The UK real estate market: Where next?
The UK commercial real estate market has experienced high transaction volumes over the last two years. As a result, the market has delivered two years of double-digit total returns. Given these record levels of activity and returns, the pertinent questions now are whether this remains a suitable time to invest into the UK market, and if so, what strategy and asset types to pursue?
2014 – A strong market
2014 was a particularly strong year for UK commercial real estate, with total returns to property averaging between 18-20%, supported by investment transactions of circa £40bn to September 2014 (£53bn annualised). This followed another strong performance in 2013 with total returns of 10.9%, supported by £53.3bn of investment transactions. These transaction volumes are the highest seen since immediately before the market peak (2006 £62bn, 2007 £55bn) and compare to the low levels of activity – circa £25bn – observed in 2008 and 2009.
In 2014, overseas investors were the largest single investor type in the UK, comprising 39% of transaction volume. The next largest class of investors was UK institutions, responsible for 30% of total investment in the UK. This highlights the continued high demand for good quality assets in the UK, which are seen both as a yield play in a low interest rate environment, as well as a “safe haven” store of value for both UK and foreign investors.
Driven by this surge in investment activity, prime real estate yields fell for all sectors across the board, and recovery was evident even in those sectors that appeared to be under additional macroeconomic stress and constraints, such as High Street Retail, Retail Warehouse and Shopping Centres. The only sector that has seen an increase in yield over the last two years is the Food Stores sector, which has continued to be negatively impacted by the well-documented issues facing the large UK supermarket chains.
Yield shift across all but one primary commercial property sector (Food Stores), driven by capital flows, has delivered a material impact on the capital values of real estate across all sectors. It is important to note, of course, that the significant implied capital value growth presented above does not take into account the impact of rental growth and value created from asset level improvements.
After two very strong years, when real estate outperformed most asset classes, the main questions are whether asset level fundamentals support the current valuations and whether underlying rental growth is sustainable. In short, has the market reached a new peak, and where do investment opportunities remain?
The hunt for value
The hunt for value is already on! Anecdotally, investors’ investible universe appears to be expanding as risk aversion falls away somewhat and demand for non-core assets/locations increases. This has been evidenced by the increased transaction volumes in regional buildings, as well as a sharp narrowing in the yield spread between prime and so-called secondary assets (namely, those in lower-quality locations, buildings with lower-quality tenants or shorter lease terms, or those buildings requiring capital expenditure). This narrowing of yields has been consistent since the end of 2012 and is expected to continue as investors seek higher yielding assets. However, the market remains a long way from the very narrow spreads observed before the last peak, where secondary assets were often traded at a yield premium of less than 50bps over their prime counterparts. Indeed, the yield spread is currently more than a percentage point higher than its long-term average.
Consensus view on market outlook
The general view for the whole UK market is that 2015 will see a continuation of the recent upward trends in both investment activity and returns. Whilst there is an apparent consensus that the market will enjoy double-digit total returns, during the course of this year, we have noted a wide spread in forecast returns, with, for example, CBRE forecasting total returns of 3%, whilst Aviva Investors is currently predicting a total return of 17%.
The IPD UK consensus forecast, which pulls together the research of 30 organisations, has a mean forecast for UK All Property total return of 10.8%. However, it is the four-year outlook to 2018 that is of most interest. For 2016 onwards, the levels of capital growth are forecast to reduce dramatically, with total returns expected to be driven primarily by income returns. The consensus forecast for 2016 shows capital growth of only 1.1%, with total returns at 6.6%. 2017 is forecast to report capital growth of just 0.1% and total returns of 5.3%, whilst 2018 is forecast to see capital values fall by 0.3% and a total return of 5%. Total annualised returns from 2014 to 2018 are expected to be 9.2%, a figure skewed by 2014 returns. Taking 2014 out of these calculations results in anticipated annualised returns of circa 6.9% per annum for the years 2015-18.
This suggests that the market will reach its peak towards the end of this year or early 2016. However, given strong recent returns, the total returns offered by the UK real estate market still makes this asset class look relatively attractive to others. This continues to drive capital flows into the market, with high levels of both institutional and retail inflows into most open-ended funds. The market consensus is that yields still have further to fall during 2015, as capital continues to chase assets. The market has enjoyed an unexpected and extended boost from the renewed fall in sovereign debt yields and other fixed income investments. However, after 2015, the drivers for UK real estate performance will be a combination of, first, improved real estate fundamentals, and second, commercial activity and development among owners of real estate. In a sense, the market will enter a period of normality, subject to macroeconomic conditions and demand from end users.
