Market Comment - A Year of Consolidation
Whilst 2014 saw intense competition and compressed yields for London assets, 2015 was characterised by increased trading volumes in the regions and rental growth for offices and industrials outside London and the South East.
An overall increase in capital values for UK commercial property investments as measured by IPD’s annual index is expected to be confirmed at around 9.5% in 2015 (2014: 12%) meaning total returns of circa 15%.
House price growth across the UK in 2015 was 4.5% according to the Nationwide house price index.
The above compare with a decline in the FTSE All Share Index of 2.5% (2014: 2.13% decline), and near standstill of Government gilt prices (5-15 years) with a 1.08% total return (2014: 11.86% increase). However, the FTSE 250, a more reliable guide to UK plc, was up 8.4%.
Q4 2015 saw market activity calming down, with some commercial fund managers reporting neutral capital flows and predictions of single digit total returns in the range 7%-9% for commercial property in 2016.
SDLT increases are already starting to adversely impact on the volume and value of prime Central London residential property.
2016 Predictions for Property Influenced by Geopolitics and Property Fundamentals
Whilst the UK political scene is currently stable and the US interest rate rise well received by financial markets,there are other geopolitical uncertainties. In particular, the potential close-run outcome to an EU referendum provides a greater threat to the stability of property markets than an increase in UK interest rates, especially with forecasts for the CPI to be sub 1% for much of 2016.
After a year of deflationary pressures across the world, with expectation of lower returns and corresponding yield consolidation, the focus is now on property fundamentals.
2016 should also see greater use of bank lending to both increase short term returns on equity, and also counter slowing inward flows of investment monies. This comes at a time when banks continue to be accused of over-exposure to commercial property.
Average Yields to Stagnate – Rental Growth is the Driver
There are clear signs of purchasers becoming more discerning, with an upward drift in yields for secondary assets without positive occupational or development angles.
This is contrasted by yield compression for sectors offering secure long term income. Annuity-style buyers are increasingly prepared to consider specialist properties (such as pubs and restaurants, hotels, student accommodation, car showrooms and primary healthcare). Yields for properties outside London let to strong covenants for terms of 15-20 years, with open market rent reviews, are consolidating at 5%-5.5% (compared with 6% in 2014).
With yields close to the floor across most asset classes, property still enjoys a yield margin, giving capacity to cope with a modest upward trend in interest rates (relative to bonds and equities). However the real differentiator will be future income potential and the ability to drive rentals through strengthening local market conditions and management actions.
Central London and Prime Big Six Regional Centre Office Rents to Reach Cyclical Peaks by 2017
With vacancy rates in all London submarkets at historically low levels, and office rents of £60-70 per sq ft set to become the norm, many occupiers will be forced to reconsider ever more efficient utilisation of space. This will also fuel the growth of serviced office accommodation, which now accounts for five million square feet in London. Serviced offices cater for the smaller and growing companies who are looking for flexibility, quality of accommodation and environment, together with a single quantifiable cost.
London submarkets have seen rental increases typically in the range 10-15% over the past year, and up to 50% over five years in the longer established City, Mid Town and West End markets.
Increases over five years have been significantly higher in fringe locations such as Southbank, Farringdon and Clerkenwell, where prime rents on new stock are eclipsing the City at around £65 per sq ft. Other non-core locations of Shoreditch and Aldgate are likely to record double digit increases in 2016.
High accommodation costs will continue to drive companies from traditional core London locations. With quoting rentals in established satellite locations such as Hammersmith, Chiswick and Wimbledon above £50 per sq ft on prime stock, occupier focus will also turn to re-emerging centres such as Croydon, where rents have yet to break through £30 per sq ft.
Regional centres should also benefit from a Central London drift, however some such as Bristol and Birmingham face a shortage of Grade A space, with limited new development and secondary buildings being taken out of the supply chain and converted to student or private rented residential through permitted development rights. However, whilst Manchester has a permitted development exclusion zone, rents have powered ahead due to high levels of take-up and diminishing supply. Rents have risen by over 6% over the past year to reach £34 per sq ft, broadly on a par with South East centres such as Staines and Reading, all ahead of Birmingham which is currently at £30 per sq ft.
Satellite markets of Manchester, such as Salford Quays, will be increasingly viable alternatives to the city centre market. “Next level” centres including Liverpool, Newcastle and Sheffield, with strong local infrastructure and communication links, are becoming compelling propositions for both occupational and investment purposes. Good quality refurbished office space in the core Liverpool market can be acquired off headline rents in the range £10-13 per sq ft.
