Property Insights June 2008

UK Market Update

More doom and gloom. It's no surprise with oil prices at $142/bbl, and inflation has reared its ugly head again. Indeed the negative impact of oil prices on inflation could have been far worse so far, but the affects are well and truly now feeding through. In the UK CPI inflation is now 3.1% and looks likely to rise to over 4% in the next year. So this in theory would add at least 1% to interest rates, and push mortgage costs up about 20%. If oil prices don't rise further then it's likely inflation will drop back from 4% to its target range 2 to 3% within a year - but we believe oil prices will continue to rise and cause inflation to stay stubbornly high and put pressure on the Bank of England to raise interest rates. They cannot do this indefinitely because this could cause a fully-fledged recession, but they are well and truly between a rock and a hard place on this issue. We believe it's all down to the oil price – as we've been warning for the last 18 months.

Meanwhile the effects of the credit crunch appear to be working their way through, and some interest rate offers have recently been reduced – a good sign of good credit availability to the banks. Berkleys the builders will now start buying large tracts of UK land, have stopped paying out dividends and therefore seem to have called the bottom of the property market – they've called the bottom and top successfully before. We'd like to re-iterate our view that the property market has not reached the bottom yet, and is unlikely to do so any time soon. It may now take years to properly recover because of high oil prices. This is why we have been advising for 18 months to invest in cities and areas that are positively impacted by high oil prices. You can read the range of Special Reports at the end of this Newsletter.

One element missing so far that could cause a fully fledged house price crash in the UK is dramatically rising unemployment – employment has stayed stable for the last year. As long as the jobs market holds up – which is not for certain of course – then house prices should not drop more than say 5-10% per annum for the next year or so – with the possibility of stabilizing prices at any time if the oil price drops.

Landlord Rental Update

The rental market generally remains firm as first time buyers struggle to obtain mortgages because of the credit crunch, and are avoiding taking the plunge because house prices are likely to drop further. This has been a boon for buy-to-let investors as there are plenty of tenants for reasonable quality accommodation in central – convenient locations. The employment market remains strong and the wave of immigrants needing accommodation shows no sign of reversing. We believe unemployment may rise slightly, but not significantly despite the UK slowdown. As long as your properties are in reasonable decorative order, well presented and in handy locations at competitive prices, you should avoid long void periods in the current market. Rents have generally been rising in the last year or so, particularly in London. Yes, mortgage costs have risen a lot as well, but although many buy-to-let properties don't make positive cashflow, most buy-to-let investors are sitting on sizeable equity so are not suffering undue distress as yet. Some reports of distress seem to come from media coverage of people who entered the market very late and also bought into new build developments for instance in northern cities. But this is not the average buy-to-let investor – most investors purchase older flats and houses and are less exposed to a flood of new build properties hitting the market at the same time.

Continued Housing Shortage

As house prices rose in 2007, the government predicted that the UK needed an additional 300,000 properties per year, yet only a net 180,000 were being built. Now building levels have dropped considerably, probably to something like 120,000 a year - mostly flats. But these government targets should not really change since they are based on population growth, immigration, aging population, and predicted smaller family units. So we expect a further shortage of property now and in years to come as building levels drop when they should be rising. Any older house in the south of England that can be purchased at low price in a good location close to higher paid jobs should be a good long term investment. So we advise looking for selective bargains in London and southern and SE England within 60 miles of London – hopefully requiring some easy renovation – upgrade. As oil prices rise, huge profits will be generated from London based oil/gas and mining companies – London is also energy efficient compared with most areas with its electric trains, commuting and lack of manufacturing. So GDP should be maintained at reasonable levels as long as banks do not go under (unlikely since the key reason they would go under is stress caused by high oil prices, and Middle East investment funds would then step in and buy them up).

In summary, the current conditions are enough to discourage building just when there should be a big building spree for the medium to long term. This lack of building should help support prices into 2010. Yes, transaction levels have halved, and people are staying put, but there is not much sign yet of severe distress, unemployment or a crash. It's hardly surprising so few people want to move because of massive stamp duty increases and transaction costs – a key reason why so many people are choosing to extend or upgrade existing homes. So for the buy-to-let investor, one can see opportunities abound in southern England and London – particularly in the run up to the Olympics in 2012. (Stratford, Hackney, Bow, Canning Town spring to mind, with Gravesend further out another good bet with the new Ebbsfleet station).

