Strong performance of UK real estate to continue in the near term, despite slower capital growth.
- Returns from UK real estate remain strong.
- Capital growth is easing but a rental recovery is becoming firmly entrenched.
- The industrial sector has overtaken offices as the strongest market sub- sector overall.
- Transaction levels may have moderated but they remain robust by historic standards.
- The strong performance of UK real estate is set to continue in the near term with our average 2015-19 total return forecast unchanged at almost nine per cent pa.
Highest returns in 26 years
Returns from the UK real-estate market remain strong. According to the IPD Monthly Index (IPDMI), annual all-property total returns hit 15.7 per cent in August. The pace of capital growth has eased over the past three months but remains high amid strong investor demand. The recovery in rental values is now firmly established with the IPDMI recording a four per cent year-on-year gain in rents in August – the best rate of increase since 2007.
Not surprisingly, rental growth remains strongest in prime London offices and retail with continuing supply constraints and strong occupier demand suggesting that rents here have further to go yet. Encouragingly, the rental picture is also noticeably strengthening in the UK’s regional markets, providing greater confidence for the medium term. It’s now more than two years since the current rally in real-estate values began and the market continues to see above-trend performance. The industrial sector has now overtaken offices as the strongest sub-sector, delivering a 4.8 per cent return in the three months to August compared to 4.4 per cent from the office sector. By contrast the retail sector, with a 2.2 per cent return, continued to trail1.
The investment market may have softened a little after a record fourth quarter of last year (£21.4bn) and a substantial £18bn in the first quarter. Even so, acquisitions from UK institutions and overseas buyers still accounted for around half of the second quarter’s £16.3bn of transactions.
UK commercial real-estate transactions by investor type (£m)
Source: Propertydata.com, 20 July
Stronger occupier demand in most sectors
Intense demand for central London office space in the second quarter saw total take-up jump almost 30 per cent from the first. Such demand is driving rents significantly higher. Meanwhile, regional office markets are also gaining ground as limited supply, especially of grade A assets, drives up rents.
Although UK manufacturing output has softened, leasing activity in the industrial sector remains brisk. Despite robust numbers of construction starts, ebbing availability is also now driving rental growth here. In August, the IPDM Index saw its strongest uplift since 2001 with annual rental growth in the industrial sector hitting 4.2 per cent.
In retail, rising retail sales and an ongoing recovery in wages is gradually feeding through to retail occupier markets. Rents in the sector are rising although they continue to be led by central London where limited vacancy, booming tourist numbers and ardent demand from international retailers is driving rents to new records.
UK market outlook
Investor demand remains very robust while the availability of credit is also improving. Meanwhile, the occupier market recovery is now spreading to regional markets and to secondary properties.
We expect the recent strong performance of UK real estate to continue in the near term, largely because real estate is likely to remain attractively priced relative to other asset classes, especially government bonds.
But looking further ahead, performance is likely to moderate as yield compression gives way to modest rental growth as the main driver of returns. And as the interestrate environment begins to normalise, we expect the downward pressure on yields to abate. Consequently, our five-year all-property total return forecast for 2015 to 2019 remains almost unchanged from last quarter, averaging 8.8 per cent per year.
UK all-property relative pricing
Source: Aviva Investors as at August 2015. The relative pricing analysis compares the difference between real estate yields and the yields from other asset classes in a specific quarter with the long-term average difference. A standardised score is thereby created for each quarter and the standardised scores for each asset class are separated into quintiles, with the top (bottom) quintile indicating that property is very cheap (very expensive) compared to the other asset class.
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