Get Real (Estate)

Returns from the UK commercial real estate market have arrived at a critical inflection point.  A year ago, the average rental yield on commercial property across all regions and types of property was 6% per annum.  However, capital values were declining by about 0.5% per month, giving a zero total return to investors.  These declines have become steadily smaller over the year and in May this year, capital values actually rose by a very small amount.  Thus total annualised returns from commercial property have risen from zero to almost 6% over the last year.

The fundamental demand outlook for UK commercial property is improving.  For the first time in several years, data from the UK economy have been starting to show a sustained pick-up in growth, and unemployment, a key indicator for property demand, has been broadly stable for some time.  In addition, the Bank of England survey of credit conditions recently showed a positive reading for the first time in three years.  The market has been held back in recent years by banks selling down the property collateral that they were forced to take up after the financial crisis – the early signs that they are now prepared to consider lending to property investors is a good indicator that they no longer believe themselves to be over-exposed to property.  In terms of supply, new construction orders are at historic lows and outside of London there is barely any new supply of commercial property coming onto the market in the next few years.

Relative to the expected returns from other asset classes available to UK investors, commercial real estate has now become much more attractive.  The Bank of England Base Rate of 0.5% is likely to remain there for several years, and interest rates on the banks’ best deposit accounts have been falling sharply this year, as the Bank of England has been prepared to provide very cheap liquidity to those banks, which are increasing their lending.  In the gilt market, investors have to lend their money to the government for about 5 years to get a yield of 1% pa, about 8 years for a return of 2% pa and about 17 years for a return of 3% pa.  With markets pricing in an expected rate of increase in the Retail Prices Index of about 3% pa, most gilts are offering negative real returns, and that is before any taxation on the interest payments.  The UK equity market has a dividend yield of about 3.5%, and we would expect long term capital growth of an additional 4%.

From June 2003 to June 2013, the IPD UK All Property index has produced a total return of 73% (about 5.7% pa), all of which has come from income over the period, which encompassed a strong bull market, a major bust and a slow recovery.  Over the long term, we would also expect some capital growth from commercial property, if only to reflect the expectation that rents should grow in line with inflation.

Income returns of 6% pa (both currently and historically) plus the possibility of some capital growth as the UK economy starts to perform a little better after several years of stagnation, provide both a healthy level of return to investors and a strong consistency (low volatility) of those returns.  UK commercial real estate is an attractive asset class, and we have moved to a Heavy exposure across our portfolios, believing that now is a good time to be building positions in the asset class.