A backdrop of limited new development outside London has created clear potential to restructure leases and reposition buildings. However, a growing development pipeline in some London markets, especially the City, could lead to an over supply by 2018/19.
E-tailing to Continue Driving Change in the Logistics Markets
With online shopping growing rapidly, substantially generated by retailers own store-based click and collect facilities, the logistics industry will continue to re-shape.
John Lewis trading figures for the week to 26 December 2015 showed a year on year increase in online shopping revenues of 25.1% (compared to an overall increase of 2.3%), which is likely to exceed 40% of total sales with over 60% via click and collect.
The demand for same day deliveries will continue to drive an integrated approach to logistics, in the form of national and regional distribution warehouses, as well as smaller units housing associated systems and techniques to cover the “last mile” to the customer, and handle returns.
The growth in click and collect over home delivery should give renewed relevance to high street stores and shopping centres, especially if also offering eating, drinking, cinema and other lifestyle experiences.
Private Rental Residential
Whilst the private rental sector (PRS) has fulfilled an historical role in the residential sector, it has been associated with small lot sizes, high management costs and relatively low prime London yields of 3-4%.
Predictions that 25% of households will be living in rented accommodation by 2025 have been fuelled by urban population growth, affordability issues for owner occupation and a systemic undersupply.
The Autumn Statement tax raid on private buy-to-let investors should lead to some landlords selling homes. This will release supply for first time buyers and help moderate prices, providing a gap for larger specialist PRS players.
With much of the commercial property market fully priced, and yields plateauing, institutional investors looking for steadier long term returns are now increasing their exposure to this sector, by targeting build to let schemes of 80-300 units.
Whilst London will prove challenging, in terms of low yields and limited potential for scale, there will be potential to create higher income returns from larger build to rent developments outside the South East where net post development yields in excess of 6% are currently the aim.
LaSalle IM, Hermes, Legal & General and M&G Real Estate are amongst UK investors each targeting funds up to £1 billion and have all made their first investments. Several private groups have also entered the market, most notably from the USA where PRS (“multi-family”) is a significant and mature investment sector.
Although there is low occupational risk in large multi-family schemes, institutional investors will diversify their residential exposure through student accommodation and budget hotels. The latter tend to be secured on long leases to single tenants, although yields are more typically close to 5% or lower.
Owner Occupied Residential
Throughout 2015, we anticipated a modest fall in luxury London values outside established core locations, which has materialised. There should be continuing price support from a diverse range of overseas investors, who continue to see London as a safe haven.
However, the most significant risk to the London market is increasing uncertainty over the outcome of an EU referendum, with a doomsday scenario of an exit resulting in curtailed labour movement from the EU. This would impact on both the lettings and sales market. Economic slowdowns in countries such as China, as well as currency devaluations, also pose an ongoing threat to economic growth and London residential markets.
The lower value outer London markets offer the greater potential for short term capital value growth, due to limited stock, and the opportunity to provide the badly needed “right type” of housing for ordinary Londoners with average values currently around £600,000. For example, according to research by Molior, over 40% of residential units both under construction and in the pipeline are in east and south east London, where capital values are currently around £500 per sq ft, about half the levels around Canary Wharf.
The Prospect Beyond 2016
Affordability will be the tipping point in both commercial and residential markets, and prospects across all asset classes will be influenced by global political and economic uncertainties.
London office markets should continue to see rental growth through to 2017/18, with much current pipeline space being pre-let. Thereafter there is a risk of cyclical over-supply especially in the City market.
The markets will become less London centric, with the focus on proposed infrastructure projects, devolution for regional cities and on the investment required to drive the Northern Powerhouse Manchester hub initiative to challenge London’s competitiveness.
The lack of affordable housing stock in the South East is likely to continue to support the decentralisation of back office functions to the regions, where lower occupational costs and arguably more cost effective employment can be achieved.
The private rental residential and logistics markets should provide the most stable returns, given the longer term transformational changes taking place in both of these sectors.
Permitted development rights will have a transformational impact beyond the office market, with a widening of permitted uses.
Whilst the UK economy is perceived as a one of the strongest in the world, and there is scope for manoeuvre, concerns over high levels of UK debt and inability to utilise debt to realise infrastructure projects across the UK could come back on the agenda.
For further information contact James Routledge