Beware the ‘exogenous variable’ in London’s frothy market Beware the ‘exogenous variable’ in London’s frothy market
  • August 2015
  • Jonathan Goldstein

I am a poor (and rare) gambler, but last November I defied my own expectations by winning at blackjack while away for a weekend in Las Vegas.

My good friend who was with me, himself an ex-trader, lost as a result of a series of unexpected events caused by my win and has since tried to explain away the loss by saying he was subject to an “exogenous variable”, which, in trading terms, means an unexplainable and unforeseeable series of events that distorts a trading sequence.

As London in all respects continues to power on to rarified heights and as a big investor in the space, with more than £1bn of debt and equity committed since launching Cain Hoy in early 2014, I have been trying to identify the exogenous variable that might turn everything around, causing a number of casualties in the process, and make us as an industry wonder how we missed such an obvious set of circumstances.

Pick up any newspaper and the issues being discussed are plain for all to see, from the government hiking up taxation and potential increases in interest rates, to a global hiccup caused by a Chinese slowdown, and so the list goes on. Yet for the most part, product – particularly in the London residential sector – continues to move and price records continue to be broken. A developer in Mayfair recently claimed to have reached new heights with a sale at £7,000/sq ft.

Certainly the shocks and fallout we expected to see at some point have not yet occurred. Although the market for homes in London may have cooled slightly in recent months, particularly at the very top end, as a whole it is still in rude health. As it stands, the market has experienced an almost straight line of growth since 2008, with more than seven years of unparalleled price rises.

So what is the exogenous variable that could bring developers back down to earth and shake the market? Certainly the widely cited potential issues such as the Chinese economy, interest rate rises and policy changes could affect the industry. Another less regularly discussed potential problem is contractor default.

When the market began to recover after the ‘correction’, many investors and developers diverted focus from office and retail into the resi space, seeking in part to emulate the success of One Hyde Park. Where the money went, so the contractors followed and they did so aggressively, buying turnover with aggressive bids. However, evidence shows that they missed something important. Finishing resi units is more complicated and more costly than offices and too many contractors did not anticipate that.

Research into delays to completions of buildings carried out by the Chartered Institute of Building found that only a third of high-rise constructions are finished on time. Contractors have therefore been suffering from their own cost overruns and have had to bear the losses themselves, and are now tendering more aggressively to attempt to rebuild their own fragile balance sheets.

With little equity cover sitting behind many schemes and stock at the top end of the market now shifting much more slowly, delays and cost overruns are not necessarily provided for. They are also beginning to be the subject of disputes and litigation is a costly and lengthy process. Read the construction press and it is common to hear that many of the subcontractors are feeling the squeeze. On one of our schemes, a subcontractor recently went into administration and the main contractor had to step in, incurring additional costs and carrying out the work.

The loss of confidence and the domino effect of one contractor defaulting adding to the pressures of another could have a very considerable effect on the market. In the investment game, one has to expect the unexpected. No market goes on forever and London has had an exceptional run. Whatever the exogenous variable may be – and it could well turn out to be the weak balance sheet of the fragile construction industry – we as an industry need to be prepared.

Jonathan Goldstein is senior partner and head of European investments at Cain Hoy

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