UK real estate: returns cooling but outlook remains positive
UK property yields fell further in the first quarter as occupier markets continued to strengthen. But the pace of capital growth slowed.
- Returns remained strong in the first quarter of 2015 with yields continuing to fall as rental growth became firmly established.
- All-property total returns of 2.9% in the first quarter down from 4.1% in the previous quarter.
- Real estate likely to remain attractively priced relative to other asset classes, especially government bonds.
- Further yield-driven capital growth looks probable in the near term with good secondary and regional assets likely to perform especially well.
Strongest returns on record
Real estate returns in 2014 were among the strongest on record as high levels of investor demand met with improving occupier fundamentals. According to the IPD Annual Index, all-property total returns were 17.8% p.a. in December, the best year-end result since 2006.
More of the same
Returns remained strong in the first quarter of 2015 with yields continuing to fall as rental growth became firmly established. But the pace of capital growth slowed. All-property total returns were 2.9% in the first quarter, down from 4.1% in the fourth quarter of 2014 according to the IPD Quarterly Index.
Record first quarter transactions
Demand for UK commercial real estate remains very high. According to PropertyData.com, the first quarter saw total transactions of over £16 billion – the strongest on record. This was influenced by a significant number of large portfolio and ‘alternative’ deals, such as long-income, hotel and student housing transactions. The total value of ‘traditional’ core/core+ transactions was more muted, although still above average.
The surprise of a Conservative majority government on 7 May is likely to have only a modest impact on commercial UK real-estate performance in the short term. The market appears, however, to be adjusting to the lower interest-rate environment more slowly than anticipated. We have therefore reduced our forecast total return for the UK market in 2015 from 18.8% to 16.4%. Despite this, our forecast all-property total return of 9% p.a. for the 2015-2019 period remains unchanged.
Secondary assets outperform
While demand remains strong across the property spectrum, we are continuing to see signs of a narrowing pricing gap between prime and secondary assets. We have been recommending such assets for some time: they offer attractive yields and potential to capture the ongoing improvement in the UK’s occupier markets, particularly in the office and industrial sectors.
The office sector continued to lead the market in the first quarter, narrowly ahead of the industrial sector. Retail remained the weakest sector, but still delivered respectable returns while offering strong prospects for improved performance this year.
The office sector
Availability in Central London fell to its lowest level since 2002, driving prime rents up in the City and West End. Similarly, several regional office markets have seen availability fall while take-up has been robust.
According to DTZ, prime rents in the eight largest UK markets increased by 5% on average in 2014.
The industrial sector
Declining availability has helped to shift negotiating power to landlords. The IPD Monthly Index recorded year-on-year rental growth of 3.3% in March, the biggest annual uplift since 2001.
Relative performance is likely to benefit from overweight positions in regional UK offices and industrial assets.
The retail sector
The ongoing polarisation between London and the regions, driven by the capital’s strong economy, record tourist numbers and high demand from international retailers, remains conspicuous. Even so, improving household finances are driving a rise in retail sales resulting in modestly rising rents.
We believe real estate remains attractively priced relative to other asset classes, especially government bonds. The weight of money chasing real estate, supportive credit conditions and the strong valuation case all make further yield-driven capital growth probable in the near term. Good secondary assets are likely to perform especially well.
As a consequence, relative performance is likely to benefit from overweight positions in regional UK offices and industrial assets. Strategies focused on higher-yielding market segments, secondary assets, development and refurbishment or portfolio sales are also likely to reward.
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