 

US Market and Future Economic Outlook

The dollar has dropped as we all know – by about 25% against most currencies in the last 8 months. This has probably fuelled about 25% of the oil price rises. It's also helped re-balance USA's massive trade deficit. Exports have been very strong since the dollar dropped – hardly surprising. Inflation has been remarkably well contained despite higher energy prices and the weak dollar. Productivity improvements and general efficient public and private sectors have helped the US weather the economic downturn – and it now looks likely that despite the sub-prime crisis, credit crunch, house price declines and general low consume and business confidence levels, the economy will escape any form of recession. Indeed, GDP growth is likely to be well over 1% in the next year or so. Even with oil prices up to $170/bbl, we believe the US economy is robust enough to not drift into a recession. We think the worst will be over by end 2008 and a recovery will start in 2009. For US real estate investors, end 2008 is probably a good time to purchase bargains – particularly in areas hit hardest by the sub-prime crisis and re-possessions such as Florida, Phoenix in Arizona, and parts of California. These are the areas that in future years will encounter large population increases, GDP growth and retiring baby-boomers settling in the sun. Texas is another winner with the oil prices booming. Wyoming and NE Colorado (coal) are other areas that will benefit from high energy prices. Bakersfield in California is another – a rather depressing small industrial city, but oil production activity will continue to boom – so rentals and oil worker homes will be in short supply.

For non US investors, there is a dollar currency risk to investing in the USA which needs to be properly considered. If you believe the US dollar will continue its decline, it might be worth investing in your home country. It's also a function of local interest rates, local inflation, where you are financing, how much equity you put in yourself (and currency) and which currency you are financing in. We're no experts at currency risk – not many people are – hence your real estate investment strategy needs to add this risk into your decision making. They say if you don't understand it – it's best to avoid it! Overall, if you are a non US American investor and believe the dollar will strengthen – it should increase your appetite for US investments. If you believe the dollar will continue dropping over many years, its probably best to avoid the exposure – unless you intend to settle in the USA one day.

For global investors, our steer is, don't under-estimate the US economy. People have been writing the USA off for years, but it's got the following going for it:

• Highly motivated, organized and educated workforce
• Innovation and high technology
• Available financing for business
• Small public sector, large private sector
• Low taxes
• Increasing workforce and population
• Low cost building
• Coal, oil, gas, nuclear, water, forestry, agriculture, minerals
• Oil shale deposits, and tight gas deposits for when oil price rise further
• Much land, varied climate, good security and political stability

There are not many countries that have so much going for them – yes, the US uses too much oil and gas, but they do produce half of what they need. They have the largest coal reserves in the world – these will not run out. So when the US finally begins to wean itself off its addiction to oil, it should be well placed to trade with China, Brazil and India in the global economic expansion.

Most countries have public sector inefficiencies dragging down their economies – the continued US productivity improvements in manufacturing and services is impressive and it's difficult for many European countries to compete, particularly now the dollar has declined in value.

Norway focus

Let's take a look at Norway. This cold and rainy northern outpost! The population is 5 million. We predict oil and gas revenues will top $200 billion a year by 2009 – massive. That's $40,000 per person per annum. Meanwhile inflation is moderate, currency is strong (hardly surprising with high oil prices), and the Norwegians have been investing their oil wealth for years internationally in high earning investments. The trade balance is massively positive. The population is stable. No problems with immigration, emigration, asylum seekers etc. Politically very stable democracy. Highly educated workforce. Efficient working practices. Trusting and honest people. Very high on transparency and business ethics. Good legal framework. Many good engineers. Beautiful scenery. Long summer evenings. Hydro-electric power in abundance. Forestry in abundance. Nordic culture. The list goes on.

Okay, taxes are high and it's cold and rainy in the winter. But property investment in such a booming business climate looks to us to be low risk and relatively high reward. Another bright outlook is the currency – how can such a currency drop when the oil prices are booming, look set to continue this boom, whilst the currency is not pegged to the dollar or Euro.

Our favoured locations are:

• Oslo – capital, oil company headquarters, banking, services, government-public sector jobs
• Bergen – oil town
• Stavanger – oil town, port, oil-gas import-export terminals
• Southern coastal seaside resorts SW of Oslo – 2 nd homes for increasingly rich Norwegians

If you like long distance skiing and the northern lights (Santa for the kids), the place is also a winner in the winter. In the summer, 20 hours of daylight, skinny dipping in the Fjords and the staggeringly beautiful scenery are all plusses. Good healthy outdoor life. We really cannot think of anything particularly negative about Norway – you've got to break into the relatively introvert family oriented cultural persona and social circles. It's got Finland, Denmark, UK and Sweden as it's neighbours – nothing negative here either! The real highlight though is massive oil revenues and massively increasing gas revenues projected over the next twenty years. Norway will overtake Switzerland and Luxembourg as the most wealthy state in Europe soon – and it's difficult to see property prices not rising off the back of this.

