes 2008 at 6.5% Prime City Peaks at 7% 11 Hardens back to 5% by 2013 10
9
FORECAST 8 Total Correction
% 2006-2009: 275bp 7
6 Positive re-pricing: 2010-2013: 200bp 5
4
3 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
Source: CB Richard Ellis, IPD
3. Property Derivatives
The nascent property derivatives market provides an additional benchmark for measuring future property performance and a potential hedge to further market falls. Derivative contracts are written against the IPD annual total return index (rent and capital), a valuation index covering approximately £180bn of UK commercial real estate.
Despite the fall in direct property transactions the property derivatives market has been in the ascendancy with approximately £8bn being transacted of last year. Pricing presently extends out to December 2013, albeit at an All Property level only. Pricing for sub-sectors such as City offices is available on a request basis but liquidity in longer dated contracts is likely to be incredibly thin.
At All Property Level the property derivative market is forecasting the following capital returns (pricing as at 20th October 2008):
Calendar 09 - 20.0% Calendar 10 - 1.5% Calendar 11 + 10.25% Calendar 12 + 9.00% Calendar 13 + 10.75%
When one takes into account falls that were realised in 2007/2008, the anticipated fall - peak to trough - is approaching 58%.
To interpolate this data into yields, the impact of such capital fall would be to imply the following yields at All Property level.
Dec09 Dec10 Dec11 Dec12 Dec 13 IY 9.07% 10.13% 10.11% 10.25% 10.23%
Clearly, there is enormous basis risk between a single building and All Property IPD, but historically the City office market has been more volatile, not less, and as the lease length erodes the property beta component of this building will increase as credit risk diminishes.
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4. Plantation Place -Property Characteristics
a. Property Overview
The property was completed in 2004 by British Land Plc and provides in excess of 545,000 sq ft of Grade A office, retail, restaurant and ancillary accommodation together with 34 car parking spaces. The freehold island site extends to in excess of 1.90 acres and represents one of the largest holdings in the City of London. The property is situated in a core City location, traditional occupied by both banking and insurance companies. The area is currently the subject of significant development activity with a number of schemes scheduled to be developed in the short to medium term.
Providing a range of floor plates from 55,000 sq ft to 13,500 sq ft, the property appeals to a number of occupier types with the benefit of two specifically designed trading floors also provided. The property also benefits from excellent levels of natural daylight from all four elevations. The property was developed to an institutional specification and would meet the current standards expected by an occupier in the City market.
In terms of the overall build quality, this property is of the highest quality in the City, providing flexible accommodation which will appeal to a range of occupiers. There is a consensus that it is one of the best properties in The City and certainly in the EC3 (insurance) district.
b. Income Profile
The aggregate net rental income is currently £27,084,070 per annum exclusive, equating to approximately £49.50 per sq ft overall. Certain occupational leases provide for a minimum rental increases at the first review and accordingly, the rent reserved will rise to a minimum of £27,304,686 per annum by 1st April 2010. The average weighted unexpired lease term is approximately 17.50 years (to the earlier of the lease expiry date or the option to determine date).
72% of the contracted rental income is derived from leases which are secured against the covenant of Accenture Ltd (the ultimate parent company) for a further twenty one years certain.
The average office rent of approximately £49.75 per sq ft would now be regarded as over- rented given that rents on individual leases range from circa £46.00 per sq ft to £54.00 per sq ft against the current prime rent of £45 per square foot and falling.
With the majority of the office leases subject to upward only rent reviews in 2009 and 2010, assuming the current rental projections for the city market, it is unlikely that this property will deliver significant performance driven by rental growth in the short term. A small increase in the office passing rent will be realised by April 2010 given that certain leases contain minimum fixed uplifts at rent review.
Accenture (UK) Ltd have a total liability for 377,737 sq ft (71.74% of the total income), albeit have sublet 224,593 sq ft (equating to 59.50% of the floor space leased). Wachovia Bank National Association have a total liability for 51,134 sq ft (8.71% of the total income) until November 2019 (11 years unexpired). Aspen Insurance have a total liability for 49,555 sq ft (8.55% of the total income) until March 2020 (11.5 years unexpired). Royal & Sun Alliance have a total liability for 36,184 sq ft (5.90% of the total income) until June 2014. It should be noted that this lease contained a tenant option to determine in June 2009 subject to 12 months notice. It has been assumed that the tenant has not served notice to determine this lease and as such, the tenant has the benefit of a 25% rent reduction for 6 months from September 2009 to March 2010.
