As the UK occupier recovery broadens, rental growth is replacing yield compression as a key driver of returns

Key points

  • Returns from UK real estate are slowing from high levels
  • Capital growth is easing but a rental recovery is becoming firmly entrenched
  • Rental growth is strongest in Central London offices while industrial rental values are increasing at their quickest pace in over a decade
  • Late cycle risks are rising as some sectors approach a seventh consecutive year of yield compression
  • Strong performance is expected to continue in the near term but at 6.4 per cent, our average annual total return forecast for 2016-2020 is lower than our 2015-2019 forecast

The third quarter witnessed another very strong return from direct real estate as the rally in UK commercial values entered its third year. According to the IPD Quarterly Index, all-property total returns hit 3.2 per cent during the quarter for an annualised return of 13.5 per cent.

While this is far ahead of long-term trend returns for the sector, it nonetheless represents a slowdown from the very strong returns we’ve seen in the last year due to the easing off we are now seeing in yield compression. This was always on the cards given the degree to which yields have already contracted since the financial crisis. Back in June of 2009, the IPD all-property initial yield hit its cyclical peak of 7.7 per cent, by September of this year it had shrunk to just 4.9 per cent.

Occupier market recovery broadens

But as the occupier market recovery broadens, rental growth continues to climb steadily in the UK and this promises a better balance to returns in the coming years. According to IPD, by September all-property rental growth was running at 4.0 per cent year-on-year. This is being led by rents in the office sector which are currently growing at an annual rate of 8.5 per cent. Rents in the industrial sector are also rising fast with a 4.6 per cent annual increase recorded in September.

However, at just 0.5 per cent, growth in retail rents is bringing up the rear as the sector struggles to slough-off the excesses of the pre-crisis years while facing up to a range of structural challenges. This helps to explain why total returns from UK retail properties in the third quarter (2.2 per cent) were around half those delivered by office and industrial properties.

Cycle progresses further

The upward leg of the property cycle is now well advanced. Indeed, some parts of the market have experienced unbroken yield compression for the past six years, most notably Central London offices and shops. The build-up of late cycle risk is thus a key concern. With absolute pricing in parts of the market looking expensive by historic standards and relative pricing becoming slightly less favourable, parts of the market appear vulnerable to a demand shock (see charts).

Positioning for the next five years

For the time being, yield compression will remain a key feature of returns. We expect further downward movement here in the near term given the weight of money chasing real estate and the strong valuation case for the asset class in such a low-yield world. Above-trend returns look set to continue into next year with good secondary assets likely to do especially well.

Thereafter, returns are likely to ease and become more dependent on improving income prospects. Normalisation in bond yields and interest rates looks set to be a gradual multi-year process coinciding with ongoing economic and financial sector recovery. As such, it’s unlikely to cause a shock to real-estate returns.

In our view, relative performance over the next five years is likely to be enhanced by overweight positions in regional office markets and industrial assets. At the same time, we think portfolio investors would be well served by reining in their leverage, disposing of potentially illiquid assets and reducing exposure to more cyclical assets such as Central London offices.