Economy

The current combination of GDP growth running at 2.8% and zero inflation is probably as good as it gets in the short-term. Schroders expects inflation to increase to 1.5% by the end of 2015, as the fall in oil prices drops out of the calculation, and for GDP growth to slow slightly to 2.6% this year and 2.0% in 2016. Part of the deceleration in growth will be due to a gradual increase in interest rates – we expect the Bank of England to make its first move in November – and part will be due to a tightening in fiscal policy after the general election. In addition, the housing market appears to have lost momentum following the introduction of new rules on mortgage lending last year.

Occupational Market

While office rental growth in the regions is a long way behind that in central London (+11% in 2014), there are some bright spots. Brighton, Cambridge, Cardiff, Edinburgh, Reading and Manchester all saw office rental growth of 3% or more in 2014 (source: Investment Property Databank (IPD)). The main impetus has come from professional services, IT and bank back offices. We expect office rental growth in the regions will probably continue at 2-4% pa through 2015-2016, and 1-2% pa from 2014-2019 (see chart). We are cautious partly because some cities still have quite high vacancy rates and partly because there are likely to be further cuts in public sector jobs after the general election.

Despite strong consumer spending, large parts of the retail property market remain in the doldrums. While certain retailers are expanding (e.g. discount stores, restaurants), they remain outweighed by store closures (e.g. banks, bookmakers, fashion, phones), reflecting the rapid growth of mobile banking, internet gambling and online sales. Online clothing & footwear sales jumped by 17% in 2014 (source: ONS). Moreover, the recent U-turn by the major supermarkets to close, or sub-let space in their big stores, will add to vacancy out-of-town. Javelin Group estimates that the amount of space in hypermarkets and superstores could shrink by 25% over the next five years.

In the industrial sector, most regions are now seeing steady rental growth of 2-3% pa. The market is benefiting from both the growth in express parcels generated by online retailing and a cyclical recovery in small and medium sized enterprises (SMEs). The number of SMEs has grown by 10% in the last three years (source: Department for Business Innovation & Skills). In addition, the amount of space in standard industrial units has fallen over the last decade as estates have been redeveloped for housing, particularly in London and the South East.

Investment Market

The investment market was very busy in 2014 and the total value of real estate transactions at £63 billion matched the previous annual record set in 2006 (source: Property Data). Central London offices were once again the most liquid part of the market, but last year also saw a pick-up in shopping centre and industrial transactions along with a number of deals in student accommodation and health care. Although the fall in oil prices means that interest from Middle Eastern and Russian buyers is likely to wane in 2015, we expect that Japanese and Taiwanese pension funds and Chinese insurers will become more active.

As a result of strong competition in the investment market, the IPD all property initial yield fell to 5.3% at the end of February 2015, its lowest level since early 2008. On the one hand, this looks reasonable in the context of 10 year gilt yields at 1.5% and given prospects for steady rental growth over the next few years. Our pricing model suggests that the gap could narrow to 1.5-2.0% without putting real upward pressure on real estate yields. On the other hand, we are aware that certain parts of the investment market have got ahead of occupier fundamentals (e.g. prime West End offices, shopping centres, distribution warehouses). We are therefore tilting our portfolios towards those assets and sectors (e.g. alternatives, multi-let industrials) which should be relatively resilient if investor sentiment turns.

Outlook

The latest IPF (Investment Property Forum) Consensus Forecast suggest that commercial real estate could achieve total returns of 12% in 2015. Our view is that total returns in 2015 should probably be closer to 15%, although the more yields fall this year, the greater the risk of a potential correction in the future.

The other immediate uncertainty is the general election and the risk that business confidence will be shaken either by the prospect of an EU referendum, or by large increases in corporation tax and the minimum wage. The former could be problematic for London, given it is a hub for international financial and business services, whereas a jump in the minimum wage would affect care homes, hotels, leisure, pubs and retailers in particular.

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