Mining Property Boom

As India and China industrialize, commodity price have risen fast – all commodities have experienced big rises in the last five years. This cycle seems unlikely to be ending any time soon. Minerals like iron ore, aluminium, platinum, uranium, copper, lead, gem stones and coal are required to fuel industrialization in the “BRIC countries”. This cycle has been described by investment banks as a “supercycle” which could last a decade or two – rather than the normal five yearly boom-bust cycle. The reason is this time the expanding global population, shortage of supply, increasing demand for raw materials and rapid industrialization of India and China are likely to lead to a sustained demand over a long period. Countries heavily positively exposed to mining are:

• Chile
• South Africa (NW and north of Johannesburg)
• Australia
• Russia
• Kazakhstan
• Mongolia
• Democratic Republic of Congo (high risk)
• Sierra Leone (high risk, diamonds)
• Canada (oil sands open cast extraction)
• Indonesia
• Zimbabwe (high risk)
• USA (coal in Wyoming, low risk)
• UK ( London is the biggest global financial centre for mining companies)

Out of these Russia and Kazakhstan are also rich in oil and gas and to a lesser extent Australia is also. South Africa has no significant oil or gas, but is very rich in minerals – however, the government recently cut off electric power to the mines in January due to power shortages which reduced mining GDP by -22% - risks have therefore increased and inflation is now over 10%. For a pure mining real estate play, Chile is probably the closest you can get. When mineral prices skyrocket, mining jobs multiply and the mining rental market strengthens – all the employment leads to property prices rising. Void periods are low and yields are high. In Canada, the oil sands mining town of Fort MacMurray is a place the canny property investor can make serious money – purchase of oil company temporary accommodation. Rents are high, property is in short supply, real estate prices are rising and the employment scene is booming – massive skills and accommodation shortage are the order of the day in this oil sands boomtown outpost.

For a booming city with a stable economy, mineral wealth, oil and gas wealth and general exposure to Asia Pacific's booming economy, Perth is a place to consider, albeit it is very remote. Many oil, gas, LNG companies and successful mining companies have their offices in Perth – Melbourne is another city positively exposed to all these booming sectors. In Kazakhstan, Almaty is a city to consider – massively changing in a positive sense. The reason for mentioning all these great cities is that if one finds the sweet spot of rising oil, gas, minerals prices coupled with real estate – you can massively reduce your risks and increase returns – if you can be bothered to visit these cities and invest in these expanding regions. So much easier than trying to make serious returns in Italy, Greece and Morocco – all countries with negligible oil, gas and mineral wealth and set for economic downturn as oil prices rises.

Powerful global forces at work

Our analysis of oil and gas imports-exports suggest a massive transfer of wealth in future years from oil importing nations to oil exporting nations. The dollar is likely to continue its slide and asset prices in western countries are likely to drop. This will provide conditions for Middle Eastern oil wealth to be re-invested into low priced dollar and UK pound denominated assets such as commercial property, businesses, infra-structure and residential property. In general the Middle Eastern, Russian and Far Eastern economies will inflate – whilst the western oil importing nations will deflate. Banks may well go bust in the west as write-downs and lack of credit begin to bite. How long this process lasts and how severe it will be is very difficult to judge – part of it depends on how high the oil prices go – high cost of oil imports acts like a huge tax on energy importing nations. Economic balance will shift further to China, India, Middle East and Russia – and away from Europe and USA – albeit these economies will of course continue to be dominant as far as percentage of global GDP for the next few years. China and India will be catching up fast. Overall global GDP should continue to motor onwards at 3 to 4% growth per annum – fueled by expansions in BRIC countries and oil/gas and minerals exporting nations. For UK investors, avoid the FT100 stock market – all shares except oil, gas and mining stocks. Retail, property and construction will continue to take a hammering. In the USA, the Dow will also suffer (except for oil, gas, coal and mining stock) as asset prices drop and business profits come under pressure from inflation and high energy prices. We re-iterate our stance to invest in property in areas positively exposed to high oil and gas prices.

For Europeans who have been living off debit, rising house prices and the seeming never ending growth period – particularly in the UK – tough times lie ahead. The amount of air travel to foreign locations is likely to drop, with it the holiday home markets in place like Portugal, Greece and Italy – possibly Spain. Much of the property price increases have been driven by mobile UK and other European citizens buying second homes. As retrenchment begins, these prices should come under pressure. There will be exceptions though in fast growing local business areas like Barcelona, Valencia, Montpellier and Malaga/Marbella. But areas remote from jobs and business relying on ultra-low priced air travel will suffer – Cyprus, Greece and remoter areas of Portugal spring to mind.

Property prices are likely to stay firmer in Nordic countries that have efficient industry, knowledge based economies and many high paid jobs with relatively low unemployment – also with better demographics and less of an aging population. Some of our favourite locations are London, Oslo, Luxembourg, Aberdeen, St Petersburg and Moscow.

As Italy and possibly Greece and Portugal slip towards recession, there will be pressures building to reduce Euro interest rates. However, because EU inflation is running at 4% and driven by high energy prices and growth in Germany and France, the European Central Bank is likely to INCREASE rates – sending the peripheral EU economies further towards recession. In a year or so, if oil prices stay high – which we expect – this could eventually lead to the break-up of the Euro currency – as Italy, Greece and Portugal split then deflate their currencies to stimulate business, growth and competitiveness. If they keep pegged to a Franco-German Euro dominated Euro, they will likely slip into recession if oil