The stratospheric cost of home renovations in London

If you want good value, don't look for it inside the M25.

I recently undertook a renovation project for a two bedroom property in West London which is owned by an investor with whom I've done multiple deals up in Manchester.

London is more expensive than any other UK city on just about every metric including hourly labour for building contractors. (I once made the fleeting mistake of thinking that the "day rates" for various trades published on the website of a well known London property maintenance company were somewhat reasonable, before realising that they were in fact quoting hourly).

So whilst I expected the cost of building work to come in significantly higher as compared to similar projects we have done in the North and elsewhere - I hadn't realised by quite how much.

I have completed multiple kitchen & bathroom remodels on properties in the North and East for c. £6k all-in including units, fittings and labour. I had five contractors quote for the job in London against the very same schedule of works. The labour alone was quoted from £13k all the way up to £23k. What a bargain. With yields on investment property in central London languishing around half of what you can get in Manchester and elsewhere, any return on capital employed will quickly be eaten up by the cost of maintenance and renovations.

Perhaps it's a result of the extreme imbalance between current demand and supply for such services - driven by the coronavirus pandemic and the consequent and much publicised boom in home renovation projects. Or perhaps it's just a reflection of what contractors can get away with in a neighbourhood where the average home price is approaching £2 million.

To summarise: if you want to make money investing in rental property, go North. If you want to make money fitting bathrooms and kitchens, buy a house in Slough and work exclusively for property owners in Kensington and Chelsea.

Big picture, small details

I've spent much of the past two weeks cleaning. Cleaning ovens, cleaning bathrooms and scrubbing floors on my hands and knees. A day's cleaning can be pretty physically demanding if the calorie count on my Apple Watch is anything to go by.

Whilst not exactly among the most glamorous of jobs you might envision for a real estate investor, it's good to get one's hands dirty from time to time. There's actually something pretty satisfying about a job well done. The kind of satisfaction that comes from seeing the fruits of one's physical labour in real time.

Inevitably, at the end of a long renovation project, there are loose ends that need to be tied up and finishing touches to be administered. Usually these tasks fall to me personally since it's more difficult to efficiently contract out lots of small and disparate tasks without investing a disproportionate amount of time and money.

It's not just at the margin that these tasks make a difference.

If you want to convert prospective leads into actual leasing applications then perfect turnkey is essential (a point which too many letting agents and landlords unfortunately seem to forget...). It would be a shame to spend several months and tens of thousands of pounds renovating a property or unit only to fall short on the finishing touches.

A perfectly finished, well designed and spotlessly clean property can certainly help to drive incremental monthly rent, producing cashflow which will flow in its entirety through to the bottom line. And never underestimate the difference that a bad choice of paint colour can have on a property's appeal.

Moreover, there's also something quite humbling in talking to an investor about new acquisitions in the morning and then putting on the marigolds for a few hours scrubbing toilets in the afternoon...

The search for yield leads to the real estate investment assets of the future

Source: BMO Global Asset Management & Bloomberg

The impact of the coronavirus pandemic continues to wreak havoc on economies around the world. Central banks are cutting interest rates and firing up their printing presses to facilitate record amounts of quantitative easing and other asset purchases.

Real estate investors have been a major beneficiary of central bank policy in the last few years as yield curves have continued their largely unabated march downwards.

Cap rates have fallen dramatically pushing up asset prices and lowering the cost of debt capital. Moreover, with global volumes of negative yielding debt reaching a record $15 trillion prior to the onset of the coronavirus, long term investors seeking secure income are struggling to find it in sovereign debt or investment grade corporate bonds.

Instead, many long-term investors, including pension funds, have increased their allocations to alternatives (such as real estate) as a means to generate the necessary returns required to meet their future obligations.

The knock-on effect of this has been to push cap rates on core real estate in many parts of the world down into the low single figures. It is increasingly difficult to generate the kinds of forward-looking returns that investors in these assets may have come to expect. In major European capitals such as Paris and Berlin, cap rates on prime office assets have fallen to sub 3%.

In the UK, data from Savills shows that the average prime yield across all real estate sectors has fallen to 5.3% — even accounting for much higher yields in retail & leisure assets of up to 7% or more.

In prime London office assets, yields remain at 4% or below.

With expected returns from core real estate in gateway cities around the world continuing to decline, it gives rise to the question many major real estate investors will increasingly be asking — how to generate superior returns commensurate with investor expectations in this new ultra-low interest rate environment?

Some investors may simply accept that the days of 20–30% IRRs are long gone. Others are likely to move into new geographies in ‘emerging’ markets such as Eastern Europe, Southeast Asia, Latin America and India.

Some may seek to move up the risk curve and take on more development risk or greater leverage in order to meet return expectations.

None of these approaches is without risk in a world of rising geopolitical tensions, domestic unrest, trade wars and currency volatility.

That’s before even considering the sledgehammer blow that coronavirus has dealt to many areas of the global economy — bringing with it drastic changes to consumer behaviour and working preferences which may have a meaningful impact on demand for different real estate assets for years to come.

Perhaps a better option is to tap into a new class of emerging real estate assets.

Logistics assets have long since been adopted as a major staple of any real estate investment portfolio, benefitting from the continued growth of e-commerce. The coronavirus crisis, however, has helped to shine a light on some emerging niche assets that are likely to grow exponentially in the future as technological changes are accelerated around the world.

From cloud kitchens to film studios and micro-fulfilment centres — technological developments funded by billions of dollars of venture and growth capital from Silicon Valley to Shenzhen will likely help to shape the emergence of new real estate asset classes in the years ahead.

