According to the latest analysis from Schroders it has been another good year for UK commercial real estate and unleveraged total returns are likely to be close to 15%.
One of the keys to success in 2015 was rental recovery. The report explains that whilst one of the drivers was a continued favourable fall in real estate yields, the key difference to 2014 was a broad based recovery in rental values.
While central London offices have led the upswing, several other cities including Brighton, Bristol, Cambridge, Manchester, Leeds and Oxford have also seen a significant increase in office rents. Likewise, industrial rents rose in many locations, boosted by growing demand from on-line retailers and parcel couriers.
In contrast however, the retail sector is still adjusting to a world of multi-channel sales, the report adds. While there are pockets of rental growth in London and some tourist destinations, most centres have a significant amount of vacancy and rents were either flat, or fell slightly in 2015.
The outlook for 2016 is already categorised by some commentators asking whether we are now at the top of the cycle. Schroders' head of real estate, Duncan Owen, explained that the income from commercial real estate has historically been very stable, but capital values have been cyclical. However, capital values have risen by 25% in less than three years and there is sentiment that cannot continue.
‘This sentiment is understandable, but not necessarily rational. The immediate trigger for previous downturns has been a recession, which has depressed rents and pushed up real estate yields as investors have withdrawn from the market and liquidity has dropped,’ said Owen.
‘In addition, commercial real estate has had a habit of contributing to its own downfall, either through excessive borrowing which inflated prices such as from 2005 to 2007, or because of a boom in development which left an oversupply of space, for example from 1988 to 1990, and falls in rents,’ he added.
He believes that none of the usual suspects appear to yet be evident currently. ‘Looking at the economy, the outlook is positive and the consensus is that UK GDP will grow by 2.25 to 2.5% through 2016 to 2017. The main reason for being optimistic is that the UK is finally seeing a recovery in productivity, which should support a steady increase in real disposable incomes and consumer spending. Furthermore, exporters stand to gain from faster growth in the rest of the European Union, which accounts for 45% of total exports,’ Owen pointed out.
His analysis also points out that there are few signs of excess borrowing. ‘In general, banks and other lenders have continued to take a disciplined approach to commercial real estate and although total loan originations in 2015 are likely to be around £50 billion, they are still well below the peak of £80 to £90 billion reached in 2006 to 2007,’ said Owen.
‘The final reason for being sanguine is that new commercial development remains at a low point in most markets. The only grounds for concern being the City of London, where a number of new offices are due to complete in 2018 to 2019. Even so, these levels of development are well below previous cycles. The lack of new development reflects in part the reluctance of banks to fund speculative schemes and in part the hollowing out of the development industry during the last financial crisis,’ Owen explained.
He added that employment in construction is still 10% below its pre-crisis peak and another constraint on development in the commercial sector is sites being instead used for residential development.
Looking ahead to likely performance in 2016, Schroders believes that, on balance, capital values are likely to rise in 2016, but at a slower pace than in 2014 to 2015 with total returns expected to be respectable at between 7% and 9%.
‘There are, of course, risks around this outlook. One possibility is that 10 year gilt yields jump more sharply in 2016 than anticipated. A second risk is the EU referendum. If the UK were to leave, then UK real estate could be hit as various investment banks and institutions, as well as some manufacturers, switch to continental European locations,’ said Owen.
‘The best market returns will be achieved by real estate which is in the right city, the right location and which best suits occupiers’ requirements and maximises their productivity. The outlook from this point in the cycle is therefore set for more polarised performance across different parts of the real estate sectors,’ he concluded.
Meanwhile, total returns on investment into central London’s booming office market increased to 1.5% in November, the fastest growth in all commercial real estate markets, according to the latest CBRE Monthly Index.
Central London offices also delivered rental value growth of 1.1% and capital value growth of 1.3%, both over three times that of offices in the rest of the UK segment.
The strength of the central London office market has been a feature of 2015, with total returns reaching 16.8% so far this year, well ahead of the 12.8% total return seen across the UK’s commercial property market as a whole. The industrial sector has also performed particularly well, delivering returns of 16.4% in the first 11 months of the year; 17.8% from industrial property in the South East.
Within central London’s strong office market, Midtown has been the star performer, delivering returns of 2.3% in November alone and 21.5% so far this year. The West End and City both recorded total returns of 1.6% last month.
Based on the trajectory in 2015, total returns measured by CBRE’s Monthly Index are expected to reach over 14% across the UK by the end of the year, slightly lagging the 19.7% return seen in 2014.
However, the report points out that monthly index returns, both CBRE and IPD, have been higher than IPD’s quarterly index so far this year. This is probably due to the different type of asset in the monthly indices, generally slightly higher yielding assets, particularly in the Retail sector.
‘Commercial property investments won’t deliver the same return as in 2014, but our monthly index is likely to show total return of 14% for 2015, well ahead of the 8.2% average since 2000. London and the South East have been an engine for growth, driving returns in both office and industrial markets,’ said Chris Brett, head of International Capital Markets at CBRE.
