Chairman's letters

19 October 2016

Guy Hands speech at MIPIM UK: Brexit and its impact on UK property investment

Good morning.

Since the outcome of the EU referendum in June, we in the real estate investment industry have been facing a big question: how will Brexit affect property values in the UK?  

I have been involved in real estate investment in the UK and Europe for many years, and I have seen property markets go through numerous boom and bust cycles. On an institutional basis, I started in the early 1980s at Goldman Sachs, working to put together futures contracts on real estate prices, before becoming involved with property securitisations. Amongst other assets, we securitised shopping malls, Saks Fifth Avenue and pubs. In 1995, after founding the Principal Finance Group at Nomura, we acquired 1,800 pubs from Grand Met and Fosters, which we grew to a portfolio of nearly 9,000 pubs by 2001. 

Over the last 20 years at Terra Firma we have conducted over €15 billion of real estate transactions, including one of the largest ever transfers of residential property in the UK: the acquisition of more than 57,000 properties from the Ministry of Defence in 1996 to form Annington Homes. More recently, in 2014, our exit of Deutsche Annington and its portfolio of 180,000 German homes realised one of our most successful investments.

While I have been involved in property on an institutional basis since the 1980s, my personal involvement goes back even further. I bought my first property while at university in Oxford in the 1970s: an old, derelict house in need of complete renovation. I also bought an old laundrette while still at university, which I turned into an art gallery.

On a personal basis I have made some great investments, and I have made some terrible investments. By far the worst were the light industrial units which I bought in Rotherham in the 1980s, while my best was a share in a London Docklands office block, also in the 1980s. Today one of those is worth 10% of the value at which I bought it; the other is worth more than 10 times the amount I paid. Fortunately, I put four times as much into Docklands property than light industrial property in Rotherham.

A few years later, a friend at Goldman paid $1 million for a spectacular apartment in Tokyo. In 1990 nobody would have believed that Tokyo real estate would go down in value compared to London property. Today that apartment is worth less than $600,000, as property in Japan has fallen by more than 40% over the past 25 years. 

During this same period, prime property has increased in value by over 10 times in parts of London. The same amount invested in a London apartment as my friend invested in Tokyo would be worth $10 million today. That is a return more than 16 times better than the so-called ‘sure thing’ of investing in prime Tokyo real estate in 1990.

During the last 30 years I have seen London prices fall by almost 20% in a single year twice, in 1990 and 2008, and rise by over 20% between 1986 and 1987, and again in 2013 to 2014. I have seen up markets and down markets, and when people have said that real estate will go down because of a falling currency, I have seen the reverse happen.

What I have learnt is that having complete confidence in any prediction about property prices is impossible. Nobody has any real idea of what will happen, especially now following the Brexit vote. 

Therefore, what I can do this morning is tell you some of the things that I believe will affect UK property investment over the next 10 to 20 years. However, what I cannot tell you is when – or if – property prices will go up or down. Investing in property is a risky business, and one which requires a long-term perspective.

Take the case of Annington Homes, which is today the largest private owner of residential property in England and Wales. The story of our Annington ownership is one which provides a good indication of how UK property investment should be viewed over the long term.

In 1996, NatWest Bank identified more than 100 potential buyers for the MoD’s estate, and predicted a selling price of £1 billion, compared to the MoD’s estimate of £400 million. We were part of a competitive auction process lasting more than one year, which in the end received 19 qualified bids. Warren Buffett is believed to have bid £1 billion, while Lehman Brothers’ consortium offered the second-highest bid at a reported £1.5 billion. Our bid was £1.67 billion, which was comfortably the highest.

In November 1996 we purchased the freehold of the portfolio along with over 2,000 sets of keys to the homes being released to us in the first year. These homes were in desperate need of renovation, and we immediately found ourselves spending money to bring them up to a luxurious state in which they could be sold to affluent middle-class buyers. The cost of renovation was £27,000 per home, and we found it impossible to sell them to our target demographic due to the weak housing market and high cost of mortgages. To exacerbate the situation, our low sales volumes meant that we were forced to bulk-sell large numbers of houses at up to 30% discount to meet Annington’s quarterly debt payments. In just over 18 months, four CEOs quit, with one after another trying and failing to make this business a success.

