Blessed with accessible investments worth around £300bn (e 443.2), the UK property market is Europe’s largest, and is also the continent’s most transparent, liquid and diverse.
As a result, the market is often the first choice for cross-border investment and so around 15% of it is held by foreign visitors.
Over the past few years there has been a marked increase in investment in commercial property by both foreign and domestic investors. Underlying this has been the global appetite for higher yielding assets, which is not limited to the property market. This has been reinforced by the relatively high level of commercial property rental yields compared to interest rates, with a substantial increase in the proportion of debt-backed investment activity.
The strength of demand for UK property over the last two years has pushed up prices, with IPD reporting that movements in valuation yields account for over half of total returns over this period. But the UK property market has not been alone in seeing declining yields; this has also been evident in other asset markets, in what appears to be a significant shift of capital away from equities towards more income-generating assets.
Property yields are now at the lowest levels in nominal terms since the 1960s and some commentators believe the market to be over priced, although given the weight of money that is still flowing into the sector they appear to be in the minority. But herd instinct is a poor basis for an investment strategy, especially when there are many compelling reasons which suggest that commercial property remains a sound investment for the future.
One of the most significant is its pricing relative to other assets; commercial property still produces a healthy yield premium over interest rates, even before taking into account prospects for future rental and capital appreciation. The context of any historical comparison of yields is also somewhat misleading.
In real terms, property income yields are well ahead of their average over the last 24 years. The limited information available suggests that the nominal level of yields is somewhat similar to the 1950s and 1960s which was the last period in which the UK experienced stable inflation and low interest rates.
Another trend has been the narrowing of the differential between lower-risk and higher-risk assets. In commercial property this has perhaps been exacerbated by the requirements of bank debt covenants forcing investors up the risk curve. As a result the yield differential between the poorer-quality properties – which tend to have weaker rental growth prospects, poorer income streams and possible obsolescence issues – and the better-quality properties has narrowed over the past few years.
This has been evident in many markets but particularly in the shopping centre and industrial estate markets. These properties tend to have the advantage of diversification of risk via a large number of tenants but they also tend to be let on shorter leases and to financially weaker covenants. However, it is unlikely that tenant covenant issues will play a significant role in differentiating the performance of these properties over the next few years, whereas the potentially hidden costs of refurbishment and re-letting will.
The retail market
Prospects for the UK property market are closely linked to those of the wider economy. Part of the reason for the relatively strong performance of the UK market over the past few years has been the strong performance of the retail sector. This has been underpinned by a strong housing market and high levels of growth in unsecured consumer debt.
However, in the past 12 months there has been a noticeable weakening in the pace of economic growth due to lower retail sales and a weaker housing market. The slowdown in retail sales and house prices on the back of a period of unprecedented growth suggests that the UK is due for a downturn. This would be a cause for concern if consumers were unable to meet their credit obligations, but with interest rates remaining low and more people in work than ever before this scenario seems unlikely.
Perhaps the more likely prospect is a temporary slowdown in demand after which consumer demand will recover, such as happened in 1998 after the Russian debt crisis and in 2002 after the terrorist attacks.
The UK retail sector has undergone a radical transformation over the past 20 years, from almost exclusively a city and town-centre affair to one in which every other pound of retail spend now occurs in out-of-town retail warehouses or purpose-built regional shopping malls.
This change has been driven by consumers, retailers and investors. Mobile consumers increasingly prefer the wider choice available at out-of-town locations, Retailers also prefer these locations as consumers tend to spend more in them, they are easier to service and tend to cost less in rent and taxes. Investors and developers have also embraced these formats as a result of strong demand from retailers, which has resulted in retail warehouse rents rising at double the rate of town centre shops.
Out-of-town retailing is expected to continue to outperform that in town centres over the next few years as the format remains more profitable and the stock of new out-of-town sites remains inelastic due to stricter planning controls.
The office market
Tenant demand for offices, especially those in London and the southeast of England, collapsed after the stock market crash of 2000. This came at a time of relatively high development activity, which made the resultant oversupply even more acute.
Office rents fell sharply in 2002 and 2003, but due to the unique structure of UK leases with their upward-only rent review clauses, the office sector continued to produce positive returns for all but a few months at the end of 2003.
Since then occupier demand for offices has recovered, led by London’s West End market in 2004.
This was closely followed by recovery in the
City of London financial district. This has been accompanied by increased investor demand for offices partly for the high levels of income yield and partly as investors recognise the opportunities for rental income growth.
