By Chris Urwin
Back in February, we predicted that there would be a turnaround in UK real estate during 2013. We believe we are now seeing more signs of an increased appetite for risk that is likely to support this. According to CBRE, the first quarter of this year was the first for two years where no secondary UK sector saw outward yield movement. Although capital values and rents did continue to decline in Q1, the pace is slowing and we are increasingly confident that we are now approaching an inflection point in the market.
The IPD Quarterly Index showed that upward pressure on yields removed 0.4% from UK capital values in the first quarter of this year. However, the fall in capital values was not enough to completely erode income returns. Overall, property managed to deliver a positive return of 1.1%, the strongest quarterly return since 2011.
So we are encouraged to see data that supports our view. In this persistently low-yield environment, the appetite for riskier assets continues to grow and real estate is benefitting from this trend, especially as it looks very cheap compared to other assets. Prime property yields in some sectors have fallen recently and the IPD Index shows that valuations more generally are stabilising. Furthermore, anecdotal evidence suggests that transaction pricing is improving ahead of valuations. So it seems that favourable relative pricing is driving a turnaround in UK real estate.
Although occupier markets remain weak, the supply of new real estate is severely constricted. Construction output continues to fall and the value of new construction orders is close to a historic low. Excluding central London offices, new supply is expected to be extremely limited over the next few years and selective strategies targeting better-quality secondary assets look likely to outperform. In particular, Aviva Investors favours offices outside of central London and industrial assets outside of the capital.
In the shopping centre market, dominant retail and major urban centres are performing well, however smaller centres are suffering disproportionately from the impact of retailer administrations and online retailing.
Office markets continue to show a wide divergence between Central London and the rest of the UK in terms of occupier demand, investment conditions and development activity. Although development activity is muted in the West End, new completions in the City will increase significantly in the near term. Though well below record levels, take-up in Central London is keeping availability at tolerable levels and modestly lifting rents.
In the regions, conditions are more muted and development activity remains muted. However, with Grade A availability continuing to diminish, the likelihood of a firming in rents and new construction is rising. PMA data suggests that net additions to stock in cities outside of London are likely to remain significantly lower than historical averages throughout the next five years.
In the industrials and logistics sector, leasing activity is generally weakening, although the large shed market shows greater resilience. Overall, income risks appear to be stabilising and, given the degree of re-pricing that has occurred, it seems investors increasingly feel adequately compensated for the risks they are taking on by the high yields on offer.
In summary, investor appetite for risk continues to grow and we are seeing the first signs that demand for real estate is broadening from prime London assets to good quality secondary assets in and outside London. The decline in capital values of secondary assets appears to have come to an end and we believe the market is now positioned for improvement. With the aid of yield compression in the second half of 2013, this year’s total returns are likely to be relatively strong.
We believe this supports our view that this year represents a good entry point to UK real estate.
Chris Urwin is global research manager, real estate at Aviva Investors
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