Real Estate fundamentals
Given that over the last few years, real estate values have been, in large, driven by capital flows, it is reasonable that at some point, asset level fundamentals need to “catch up” with where capital markets appear to be pricing assets. Real Estate is, of course, a cyclical asset class, and at different stages of the cycle, especially after a period of strong capital appreciation, the actual performance of underlying assets must underpin such growth. In the current market, it appears that the capital markets may well have got ahead of themselves in terms of pricing. Therefore, as capital values stabilise, it is to be expected that the emphasis will shift to the actual performance of underlying assets. This means that much more emphasis will be placed on the occupier market, i.e., the customers and end-users of real estate (namely the tenants) and their associated demand for real estate.
At the end of the day, the long-term driver of real estate value is the demand and supply of stock that meets the needs of the occupier market. Like any other market, commercial real estate is ultimately driven by fundamental demand and supply dynamics; over the next few years, strong demand and limited supply should underpin rental growth across the UK, which in the absence of yield compression should help support capital values.
Prevailing macroeconomic conditions have a significant impact on the demand for commercial real estate by end users, across all sectors. Occupying real estate is clearly a long-term commitment (especially in the UK, with typical lease lengths of 10+ years), and until recently, many business had held back on long-term commitments to infrastructure and real estate. Business confidence, together with medium- to long-term corporate investment strategies, have as much impact on user demand for real estate, as do changes in consumer behaviour, regional development initiatives and large infrastructure projects. Hence, over the next period of the UK real estate cycle, the importance of the broader macroeconomic conditions cannot be underestimated.
Overall the UK economy’s expected growth and increased employment are expected to boost both corporate and consumer confidence and should underpin the fundamentals and values of UK real estate.
Much discussion has centred on the impact of interest rates on the valuation of UK real estate. A common concern is that with rising interest rates, the comparative pricing of real estate will require yields to shift out. In part, this is already reflected in the expected reductions in yield compression noted above, whereby real estate may no longer look as cheap compared to other asset classes, once the unwinding of historically low interest rates begins. However, over the last 25 years, the correlation of real estate yields to interest rates is not as strong as may be commonly thought. Indeed, other than a small peak in the depths of the early 1990’s recession, the index of all UK Property yield has moved within a very narrow band of between 5% and 8% over the past 30 years; prime assets, of course, have seen yields some way below this level. This is despite large movements both in the Bank of England Base rate and the 10-year gilt yield from over 12% to the current historically low 0.5% during this period.
The fundamentals of real estate should act as a natural hedge to the impact of interest rate increases. Since low interest rates are expected to unwind only after we see sustained increases in economic activity levels, the current expectation is that the underlying performance of real estate assets should be stronger, given any increase in economic activity. In effect, should the yields of real estate shift out, as interest rates increase, it would be expected that the actual income being generated from the assets would increase, offsetting some of the yield impact on capital values.
Above we have addressed the demand side of real estate fundamentals, but the other key aspect is the ability of owners and investors of real estate to supply the appropriate stock in terms of location and quality and function and to satisfy that demand. Anyone travelling through the City of London, Southbank and parts of the West End would believe that the UK was currently undergoing an immense volume of development and refurbishment. However, the levels observed in the capital are the exception and not the norm.
Following the global financial crisis and the lengthy recession that followed in the UK, levels of commercial activity fell to record levels. At the end of 2008, the commercial development activity outlook scored at -49%. Whilst it recovered sharply into 2010, it has only really picked up in the last 18 months, and indeed it fell back earlier in 2014. Many real estate owners were in state of flux, with many larger funds and listed entities more focused on survival than on future pipeline and development. Consequently they deferred, cancelled or scaled back ongoing capital expenditure and refurbishing stock.
As a result of this, the UK has seen its commercial real estate stock suffer a period of underdevelopment. Existing stock has become more aged and less fit for purpose, which provides significant opportunities for investors seeking to refurbish, develop or actively manage assets across the UK.
For those core investors, seeking high-quality assets with a focus on long-term income yield, they will require an increased supply of higher specification buildings fit to meet tenant requirements while also meeting current environmental standards.
Tenants will increasingly make changing and increasing demands of their landlords and will only accept increased rental values if the quality of the stock is maintained and remains fit for use.
Value-added investors/developers therefore have a double opportunity. They see increased demand for product from investors as well as users. The best investors will stand out based on their ability to buy stock or land bank in the current competitive environment and to execute genuine value-added asset management plans, refurbishments or developments.
The UK appears to be entering a period of stability, albeit with potential headwinds from Europe and uncertainty in the coming months from the general election. However, the signs are apparent that demand from both the investor base and end users of real estate will remain strong, enabling an underpinning of the wider UK real estate market. In the medium term, the unwinding of low interest rates may have a limited impact on real estate yields, but this should be offset by stronger rental growth, driving the fundamental performance of underlying assets. Total returns are expected to normalise, but this will mean the market remains attractive to both the core yield-hunting investor and investors seeking to create value, rather than riding the wave of capital upwards.