UK commercial real estate returns are easing and likely to slow further this year, says Richard Levis.

Total returns to direct UK real estate continued to lose momentum in the first quarter. According to the IPD UK Monthly Index, All Property returns were just 1.1%, the lowest quarterly reading since 2012. The government’s surprise 1% increase in stamp duty on commercial transactions announced in March’s budget appears to have resulted in a direct devaluation of capital values of approximately 0.5% according to the IPD index.

However, a weak result was expected regardless of the tax change as momentum has been slowing since last year. With property yields at a nine-year low, the attractiveness of real estate relative to other asset classes has gradually diminished.  Having said that, both gilt yields and interest rate expectations have fallen recently which may improve the picture. Concern about the outcome of the UK’s referendum on EU membership in June may explain some of the sector’s recent weakness but this is not clear. First-quarter transaction volumes were down by around a third in value terms, year on year, to £13.5bn according to Although this was a large drop, the figure was still well above the £10.4bn quarterly average since 2000. Overseas investors have remained by far the largest net investors, offsetting a marked slowdown in activity by UK institutions.

The high levels of financial market volatility seen at the beginning of the year have eased but with economic growth having weakened a general ‘risk-off’ mood has continued to prevail. Although there has been a partial recovery in the price of UK real-estate investment trusts (REITs) since February, the market remains subdued with many REITS trading at a large discount to their net asset value. That may foreshadow further weakness in the direct property market. Other risks we are monitoring in addition to Brexit include the possible re-emergence of the euro-zone debt crisis, a faster rise in US interest rates than currently expected, and a sharper decline in Chinese economic output.

With property yields no longer falling so fast, maintaining income and generating rental growth will be drivers of performance in the near term. In this respect the prospects in several property sectors are good. For example, occupier markets appear robust in both London and core regional office markets, good quality retail properties and much of the logistics/distribution sector. That said, after surging recently, rental growth is now moderating amid softer economic data. Looking ahead we do not expect rental growth to wholly offset the slower decline in yields. Our All-Property total returns expectations are moderately lower than three months ago, at 6.6% for 2016, and averaging 5.1% per annum between 2016 and 2020.

In our view, performance over the next five years is likely to be strongest in regional offices and industrial assets, and weakest in more volatile segments, including prime London offices and retail. Yields in these parts of the market have reached all-time lows and they appear vulnerable to occupier demand shocks or unexpected interest rate tightening.

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Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 16 May 2016. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

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