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• At £9.3 billion, the total amount invested in London鈥檚 office market last year was below the long-term average of £12.5 billion
• We expect London to continue building on its position as the world鈥檚 most sought-after commercial investment destination
• ESG used to be compliance driven and a 鈥渢ick-box exercise鈥�, but now investors are demanding more
• 40% of the capital chasing London assets this year will be targeting stock that can align with investors鈥� own ESG targets
• We see a clear risk that there could be a cliff-edge 鈥渂rown value collapse鈥� on the not-too-distant horizon

A return to 鈥渘ormal鈥� in 2021?

With available opportunities, including assets under offer, 58% above this time last year, 2021 looks set to be a year in which investment volumes trend towards 鈥渘ormal鈥� levels. During 2020, investment turnover reached £9.3 billion, down on the long-term annual average of £12.5 billion, but well ahead of what was experienced during the depths of the global financial crisis in 2008 (£6.8 billion) and 2009 (£6 billion).

Read: London investment set for rebound in 2021

The total for 2020 masks the rebound in activity in the closing months of the year, with Q4 registering almost £4.9 billion of deal activity. Our Global Capital Tracker and London Capital Gravity Model both hint towards a normalisation in investment activity this year.

Read: Forecasting future capital flows

鈥淥ur Global Capital Tracker and London Capital Gravity Model both hint towards a normalisation in investment activity this year.鈥�

We expect London to continue building on its position as the world鈥檚 most sought- after commercial investment destination, following its emergence as the leading city for cross-border investment in 2020, as well as the top location for cross-border private investments. London has long been top of the target list for private investment and attracts the widest pool of private investors globally, despite the uncertainty created by Brexit.

Read: Private wealth remains focused on London

What to watch for

So, how will the weight of capital we have identified target assets in London? We investigate four key themes:

• Fierce competition for prime, core assets

We expect pricing for core assets to remain stable, as investors continue to pursue the relative discount available in London when set against other European cities and alternative investment classes. Furthermore, extensive quantitative easing globally, and, finally, a Brexit trade deal, will result in prime yield compression in central London over the next 12 months. Indeed City yields tightened by 25 basis points during Q4 2020 and currently stand at 4.00%.

We expect London to outperform due to an increased focus on best in class assets in sought-after locations. Investors reacting to key occupational indicators will favour global gateway cities, such as London, that provide greater resilience to the impact of any office space rationalisation.

Read: Global cities: a concept in question?

鈥淏uyers are seeking opportunities in strong micro-locations, usually centred on Crossrail interchanges.鈥�

• 鈥淒evelop to core鈥� plans

During 2020, a number of investors struggled to deploy capital. The restricted supply at the start of 2020 and laterally, pricing resilience, is leading to a growing trend for 鈥渄evelop to core鈥� plans. This is where buyers are competing in the 鈥渧alue-add鈥� market, with a lower cost of capital than traditional developers.

Typically, these buyers seek to identify investment opportunities in locations usually centred on Crossrail interchanges, offering either favourable existing market dynamics (think demand vs supply), or the opportunity to deliver best-in-class offices.

• The widening gap between prime and tertiary assets

Inevitably, a flight to quality will see the gap between prime and tertiary assets widen and discounts are already appearing.
From an income perspective, medium-term profiles will be more challenging than ever as investors and lenders, fixated on five-year horizons, struggle to adapt their plans.

Recent years have seen a broad expansion of 鈥渁cceptable鈥� investment locations across London, but there will be areas that miss out. Less fashionable locations, especially those lacking an infrastructure angle, or a 鈥渘ew economy鈥� appeal to tenants, will experience a material shift in pricing.

Core-plus assets have struggled during the pandemic, as capital has polarised towards core income and best-in-class value-add opportunities. Core-plus, typically providing income of three to eight years, accounted for just 21% of deal volumes in 2020, whilst core and value-add investment dominated (79%), reflecting the disparity in the depth of capital.

鈥淭enants within sectors perceived to be resilient, or within growth areas will be favoured.鈥�

• A shift in stock selection criteria

The post-pandemic environment will result in closer scrutiny of key specifics, the most important being income quality and, more specifically, covenant conviction. Covenant testing and analysis will become increasingly vital, meaning premium pricing will be reserved for ultra-secure, defensive, covenants. Obvious sectors that may fall into this category include the tech and public sectors.

There will also be a greater focus on future-proofed assets from a wide range of perspectives. Again, those tenants within sectors perceived to be resilient, or within growth areas, will be favoured over older, often more-established occupiers, from less agile industries.

Environmental, social and governance aspects (ESG) will be fundamental to this scrutiny. All of these metrics will begin to feed directly into liquidity and pricing, with the downside risk being at least initially, far more impactful than the potential upside.

So why is ESG so crucial?

Important to both investors and occupiers, ESG is no longer viewed as just 鈥渢he right thing to do鈥�. Stakeholder expectations are already forcing the ESG agenda further and faster.

And it鈥檚 easy to understand why: 40% of carbon emissions come from the built environment, so real estate plays a crucial role in addressing the climate emergency. And the social elements of property have been propelled further into the limelight in the wake of the Covid-19 pandemic.

We have identified three key reasons why ESG is rising up investors鈥� agendas so rapidly:

• Mounting investor pressure: ESG used to be compliance driven and a 鈥渢ick-box exercise鈥�, but now investors expect more, putting direct pressure on institutions, funds and property companies, driving competition and creating peer pressure.
• Increasing regulation and corporate reporting: minimum Energy Performance Certificate (EPC) requirements are already changing and there is a significant shift towards the reporting and benchmarking of ESG performance. The most prevalent example is the Global Real Estate Sustainability Benchmark which, in 2020, saw reporting from more than 1,200 companies globally, reflecting US$4.8 trillion of assets under management.
• Portfolio/building obsolescence: More awareness of 鈥渢ransition risk鈥� will mean that 鈥渘on-compliant鈥� buildings, i.e. those that don鈥檛 meet the prevailing investor and occupier expectations around green ratings, will likely deplete in value rapidly. This risk relates to changing regulation and technology, as well as the associated costs of bringing assets up to standard. Tenants are demanding buildings that reflect their values and those that help, not hinder, them in achieving their own ESG targets.

鈥淟ondon is already one of the most advanced in terms of ESG adoption with just under 3,000 green-rated buildings.鈥�

Is London the world鈥檚 leading ESG centre?

We estimate that 40% of the capital chasing London assets this year will be targeting stock that can align with investors鈥� own ESG targets. Clearly, this a global issue, but there are differing levels of adoption across the world. For instance, we know this is particularly high up the agenda for UK, European and Australian investors.

London is already one of the most advanced locations in terms of ESG adoption with just under 3,000 green-rated buildings, almost 1,000 higher than second-placed Singapore.

We believe that investors will increasingly look to assess assets using a version of a 鈥淐limate Value at Risk鈥� or 鈥淐limate VaR鈥� model. This takes into account three components: physical risk; geographic risk; and tenant counterparty risk.

We believe appraisals and valuations will increasingly be looking across factors such as the performance of the physical asset itself, its geographic locational risk and increasingly, a consideration of the type of tenant and their particular sector, or line of business. Of course, none of these factors is new; however, the depth of consideration given to them will increase substantially as ESG takes centre stage.

Investors are increasingly examining transition risk when evaluating acquisitions and their existing portfolios. Whether or not an asset can be aligned to an investors鈥� own carbon targets and other ESG performance benchmarks will ultimately impact which assets they hold, acquire and divest from.

鈥淲e see a clear risk that that there could be a cliff-edge 鈥榖rown value collapse鈥� on the not too distant horizon.鈥