Promising outlook for real estate, but getting harder to find value, says Chris Urwin.

August 2014

Key points

  • More upbeat on short-term returns on strong economy.
  • Higher-yielding sectors expected to outperform.
  • Few sectors attractively priced, office and retail among most overvalued.
  • Real estate attractive relative to other income-producing assets despite price surge and looming rate rise.

The strong turnaround seen in UK real estate last year persisted through the first half of 2014. We expect the market to continue growing strongly in the near-term and then to slow. Over the next five years, we see UK property producing total returns averaging 7.7% a year.

The UK economic recovery continues apace with output topping its pre-credit crisis peak this year, supporting our outlook for real estate. With unemployment at its lowest since 2008 we expect Gross Domestic Product to grow by 3.2% in 2014.

Meanwhile, inflation is likely to remain below the Bank of England's 2% target during 2015. Though there's growing pressure on the central bank to increase interest rates, once raised, they should stay low for several years. This positive economic backdrop propelled the UK IPD All Property Index 18% higher in the twelve months to June – its best annualised return in four years.

The office sector was the top performer, led by London and the South East. However, we expect industrials to claim that accolade by the end of this year. But for much of the recovery, retail was a laggard, but it now shows promise with rental growth finally picking up after years of declines. 

Following a brief lull early in the year, buoyant investment demand for UK real-estate, saw 400 deals closed in the second quarter worth around £15 billion, according to UK institutions are particularly keen buyers while overseas investors shrugged off a strong pound to remain significant net purchasers. Relative to other income producing assets, real-estate generally remains attractively priced. In the short term, the ongoing quest for yield is likely to continue driving up property prices.

In most property sectors very wide yield gaps remain between prime and secondary real-estate assets, though these are narrowing as risk appetite improves. Falling yields and rising rents should sustain strong total returns in the near term. However, the rapid rise in prices over last year means the opportunity to earn attractive returns in the medium term is likely to fade through this year.

Though we've raised our short-term UK real estate forecasts, we're progressing rapidly through the property cycle making it harder to uncover investment opportunities offering medium-term value.

Nonetheless, we believe UK real estate is set to deliver a 7.7% a year return over the next five years still making this asset attractive on a risk adjusted basis. But given the speed of price rises, investors putting new money into the market may struggle to participate fully in what's left of the upswing in the cycle.

With fewer available opportunities, investors might be able to make better returns by buying into higher yielding properties or by adding value to existing holdings by developing them.