How Do You Sell 7,500 Luxury Flats That The Locals Don't Like In A Falling Market?
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The spinoff or sale of Capital & Counties’ massive Earls Court development project is the most complicated and interesting transaction in London right now. And it may be the most important.
In May, CapCo said it was looking at the possibility of demerging itself into two companies: one that would own its £2.6B retail scheme at Covent Garden, and one that would own its 7,500-unit residential scheme at Earls Court in West London. It thinks the market is not accurately valuing Earls Court, so it wants to unlock that value by putting it in a stand-alone company.
That might sound a simple idea. It is not. The Earls Court scheme is highly controversial, with both local residents and the local council at loggerheads with the developer. And the development will take 10 or 15 years to build but targets a London luxury residential sector where no one has a clue what values will be in two years’ time.
CapCo said it would announce its plans by the end of the year, and with that deadline approaching, nothing is resolved. But a possible left field solution is emerging, which could see Earls Court become Britain’s biggest build-to-rent scheme.
It is worth mentioning that CapCo is probably right to say that the public market is undervaluing Earls Court, given that it pretty much attributes no value to the scheme at all. How so? CapCo’s Covent Garden retail assets are very similar to those of West End-REIT Shaftesbury, shares in which currently trade at around the company’s net asset value. Covent Garden has a net asset value of around £2.1B, analysts like Green Street senior associate Rob Virdee said, and with CapCo’s market capitalisation also £2.1B, that means that the stock market is attributing no value to Earls Court.
“The demerger is a very good idea in terms of unlocking potential value depending upon how it is executed of course” Virdee said. “Buying into CapCo now it is essentially like you are getting the Earls Court land for free.”
But a demerger is not so simple, because Earls Court is fiendishly complicated. For starters, there is the landownership. CapCo pieced together 77 acres over several years, and in 2013 its master plan for 7,500 homes received planning consent from the London Boroughs of Kensington & Chelsea and Hammersmith & Fulham. It has begun development of 800 homes over 7.5 acres at Lillie Square, the simplest part of the site, a former car park that it owns in a joint venture with the Hong Kong billionaire Kwok family. The first phase saw £245M of receipts from unit sales, with 80% of Phase 2 sold.
Here’s where things get more complicated. One of the other chunks of the development, the now-demolished former Earls Court exhibition centre site, is owned in a joint venture with Transport for London. A TfL depot on the site is owned 100% by TfL. And the final part of the scheme is two existing housing estates comprising 760 homes and about 2,000 residents, many of whom are vociferously opposed to the new scheme. CapCo has a conditional agreement with Hammersmith & Fulham Council that it can demolish the estates and rebuild them, and has paid £75M of a £105M fee agreed.
Analysts have suggested that the decision to announce the potential demerger was simply a way of hoisting a for-sale sign over Earls Court: either someone makes an offer for the scheme before the demerger is undertaken, or buys it once CapCo is simplified and Earls Court is its own listed company. Partly this analysis is because it is very hard to envisage Earls Court as a stand-alone listed company: It provides no income to pay its own running costs, so CapCo would need to gift it a big lump sum of cash before it was split off from the income-producing Covent Garden to pay staff and to actually carry on building.
Earls Court also wouldn’t pay a dividend, and investors would be buying into it on the basis of their estimation of how much completed flats could be sold for — not an easy task right now.
“Typically listed companies that just comprise a small number of development sites, like Canary Wharf or Quintain, haven’t fared well,” Peel Hunt analyst James Carswell said. “It is hard for non-specialist property investors to get comfortable with land values and estimating what sales values will be achieved and over what period of time.”
CapCo declined to comment for this piece.
But selling the scheme, either before or after any demerger, will be far from a simple process. While it is safe to say that the Earls Court site is worth more than the value attributed to it by the public market, what it is worth is unclear.
CapCo has the land valued at £707M in its accounts, and this number has been falling for some time: down 7% in the six months to 30 June, and down more than 40% since its valuation peak in 2015, when London’s high-end residential market started to turn.
The falls may not be done yet. Carswell points out that CapCo is selling roughly one flat a week at Lillie Square, a sales rate which would lead to it selling all its flats around 2162.
“The high-end London market is not performing well,” he said. “To increase the pace of sales, the market can improve, or you can play around with the specification of the units, but the easiest way is to reduce the price. We would expect that valuation to decrease further.”