Film studios

With cinemas and many other leisure venues forced to close in recent months, streaming services have continued their growth unabated. Netflix added 15.77 million new subscribers in its most recent quarter, more than double the 7 million it had expected. Not wanting to be left behind, Disney+ has also launched to much fanfare, adding over 50 million subscribers since its launch in the US last November.

In a battle of global technology giants, Amazon and Apple continue to spend heavily on their own offerings whilst Alibaba has invested in the space through Alibaba Pictures since 2014.

Producing the content for these platforms does not come cheaply with Netflix’s annual spend on original content estimated to be $15bn in 2019. This is forecast to reach $26bn by 2028.

The increase in investment gives rise to an insatiable demand for new film and TV production facilities, an area in which the UK is a global leader.

As the scramble to secure production space rages on, some real estate investors & developers are taking advantage. A raft of new sound stage developments in the UK have been announced in recent months.

Comcast recently announced a joint venture with L&G Real Estate to build 14 sound stages on a 32-acre site in Elstree, Northwest London. Blackhall Studios, based in Atlanta, Georgia, were quick to follow this up with their own announcement of a £150m investment at the Thames Valley Science Park in Reading.

These new facilities add to large existing sites at Pinewood Studios, Shepperton Studios and Warner Brothers. Indeed, Shepperton is currently undergoing its own £500m expansion.

With weekly rents of up to £25–30,000 per week for a 20,000 sq/ft sound stage at one of the top London facilities, it’s not hard to see the scale of the opportunity in the years ahead.

As content providers increasingly seek to produce original content specific to each domestic market around the world, opportunities exist to further develop such facilities beyond traditional production hubs in London, Toronto, Atlanta or LA.

Cloud kitchens

The global food delivery market is set to grow to $200bn by 2025.

UberEats, Deliveroo, Doordash, Postmates and others have ploughed billions of dollars of investor capital into expanding the food delivery ecosystem. These companies have been beneficiaries of the closure of dine-in restaurants during the coronavirus pandemic as many establishments have embraced takeaway and delivery for the very first time.

As pre-existing trends in how we purchase and consume our meals have been turbo-charged during the pandemic, cloud kitchens have been another direct beneficiary. These so called “dark kitchens” which are essentially delivery-only restaurants, allow brands to expand the geographical reach of their food delivery without full scale investment in a standalone restaurant.

In addition, culinary entrepreneurs can more easily experiment with new concepts, brands and cuisines — all available to order from a range of delivery apps and facilitated by renting space in a cloud kitchen for as little as $2,000 a month.

A host of new operating companies have sprung up to capitalise on demand for these new spaces including Kitchen United, Zuul, Reef and Cloud Kitchens — all competing with Deliveroo and Doordash who both have their own in-house offerings.

Cheap or distressed real estate in out-of-town locations can be repurposed and sub-divided into multiple cloud kitchen spaces before being rented out to restaurants and other food service providers. Think dis-used pubs, small industrial units and even car parks.

As food preparation and delivery become increasingly autonomous in the years ahead, demand for these spaces is likely to rise exponentially providing new opportunities for savvy real estate investors.

Micro-fulfilment centres

In 2019, supermarket delivery company Ocado launched ‘Ocado Zoom’, a new concept bringing customers within a 5km radius of its West London distribution centre access to 10,000 products with delivery in as little as 60 minutes.

Large-scale automated warehouses have been pioneered for many years by Ocado and Amazon. These warehouses come complete with thousands of autonomous robots moving millions of products around giant out of town distribution centres.

The rise of next-day or even same-day delivery, means that retailers are increasingly seeking to locate their distribution centres closer to their customers’ homes — in denser urban areas. Advances in technology have facilitated the condensing down of these automated warehouses into a much smaller footprint — as low as 10,000 sq/ft as compared to a couple of hundred thousand or more for an out of town distribution centre.

From these automated micro-fulfilment centres, today’s e-commerce businesses can serve their customers even more efficiently whilst facilitating seamless next-day and same-day delivery.

On the other side of this coin, traditional brick and mortar retail is suffering. Shutdowns and stay-at-home orders have added exponentially to their multitude of existing woes. Rarely a week goes by without one retailer or another announcing a major restructuring, company voluntary agreement or bankruptcy.

Retail warehouses in the UK, were predominantly built during the 1980s and 1990s and signed over to retailers on long 20-year leases. With a large volume of leases up for renewal in recent years, coupled with the demise of brick and mortar retail at the expense of e-commerce, vacancy rates and rents have been under serious pressure.

Savills data shows that between 2016 and 2019, rents decreased by an average of 17.8% from £28 per sq/ft to £23 per sq/ft.

Many of these units are in the range of 10,000–20,000 sq/ft with high ceilings and locations on the fringes of major urban areas making them perfect opportunities for conversion to micro-fulfilment centres — transitioning from the offline economy, to the online one.

How long before Shopify, Amazon and other online retailers start to lease these spaces at scale and savvy real estate investors capitalise on the opportunity?

Opportunity beckons

Record low interest rates and central bank liquidity have pushed cap rates on core real estate assets in gateway cities close to all-time lows.

Technological developments and economic disruption, exacerbated by the coronavirus pandemic, will give rise to a new class of real estate assets. These assets are well positioned to take advantage of the economy of the future. An economy in which we stream our film and TV direct to our smart phones and tablets, shop from our living rooms, and have our dinner delivered to our front doors by autonomous vehicles from automated delivery-only kitchens.

Real estate investors seeking new investment opportunities can move away from high street retail, downtown office blocks and shopping malls into film studios, cloud kitchens and micro-fulfilment centres. The question is not if these assets will become mainstream real estate investment opportunities, but when?