UK real estate: returns slowing but occupier demand remains positive
With UK all-property initial yields falling to their lowest since 2007 attention is turning to income and rental growth as drivers of near-term performance.
2015 saw returns continue at well above their long-term average for a third consecutive year with the IPD Quarterly Index (IPDQI), delivering 3.0 per cent in the final quarter to bring total annual returns to 13.1 per cent. Although a significant decline on the 17.9 per cent seen in 2014, this was still the second strongest year for the UK real estate market since 2010.
Last year also saw another record for UK real estate transactions. Despite a noticeable slow down in the second half of the year, the £70 billion of deals recorded by Propertydata.com was an 11.0 per cent increase over the previous record set in 2014.
Real estate returns are moderating as the pace of yield compression eases after falling rapidly in recent years. According to the IPDQI, the UK all-property equivalent yield declined by 32bps through the course of 2015 to stand at 5.8 per cent by the end of the year, it’s lowest level since 2007.
However, the pace of rental growth continues to climb steadily promising a better balance to future returns. By December last year, the IPDQI estimates that all-property rental growth was running at 4.0 per cent year-on-year, the strongest pace of growth seen since 2007.
Retail, office and industrial markets
The offices and industrial sectors continue to lead performance, with total returns picking-up quickly in regional markets. The retail sector trails behind overall but is polarised between the south-east of England, where conditions are often buoyant, and the regions, where rental declines continue to drag on performance in many locations.
Overall, retail rental growth was positive at 1.1 per cent (year-on-year) in December, but retail rents still remain almost 8 per cent below their 2008 peak.By contrast, industrial rents have almost returned to their peak levels while office rents have actually moved higher.
This lag in rental recovery helps to explain why the retail sector continues to underperform. According to the IPDQI, the retail sector delivered a still healthy total return of 9.0 per cent in 2015, but this was significantly behind the 17.6 per cent from offices and the 16.5 per cent delivered by industrial properties.
Despite the modest decline in manufacturing output seen late in 2015 and the fact that total output is still below the 2008 peak, leasing activity in the industrial and logistics sectors remains robust largely due to the growth of online retailing and trade counter operators.
This is maintaining downward pressure on availability and upward pressure on rents. By December, the IPDQI estimated rental growth of 4.6 per cent year-on-year, up from 2.5 per cent a year earlier. This is the strongest rate of growth since the latter part of 2000 and although rental growth remains far stronger in the south-east (5.6 per cent) than in the rest of the country (3.2 per cent), the pace of growth is accelerating across the country.
Offices, meanwhile, continued to see strong rental growth in 2015 (8.2 per cent), also concentrated in London and the south-east but increasingly spreading to the regions.
Yield compression running out of steam
Given the strong valuation case for the asset class in such a low-yield world, further downward movement in real estate yields appears likely for many parts of the market.
Nonetheless, the pace of yield compression looks set to ease further in coming quarters as investor demand moderates amid financial market volatility and elevated geo-political risks. As a result returns will become more dependent on income and rental growth prospects.
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- Returns remain above their long-term average but momentum is slowing
- In 2015, the IPD Quarterly Index, delivered a total annual return of 13.1 per cent, down from 17.9 per cent in 2014
- UK all-property equivalent yields declined by 32 basis points in 2015. The average yield at the year end, was the lowest level since 2007
- By December, all-property rental growth was running at 4.0 per cent year-on-year, the strongest pace of growth seen since 2007
- For 2016, we forecast an all-property total return of 8.7 per cent. Over the five years between 2016 and 2020 we expect to see annual returns slow, averaging 5.9 per cent per annum