UK Property Market Commentary - December 2014
Schroder Real Estate UK Real Estate Market Commentary
Schroders expects the UK economy to continue to grow by a healthy 2.5% per annum through 2015-2016. The main driver is likely to be consumer spending, which should be supported by both the fall in energy prices and by an upturn in productivity and higher wage increases. Productivity has stagnated since 2008, but should now improve, following the recent recovery in business investment. By contrast, government spending and net exports are likely to remain weak. Despite the slowdown in inflation to 1%, Schroders expects that the Bank of England will start to raise interest rates this autumn.
Although central London has already seen a strong recovery in office rents over the last few years (see chart), we believe that the upswing has a lot further to run. On the demand side, forecasts suggest the number of jobs in insurance, IT, media and professional services will grow by 140,000 between 2014 and 2017 (source: Oxford Economics). On the supply side, the overall vacancy rate has fallen to 6.4%, its lowest level since 2006 (source: PMA) and the shortage of development finance means that there is relatively little new office building. In general, we prefer areas such as King’s Cross, Shoreditch and South Bank where yields are higher than in the core City and West End locations.
Strong consumer spending meant that instore retail sales (as distinct from on-line sales) grew in 2014 for the first time since 2010. However, while this is positive for retail property, we remain concerned that most retail prices are either flat, or falling and that many towns have a structural over-supply of space. Our retail strategy is to focus on convenience stores in cities and affluent towns and on retail parks with open consents, which are benefitting from the growth in chain restaurants and click & collect sales.
In the industrial sector, the combination of a normal cyclical upturn in demand and the rapid growth in express parcels to fulfil on-line retail orders has resulted in steady rental growth of 2% per annum. The strongest parts of the market are industrial estates in London, the South East and Midlands, reflecting the lack of new building and the gradual loss of space to housing over the last 10-20 years
Historical rental growth
Annual % change
Early estimates suggest that there were £56 billion of investment transactions in 2014, maintaining the high level seen in 2013 (source: Property Data). The main net buyers were UK institutions, retail funds and foreign investors, while the main sellers were private property companies. Although the fall in oil prices is likely to restrain Middle Eastern and Russian buyers, the most active foreign investors over the last twelve months have been from Asia and the US.
As a result of strong competition in the investment market, the IPD all property initial yield fell to 5.4% at the end of November, 0.7% below its level at the start of 2014. While this rapid rate of yield compression has unfortunate echoes of 2005-2006, we think that UK real estate is still fairly priced at present, given the prospects for rental growth and the large gap of more than 3% over 10 year gilt yields. We also take comfort from the fact that unlike in 2005-2006 there is still a significant spread between prime and secondary yields, meaning that investors continue to discriminate between properties with different risks. We are also reassured that it is still possible to find assets with good bricks and mortar fundamentals which other investors have over-looked.
We expect to see another solid performance from UK commercial real estate in 2015. The latest IPF Consensus Forecast suggest offices and industrials will achieve total returns of 12% in 2015, followed by retail with total returns of around 10%. Our view is that total returns in 2015 will probably be closer to 15%, although the more yields fall this year, the greater the risk there is of a potential correction in the future, as interest rates start to rise.
The other risk is the general election in May and the uncertainty which would arise if the next government decided to hold a referendum on EU membership in 2017. That could be problematic, particularly for London, if multi-nationals started to defer their expansion plans until after the result and it might also jeopardise the city's haven status with foreign investors.
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