looking over the rooftops of muswell in london

With some of the highest real estate values in the world, the London housing market has been an attractive prospect for investors. But the last three years have not been kind to UK homeowners, particularly in the high-end London prime property market.

A number of factors have contributed to a decline in prices and sales volumes, including recent changes to the Stamp Duty Land Tax — a land transfer tax — and ongoing Brexit uncertainty. For a market that had seen prices growing at nearly a double-digit rate since the 2008 recession, it's been a shock to the system.

“I think it is also fair to say that over the last two or three years it has softened on probably what we would term the higher end," says Fiona Lucas, managing director, sales and relationship management at RBC Wealth Management in London.

The good news is that prices in the segment appear to be stabilising following a drop of nearly seven percent in 2016. But transaction volumes remain down by nearly one-third from 2014 levels, according to research from professional services firm Jones Lang LaSalle IP.

In an illiquid market, this leads to a disconnect between property owners' views of the worth of their homes and what they're likely to get on the market, says Oliver Saiman, director, relationship management with RBC Wealth Management in London.

With the potential for further changes to stamp duty, an uncertain economic outlook, and the expectation of rising interest rates, property owners may need to tread carefully to avoid making a mistake that could end up eroding years of accumulated value.

Tax changes

While Brexit may claim more space in news headlines, the stamp duty increase has had the biggest impact on the higher-end market, says Simon Ginivan, senior director of credit products with RBC Wealth Management in London.

The changes phased in over 2014-15 imposed more tax on higher-end properties, and an additional tariff on purchases of a second property. This may have been a deterrent for those thinking of buying a larger house or downsising once children have left home.

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“In round numbers, somebody purchasing a £10 million property will pay about 11 to 14 percent stamp duty, so that's a material sum irrespective of someone's wealth," says Ginivan.

The impact of the stamp duty on housing values may be close to being absorbed, with prime London real estate showing signs of stabilisation in the most recent quarter. But the more significant impact is on transaction volumes.

“People aren't moving because it's just too expensive," says Saiman. Instead, many are choosing to renovate their existing home, taking advantage of low interest rates if they choose to borrow. “They've got a bit more money, so they'll put an extension on their house because it's significantly cheaper than paying hundreds of thousands of pounds of stamp duty, which a lot of people are fundamentally opposed to."

Simon Smales, managing director, sales and relationship management at RBC Wealth Management in London, noted recent clients who had hoped to downsize, were put off by the high stamp duty. “These clients had quite a few bedrooms. But the children had grown up and left home, so they didn't need so many," he says.

Rather than purchasing a smaller residence and pay the stamp duty, they converted three bedrooms into one large master bedroom with an ensuite. “A few years ago before the stamp duty increases, they may well have looked to buy somewhere else," says Smales.

One major risk facing property owners is the potential for a further rise in the tax. The decision is very much tied to potential changes in government, but Saiman says a further increase could easily throw prime properties into price turmoil again.

“That would be an absolute game changer in a very negative way for high-end property," he says. “It's giving people pause for thought before they go and purchase property these days."

Interest rate risks

While there is a lack of liquidity, Smales points to compelling valuations for those with a strong cash position; however, there's added risk when deals tend to take longer to put together, he says.

“If [clients] are borrowing you'd want to make sure they're not over-leveraged at this point in the cycle. They need to make sure they're comfortable in terms of serviceability because it could take quite a long time to sell property."

While the Bank of England's Libor rate is still near historic lows, the central bank recently raised it to 0.75 percent. Future increases are expected to be gradual, according to RBC Capital Markets forecasts, but may still have an impact on borrowing costs.

While some homeowners are content to deal with interest rate challenges as they come, others may be nervous about the potential for higher borrowing costs. Saiman suggests a hedging strategy, which could be built around products such as an interest rate cap, which acts like an insurance policy, paying out if the Libor rate goes above a certain point. There are also derivatives such as rate swaps, where the risk of a variable rate is traded for that of a higher but more predictable fixed rate.

“Even if they don't think rates are going up in the next three years, people are happy to pay for the peace of mind," says Saiman.

Reducing property exposure

Another possible way to consider managing risk is with asset diversification, which is a principle most people adopt in investment portfolios, but homeowners easily lose sight of this option when dealing with property. According to Lucas, it tends to be the commercial property owners who see the value in not being too heavily committed to one market.

“They may reduce their property exposure by a small percentage and move that into more liquid investments because as they've seen in the last few years, liquidity is critical," she says.

One benefit of trimming back real estate exposure is that other securities can usually be sold on short notice if needed, whereas real estate transactions occur on a longer time horizon, Lucas says.

Of course, there is significant built-in value in the London prime property market that may not be in danger of going away. If so, it should continue to be a desired area for real estate, and buyers or investors with excess cash and an appetite for risk.

“A lot of money was made from buying in 2009, which was really the very depths of the financial crisis when nothing was really moving, and the same dynamic exists today," says Saiman. "There are some good discounts to be had."

For the more risk averse with a foot already in the London market, the unknowns of the next few years may require shrewd decision-making and expert advice.