Outlook 2016: UK Commercial Real Estate
After a strong 2015, we expect performance across different parts of the real estate sectors to be more polarised in 2016.
2015 has been another good year for UK commercial real estate and unleveraged total returns are likely to be close to 15%.
Whilst one of the drivers for another strong year has been a continued favourable fall in real estate yields, the key difference to 2014 is that this year has also seen 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.
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.
Top of the cycle?
The outlook for 2016 is already categorised by some commentators asking whether we are now at the top of the cycle.
The income from commercial real estate has historically been very stable, but capital values have been cyclical (albeit less volatile than equities).
However, capital values have risen by 25% in less than three years - so, surely, this 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previous downturns has been a recession, which has depressed rents and pushed up real estate yields as investors have withdrawn from the market and liquidity has dropped.
In addition, commercial real estate has had a habit of contributing to its own downfall, either through excessive borrowing which inflated prices (e.g. 2005-2007), or because of a boom in development which left an over-supply of space (e.g. 1988-1990) and falls in rents.
Supportive economic picture
Fortunately, none of the usual suspects appear to yet be evident.
Looking at the economy, the outlook is positive and the consensus is that UK GDP will grow by 2.25-2.50% through 2016-2017.
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 EU, which accounts for 45% of total exports.
Borrowing under control
Similarly, 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 £80-90 billion reached in 2006-2007.
Moreover, while the IPD All Property Index initial income yield is low by historical standards at 5%, it is still comfortably above the yield on 10-year gilts at 2% and the consensus is that 10-year gilt yields are unlikely to rise to 3% until at least 2018.
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 2018-2019.
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.
Employment in construction is still 10% below its pre-crisis peak.
Also, another constraint on development in the commercial sector is sites being instead used for residential development.
Polarised performance in 2016
On balance, given that all the usual suspects have a good alibi, we think that capital values are likely to rise in 2016, but at a slower pace than in 2014-2015.
We anticipate that total returns will still be respectable at between 7-9%.
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.
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.