Increased demand has come at a time of relatively low levels of development activity and, as a result, vacancy rates have fallen sharply and rental values have begun to rise. With relatively little new space being added to the market over the next few years prospects for rental growth, especially in central London look very good.
However, the central London office market has also seen a significant narrowing of the yield differential between better-quality and poorer-quality buildings. Current yield differentials do not reflect the disparity in the performance prospects of different buildings, with issues such as physical and financial obsolescence, over-renting (rents higher than the market), and poor pricing. It’s a particular issue for overseas investors whose holdings tend to be far more concentrated in this sub-market. (And this is despite the fact that it comprises less than 15% of the UK market by value and tends to be the most volatile.)
The most important office market outside central London is to the south and west of the capital. This market has grown rapidly over the pats 20 years on the back of a rise in its principal occupier base, technology and telecoms companies. Unsurprisingly this market was the worst-affected by the bursting of the technology bubble in 2000.
The combination of weak tenant demand and the high level of development activity caused vacancy rates to soar and rents to fall. Although very little new developments have been started since 2000, the modest recovery in tenant demand over the last few years has only recently started to reduce the level of available accommodation. This market is likely to experience a slower recovery in rents than the central London market, with little prospect of widespread rental appreciation before 2007, as the majority of properties are over-rented.
The office market outside of London and southeast England has produced stronger and more stable returns over the past few years as its occupier base is more closely aligned to the strong domestic economy and there has been a much lower level of development activity. The performance of these properties over the last few years has been driven by their relatively high yields and supplemented by modest rates of positive rental growth. Whilst lot sizes in this market are relatively small compared to the central London markets, these properties have tended to produce less volatile returns.
The industrial market
The UK is one of relatively few European countries where institutional investors hold a significant proportion of their funds in the tenanted industrial sector. Accounting for around 16% of the market, this sector is comparable in size to the central London office market.
However the comparisons end there, with the bulk of the market comprising multi-let industrial estates of varying sizes, located in or around the towns and cities of the UK and generally let on short leases to local businesses. Investors have been attracted to this sector for the relatively high levels of yield and the diversification benefits afforded by having a large number of tenants.
Although obsolescence is less of a factor than in the office market, a significant proportion of the total stock is of relatively poor quality, built in an attempt to stimulate employment in deprived areas in the 1960s and 1970s. As a result, there is a relative oversupply of industrial accommodation and plenty of development land outside of the southeast of England, which has resulted in persistently higher levels of vacancy rates and generally weaker rental growth than in the markets of the south-east.
Demand for industrial accommodation has improved over the past two years, particularly in the south east and London, although rental growth remains relatively subdued. Rents are expected to rise in London and the southeast over
the next two to three years, with growth elsewhere likely to be weaker as a result of higher levels of availability.
Investor demand for industrial properties has pushed up the prices of these investments to such an extent that the income yield on industrial estates is on average lower than that on regional offices, which are often let on longer leases to financially stronger tenants.
Further compression in industrial yields is likely over the next 12 months although it might not be justified by the cash flow fundamentals of the sector. In general, industrial buildings are the lowest value of built land use and so there is always the potential to add value through change of use to residential, retail or office accommodation especially in areas where land supply is limited.
At present, the performance of UK commercial property is probably more closely linked to that of the bond markets than at any time over the past 30 years. Low interest rates have drawn a substantial quantity of debt-backed capital into the property market, which together with expectations of lower levels of rental growth are placing the focus on the cash flow that property assets can generate.
One factor that differentiates the UK from many other property markets is the very high level of market transparency, largely as a result of performance monitoring series such as IPD’s and the continuing in-depth research that is offered by many property advisors.
The availability of historical and current performance information is invaluable in assessing the prospective risks and performance of the different elements of the UK market. This information has enabled the market to become more efficient, enabling the rapid growth of new products such as commercial mortgage-backed securities (CMBS) and property derivatives.
Although property derivatives are not a new idea, the market has remerged with vigour in 2005 with around £700m of transactions completed this year. However, the market remains polarised, with more buyers than sellers at current prices. Two main forms of contract appear to dominate: the PIC (property index certificate), which was first developed by Barclays in the early 1990s, and the three-year IPD Index All Property total return swaps. Despite the huge interest attracted by this market it remains in its infancy with very little liquidity in the products offered. However, one only needs to look at the extremely rapid growth of other derivative markets to realise how quickly the property derivative market could come of age.