There have been noises about CapCo undertaking a sale — U.K. groups like Berkeley Homes and Almacanatar have been mentioned as potential buyers, as has Saudi Arabian investor Olayan. Dubai-based investor Damac undertook significant due diligence looking into a potential purchase, but a deal has not progressed.
The market for residential development sites is patchy, even for ones not as complex as Earls Court. Data from Real Capital Analytics shows that £705M of land deals have been undertaken in London so far this year, compared to £1.8B last year and an average annual volume since 2010 of £1.3B. A particular problem is that the Far Eastern investors who have been the major buyers of large London high-end residential projects are sitting on their hands.
That is in spite of the fact that the fall in the value of the pound has made London assets cheap on a relative basis. Analysis from Cluttons shows that London residential assets are the cheapest they have been in a decade for investors from China and Singapore, 40% less than a decade ago. But they are waiting.
“There is a lot of nervousness around Brexit,” Cluttons Head of Research Faisal Durrani said. “People are waiting because there might be a better deal in six months time if Sterling weakens.”
Estimates of the end value of the scheme range from £8B to £18B, and cost estimates start at £8B. But no one wants to overpay for land when uncertainty about costs and sales values can all but wipe out profits — see for example Battersea Power Station.
The lack of a buyer also has something to do with the fraught relationship between CapCo, one of the local authorities with which it must work, and the residents of the two estates it wants to demolish.
The conditional land sale agreement undertaken between CapCo and Hammersmith & Fulham was agreed by a Conservative local authority which was replaced by Labour in 2014. For the past 10 years the residents of the West Kensington and Gibbs Green estates have been opposing the decision by Hammersmith & Fulham council to sell the estates to CapCo, and CapCo’s plans to demolish and rebuild them. The residents have formed action groups, and created companies to try and use various elements of U.K. housing legislation to take ownership of the estates themselves.
“The Earls Court scheme is a busted flush, it is a financial black hole for CapCo,” community organiser Jonathan Rosenberg said. “Anyway, the world has changed, post-Grenfell even Tory policy towards social housing has changed. No one is talking about tearing down estates and building posh flats any more.”
The residents have won the support of the new Labour authority, which has said it opposes the demolition of the two estates, and wants them handed back to the council. CapCo needs a good relationship with the council: It wants to increase the density of its site through a new planning application that would see it build 10,000 rather than 7,500 homes, in order to increase its potential profitability.
But the new council has already said it thinks there are not enough affordable homes as part of the scheme: The 1,500 proposed means 20% of the development would be affordable, against London’s target figure of 35%. So even if CapCo can build more units, more of them might need to be affordable, again reducing profitability.
Things took a surreal turn this summer when council leader Stephan Cowan said publicly that in a meeting, CapCo Chief Executive Ian Hawksworth had shaken hands on a verbal agreement to hand back the estates to the council, and that it could pay CapCo back the money it had paid for the estates at 10 days’ notice. CapCo denied this. Cowan said minutes could be produced proving this. So far they have not, and the situation is at an impasse.
There is a different strategy that some in the market are starting to talk about, one that would take its cues from Quintain.
Quintain was a listed developer with a single, large, difficult development site at Wembley when it was taken private by opportunity fund manager Lone Star in 2015 for around £800M. The U.S. firm decided to build Wembley’s 5,000 units for rental use instead of for sale and got on with building them. Today the Wembley site is the largest build-to-rent scheme in the U.K. and Quintain is worth more than £2B. Could the same thing happen to Earls Court?
Green Street’s Virdee thinks so. He estimates that Earls Court could provide a yield on cost of almost 6% if it was built as a private rented sector scheme, using the current site value and at today’s BTR development costs. That is not an amazing profit, but is the kind of return that long-term investors might find acceptable, and those are the investors that are looking at BTR development in London right now.
There is even a certain amount of pent-up demand after Lone Star cancelled its auction of Quintain. Could top bidders Oxford Properties and Delancey redirect their attention to West London? There is even a chance that CapCo itself decides to pivot its strategy to build for rent.
“Sentiment for the London build-for-sale market is at a low ebb, whereas liquidity is high for PRS and demand is burgeoning,” Virdee said. “I think the yield on cost should at least pique investor interest.”
It would be an elegant solution for a project that appears to be heading nowhere quickly, creating the U.K.’s largest PRS scheme at a time when professionally managed rented residential accommodation is in demand from both institutional investors and tenants. It might just give one of London’s most complicated schemes a legacy for decades to come.
For everything you need to know about the London residential market come to Bisnow’s London Residential & Affordable Housing Outlook on 5 December.