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Accenture occupation at the property is spread over 4 main occupational leases which is of significant benefit to a landlord at forthcoming rent reviews. Had Accenture occupied all 377,737 sq ft over one lease, it would lead to a discount being applied to the overall rental value being assumed at future rent reviews thus impacting on the level of rental growth that could be realised on this element of the property’s income.
The retail and restaurant accommodation accounts for approximately 4.70% of the total income and is let on terms expiring between 2015 and 2029.
With an average weighted unexpired term of approximately 17 years, this property offers an extremely attractive income stream to investors. The short term reversionary prospects are limited taking into account current City rental projections however the long term income streams should offer potential for growth in the future.
c. Covenant
The property has the benefit of income derived from a range of company sectors, including the professional services, insurance and banking sectors. This is increasingly significant in the current economic environment. The covenant strengths of the four main office tenants are historically strong; albeit the recent news that Wachovia Bank is in talks to be rescued by Wells Fargo will have an impact on investor’s views on the risks associated by that covenant.
Should a deal take place, it could be expected that the covenant strength would be improved on this element of the income stream. However it might be expected that Wachovia’s requirement for accommodation in the property may change particularly if Citigroup do rescue the Bank given that Citigroup’s HQ building is located at Canary Wharf and currently has capacity to house Wachovia’s employees.
With 72% of the property’s income secured against the single Accenture Ltd covenant, some investors may have concerns regarding the exposure this asset has to one tenant. Accenture have sub – let a large proportion of space to good quality sub tenants which some investors may view positively as mitigating risk.
5. Asset Value: Factors Affecting Pricing
a. Asset Quality
The property is of undoubted physical quality and is likely to appeal to a wide array of international investors seeking high quality assets. The specification of the property is to the standard expected by international occupiers and as such the current estimated rental values of the office space are not markedly below that of newly completed developments. The asset is situated in a core EC3 with significant prominence on to Fenchurch Street, an area which appeals to banking and finance, insurance and professional services occupiers. The duration of secure income streams and quality of tenant covenants make this asset extremely attractive to investors. Given that the property interest is held freehold, the asset will appeal to all investors (a number of investors, particularly Middle Eastern, will not consider long leasehold interests in property).
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b. Asset Performance
Given our forecast for prime City office rents, we consider it unlikely rents will increase above their current passing rent, other than through fixed uplifts, on reviews to be undertaken between 2009 and 2012. Furthermore, the timing of the rent review cycle is not optimal and may result in a zero rate uplift at the second review date, particularly those at the early part of the cycle. Short to medium term rental growth is therefore unlikely to be a driver of investment performance or a motivation for buyers in the near term.
The longevity and quality of the income (average weighted unexpired term of approximately 17.50 years) is likely to be the principal attraction of the building. With 20-year gilts currently yielding 4.54% (2nd February 2009), the building will return a positive risk premium of 2%/3% per annum, with potential for rental growth in latter years. Whilst we acknowledge the re-pricing of risk that is occurring at present, on a historical basis this would be regarded as a reasonable risk premium for an asset with these qualities.
There is always the possibility that a short-term outward yield shift could be reversed in a 3/5 year period generating additional capital returns. There are several potential economic scenarios that could result in yield compression: Stronger than anticipated rental growth is one scenario; the return of cheap credit and high loan to value ratios is another unlikely motivation; but yield compression could also follow a period of deflation and a consequent fall in the risk free rate.
The extent, to which investors may anticipate capital growth, is ultimately a function of the scale of adverse rental/yield shift we experience over the next few years. In our opinion it is however unlikely that anyone will forecast yields returning to their 2007 peak for some considerable time. This pricing was predicated by unprecedented liquidity, driven by an abundance of cheap credit, rather than by property fundamentals and a return to this economic environment is improbable in the foreseeable future.
If the asset is held for any material length of time depreciation will also be a material driver of asset performance. There are several factors that can lead to depreciation, locational and physical obsolescence being the most obvious drivers, but given this is a relatively new development neither are likely to materially impair performance in the short to medium term. In this instance short-term depreciation is likely to occur through erosion in lease length, in effect a reduction in credit risk and an increase in reversionary risk. This is likely to be particularly pronounced in building like Plantation Place where a large proportion of the income is let to a single tenant on broadly co-terminus lease terms.
It is difficult to empirically quantify this risk, but there is no doubt that buildings let for terms longer than 15-years tend to trade at a premium to our prime yield and at a discount to it when the lease term is less. Whilst depreciation is likely to be nominal over the next 2/3 years if the building were to be held to loan maturity so that average weighted lease length were no more than 12-years it is probable, that all other things being equal, an investor would attribute some discount to our prime yield.
