Schroders: UK Commercial Real Estate - solid performance in 2015

2014 has been a good year for UK commercial real estate and unleveraged total returns are likely to be close to 20%.  Most of this year’s performance has been driven by a favourable fall in property yields, as investors seek income. Looking ahead to 2015 we expect that total returns will remain in double figures, but that rental growth will make a larger contribution. The recovery in the economy combined with low levels of development means that the balance between demand and supply is now swinging in favour of landlords and we anticipate that rental growth will accelerate. The capital’s commanding position

London experienced the strongest rental growth in 2014 and we expect it to stay in the lead over the next 12 months.  In the office sector, the emergence of central London as a powerhouse for international accountancy, law, media and technology companies has pushed vacancy rates back down to pre-crisis levels, not just in the prime locations of the City and West End, but also in less established areas such as Farringdon, Kings Cross and the South Bank.

In previous cycles this squeeze on space and upswing in rents would have triggered a big increase in development and encouraged companies to move to cheaper offices in outer London, or other cities. However, so far we have seen relatively little new office building in central London, partly because stricter capital adequacy rules mean that banks are now less willing to fund projects and partly because competing residential schemes are often more profitable. Moreover, central London now has such a deep pool of highly-qualified labour that some companies are even re-locating to the centre from outer London or the wider South-east, even though rents and business rates are more expensive.

Retail rents rising

Similarly, retail rents in many parts of London are rising on the back of strong population growth.  To some extent London’s population growth – around 100,000 people a year - is simply a function of its vibrant economy, as people move to where the jobs are located.

In addition, we are also seeing an interesting social change as increasing numbers of young professionals – the so-called Generation Y – choose to live in inner London rather than copy their parents and move to the suburbs.  This in turn is leading to the rapid gentrification of areas such as Brixton, Hackney and New Cross which were previously relatively poor.  It also echoes the “Great Reversal” seen in several large US and German cities. 

Reawakening regional market

While rental growth outside London is patchier, some regional markets are definitely coming out of hibernation.  In the office sector, Manchester stands out as the strongest of the big regional cities, thanks to the success of its professional services.  In addition, we are also seeing good demand for office space in Bristol and Edinburgh and certain smaller markets such as Aberdeen, Brighton, Cambridge and Reading with strong local economies.  In the industrial market, rents are now rising by 2% across the South-east and Midlands.  Part of this is due to a cyclical upturn in demand from traditional occupiers such as builders’ merchants, but part is also due to the rapid growth in parcels, driven by online retail.

However, we remain sceptical about the prospects for a widespread recovery in retail rents outside London.  Although total retail sales are now increasing quite quickly, most of the growth is online and the latest wave of bank branch closures (as people convert to mobile banking) is a reminder of the structural challenges facing retail property.  In general, the only parts of the sector we favour are convenience stores, which are benefiting from the switch to “small basket shopping” and retail warehouses, which provide retailers with efficient and affordable space.  Risks and returns

Turning to the investment market, we think that the current level of the Investment Property Databank (IPD) All Property Index initial yield (5.5% at end-October 2014) represents fair value relative to other assets. If you adopt a textbook approach and assume that in future, 10 year gilt yields will settle at around 4% over the medium-term, add on a risk premium of 3.5% to compensate for depreciation, tenant default and illiquidity and then subtract long-term rental growth at around 2% per annum, then an initial yield of 5.5% looks sensible.

There are three main risks around this outlook. The first is that UK economic growth is much weaker than forecast, so that the upswing in rents stalls rather than accelerates. The second is that over-exuberant investors buying in the market push down the All Property yield to under 5% by the end of 2015. While that would generate bumper total returns next year, we believe that parts of the commercial real estate market could then be vulnerable to rising interest rates in 2016-2017. The third risk is the uncertainty which would be generated if the next Government decides to hold a referendum on EU membership in 2017. That could be quite damaging, particularly for London. Approximately half of central London offices are owned by foreign investors and the flipside of London’s highly qualified, cosmopolitan workforce is that it is quite mobile and could leave relatively easily.  

Overall, and given a reasonably high yield and a further rental growth as the economy improves, we expect that next year will see another solid performance from UK commercial real estate. The latest Investment Property Forum (IPF) Consensus Forecast suggests total returns of between 10-12% in 2015.