In 1998, we took on James Hopkins as CEO. James had an alternative strategy; he said that if I was willing to trust him, he believed that we should make the homes affordable, comfortable and safe, so we could appeal to first-time buyers and key workers who wanted to get onto the housing ladder. Not only that, we should offer the homes with 5% of the purchase price paid by us as a deposit to the mortgage provider. In addition, we should set the fee to cover all the costs of moving in to £99, with a further discount given to service and ex-service personnel of up to 10% based on their years of service. By doing this, we hoped to sell the homes quickly, while providing much needed homes to nurses, doctors, teachers and emergency service workers.

We supported James in going forward with his strategy. We believed that it would work, and we knew that our existing approach – which replicated that of a traditional house builder – wasn’t working.

James’ approach proved a great success. From 1999 onwards, people would queue for weeks ahead of an Annington sales launch. Within three years, we found ourselves 19 years ahead of our debt repayment profile.

However, we had done something in 1996 and 1997 which made sense at the time, but in hindsight was not the best decision: we had securitised Annington’s rental payments at a cost of 7.54% through to 2021. While this enabled us to pay off the bank debt and make the business financially stable, it has meant that, to date, the business has never made an operating profit given its interest bill. Compared to interest rates today, Annington’s cost of debt is very expensive.

Nevertheless, I believe Annington will prove to be a successful investment in the long term. At Terra Firma, we view property as a long-term investment. In 2021, we hope to refinance the debt at far lower rates, and the rental payments received from the government will be adjusted to market rates. Over the following five years, 30 years after we first purchased Annington, the business should start making a profit and we should be in a position to exit.

It will have been a long wait, but I am confident that it will have been worth it. This is because of my belief in the UK property market. The UK has incredibly strong fundamentals for residential property investment, with a growing population, strong planning laws and a shortage of lower-priced houses. The current shortfall is 1.2 million homes, as the UK government’s target of 235,000 new homes per year has been missed by 100,000 a year for the past 12 years. So unless the industry can increase its capacity to 335,000 per year, the UK’s chronic housing shortage will continue. 

Will Brexit change this? Well, yes. It could. However, it all depends on which route the government decides to take. The economic and political environment this government creates is more critical to the population of the UK than at any time since it joined the EU in the 1970s.

On the one hand, Britain could become more European than Europe. The red tape of Brussels could be replaced by new UK-based rules and taxes; after all, Brits have a history of bureaucracy and government interference. In this case, Britain would have all the disadvantages of the EU without the benefits of the single market. Britain would end up back where it started in the 1970s when it joined the EU as the sick man of Europe, and the economy and house prices would slump. 

On the other hand, if freedom from Brussels is used to cut taxation and government regulation, the future can be bright. Investment will flood in, new jobs will continue to be created as old jobs disappear due to technological changes, and the UK can look ahead with confidence. 

Brexit was voted for by people who see this as an opportunity to move away from Europe. The negotiators whom Theresa May has chosen to represent these people are not Little Englanders who think small. They think big, and they know that many Brexit voters want reduced taxes, reduced regulation and increased opportunities for businesses.

My view is simple: if Brexit is used as an opportunity to position the UK as the Singapore of Europe then we can truly compete, and Brexit will make the UK stronger, not weaker. Theresa May has the means to ensure that the UK remains competitive with Europe, and indeed on a world stage.

This is as relevant in the property industry as it is in the finance industry. As Morgan Stanley’s CEO pointed out this month, US banks are more likely to move their people out of Europe from London to New York than to Paris or Frankfurt if the UK loses passporting rights. Attacking the UK’s finance industry will not see Paris or Frankfurt benefit; rather, New York, Singapore and Dubai will gain to the detriment of the whole of Europe.

This would affect the UK property market. US investment banks house 87 per cent of their EU staff in the UK, while foreign banks employ nearly 160,000 people in the UK. Significant job losses in the banking sector could materially affect London property prices.

As I have said, nobody can predict what will happen. In 1996 we bid the highest price for Annington’s homes, which we have since simply watched increase in value in line with the market, at 99.9% of the nationwide housing index. 20 years later I anticipate a successful exit, even if we have to wait another 10 years. I believe in a long-term investment approach to UK property because I believe in the UK and its strong long-term fundamentals, regardless of short-term volatility.

In the early 1970s, Zhou Enlai, the first Premier of Communist China, was asked about the impact of the French revolution. His response was that it was too early to say. With only 119 days having passed since the referendum, the same is true of Brexit: none of us really have a clue. 

However, if we keep a long-term perspective in mind, we will go through the good cycles and the bad cycles and reach the other side, no matter what that other side may look like.

Thank you.

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