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c. Liquidity
Plantation Place is a significant capital commitment for any investor and its acquisition would result is considerable specific risk.
Investors have traditionally mitigated these risks through a combination of gearing and co- investment. Although co-investment remains an attractive investment option for many national and global funds, it requires an enormous equity commitment in the absence of leverage.
Whilst it is without doubt still possible to arrange debt it is only available at relatively low loan to value levels and at considerably higher margins than has historically been the case. The consequence of this is that debt is likely to be income dilutive in the near term increasing capital risk and consequently investors required returns. The inability to leverage to higher levels may also discourage some overseas investors who may have to bear a higher withholding tax burden than would have previously been the case, albeit the JPUT structure through which this asset is held may alleviate this issue.
The limited scope for gearing and the resulting demands on equity reduces the scope of potential purchasers. Those purchasers willing to consider such investments are increasingly seeking a deeper discount to the market yield to compensate them for the reduction in liquidity and increase in specific risk. Whilst is it difficult to quantify the extent of any discount it is broadly perceived that buildings with a current value exceeding £150 million are likely to sell at discounts of 0.50%-0.75% to our prime yield. Given the size of this property, it is expected that a similar discount would need to be applied.
If the availability and cost of debt were to reduce over coming months then arguably the potential market for this investment increases and the lot size discount may fall. It is not without possibility that it could be eradicated if the introduction of debt was accretive to income. d. Market Perception
The majority of vendors currently disposing of assets in the City of London are doing so either to raise capital to meet fund redemptions or because they face financing difficulties. Plantation Place falls into the latter category and has attracted a large amount of media commentary in recent months, speculation that a ‘distressed’ sale may arise. That perception is seldom consistent with achieving optimal pricing.
The perception is compounded by the fact that the current owners have been seeking to sell this asset for over 12-months. Their initial asking price was cut from £600 million, to mid- £500 million and then more recently to a price “in the region of £500 million”. Against this background the investment market is fully aware of the assets valuation through public disclosure required of the loan servicer.
Plantation Place is not alone, other large City office buildings face imminent refinancing; Mid- City Place acquired in 2007 at £320 million is due to refinance in July of 2009; the Simon Halibi £1.7 billion Central London Office portfolio is scheduled to refinance within a year. Both will find the task challenging in current market circumstances.
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6. Potential Purchasers
Despite potential adverse market risks, Plantation Place would appeal to a broad audience of investors if those risks were fairly priced. Its position in the London market, the quality and longevity of the income combined with its freehold ownership should ensure broad interest.
Demand is likely to be international rather than domestic and is likely to emanate from all continents. The Australian superannuation funds have been active investors in the UK retail market, but have only a limited exposure to office properties; North American investors from both the US and Canada continue to increase their real estate exposure and diversify away from their home market; inward investment into the UK from China and Japan is increasing; and there is always some interest from the Middle East in prime London assets.
European interest is potentially more limited but nonetheless apparent and we would not rule out a UK entity, be that a fund or a listed REIT acquiring the building in common with other global funds.
7. Approach to Disposal & Estimated Net Proceeds
In the event of a sale you have asked us to give consideration to how that process might best be handled to optimise proceeds and mitigate market risk to the bond holders.
Whilst it would be normal practice for a sale of an asset like this to be narrowly marketed, public disclosure of any enforcement action would be likely to result in extensive press coverage. Accordingly, we do not believe a discreet marketing is genuinely a viable option.
If a sale was undertaken in Q1 2009 we set out below our expectations of receipts, based on information available to us at this date. Whilst we appreciate this is less than the most recent valuation, we have current experience through the marketing of Allen & Overy’s building (£490m) that gives us an insight as to what investors might be willing to pay in the absence of an embedded loan.
Net Proceeds Net Initial Yield Likelihood
£368 million 7.25% 25%
£356 million 7.50% 40%
£345 million 7.75% 60%
£332 million 8.00% 80%
If the building was sold with the benefit of a loan of around £300m, the probability of achieving a higher consideration would materially be enhanced.
In all scenarios listed above (and at the current valuation) a sale would result in a loss to both the senior and sub-ordinate loan. The loss will be compounded by the need to sever the existing interest rate swap. The break cost (the differential between the fixed rate and the current rate to maturity by the period to maturity) is estimated at £34m and when combined with sale costs of approximately 1%, there is a chance that all categories of note holders other than the AAA class could suffer total loss. Indeed, there is a small chance that even the AAA class could see some diminution in their investment.