Uncertainty and Opportunity
Wednesday, January 05, 2011London (West End)
2010 proved to be a year of change, economically, politically and socially. It was also a time of renewed divergence in the property markets.
Q1 saw the peak of a mini-boom in prime UK commercial property investment pricing, driven by UK institutions buying on behalf of retail investors. The remainder of the year witnessed a gradual slowdown in most sectors, but with an underlying polarization between prime and secondary property. Prime Central London offices and prime shopping centres edged up, retail parks and other properties let on long leases (especially with fixed rental uplifts) held steady, whilst secondary assets started to drift.
An overall increase in capital values for 2010 is expected to be confirmed at around 6.2% as measured by the Investment Property Databank, which compares to a rise in the FTSE 100 of circa 9%.
Residential markets have been equally mixed, and although the Nationwide reports virtually no change in overall values during 2010, they identify falls in ten out of thirteen UK regions in Q4.
Prime Central London residential markets continued to flourish through 2010, driven by overseas investors perceiving London to be a safe haven, and offering medium term stability. This year, a range of uncertainties and regional variations are expected to have a negative impact on residential values nationally, with some exceptions for the best postcodes in suburban markets, where current values should be supported.
The reality of public sector cuts, the squeeze on household finances, the requirement for banks to maintain liquidity (through more rigorous tests due to Basel III and reducing overall exposure to property), investor unease at the potential for defaults by Euro zone States and a number of US local State Governments, all add to the uncertainty in an already fragile market.
2011 is likely to witness even further focus on the activities of the UK and Irish banks, where much of an estimated £250 billion of UK commercial property debt is still in default. Whilst visible casualties have so far been thin on the ground, the increasingly aggressive stance by banks towards customers will continue, with ongoing cash calls and increased margins. Whilst many banks are expected to avoid foreclosing wherever possible, and instead opting to extend and/or sell loans, the most likely source of increased supply of property for sale is the Irish Government after it has digested property assets within NAMA.
Private Equity Funds found it difficult to deploy capital in 2010 as the market was stronger than anticipated. However, an unwinding of quantitative easing measures, rises in bond yields, and increased supply of suitable investment stock should eventually provide opportunities.
Within the occupational markets, consolidation should be a key driver of demand. In some locations, a dwindling supply of available Grade A office accommodation will cause larger occupiers to seek pre-let situations, and possibly encourage a small number of speculative developments. Broader occupational demand remains weak and the speed of decline in secondary values should increase as a knock-on effect over the next couple of years, especially if the traditional fundamentals for commercial property investment remain poor.
A consensus forecast carried out by Investment Property Forum in November 2010 predicted further rental value falls, notably in the retail and industrial sectors (excepting certain sub-markets such as prime retail warehousing and Central London offices where some growth is expected). It anticipated a fall in overall total returns for UK commercial property from circa 13.5% in 2010 to 5.2% in 2011, meaning outright drops in average capital values.
We believe that growth opportunities will be largely limited to markets with tight supply in Central London, dominant retail locations across the UK, and certain properties secured on long-leases. One-off opportunities with restructuring or refurbishment potential, that are in a balanced micro market, should present themselves as supply increases and prices ease, especially from the second half of 2011 onwards.
Some overseas markets, such as within Northern Europe where some economies are in relatively good shape, currently appear to offer better sustainable returns than the UK. One example is the retail sub-market in Germany, where a stronger economic environment, slightly higher yields, and lower underlying rental levels and affordability relative to the UK is seeing the return of international investors. This could well be a market to watch in 2011.