Irfan Younus
Question marks exist over bond bubbles and equity valuations, while cash pays next to zero returns.
But if, as former Bank of England Governor Mervyn King said in May, an economic recovery is in sight, should institutional investors have UK property on their radar?
The first positive indicator of note for property is the economy. The UK saw a 0.3% quarterly rise in Q1 2013, which was better than the consensus expectation. Moreover, if conclusions are to be drawn from comparing existing economic cycle with previous ones, economic growth is expected to improve.
A key driver of growth in the UK is the services sector. The sector, which accounts for three quarters of the UK’s GDP, is seeing further improvements with June recording the fastest increase in activity2. In particular, sales volumes continue to accelerate which is putting pressure on capacity. The majority of service providers are forecasting a rise in business activity over the next 12 months.
What makes property attractive to investors, especially now, is the net income yield, currently between 5%-6%. The financial crisis hit rents and occupancy levels. However, the signs are that rent levels have now reached a floor, having fallen by 25%-30% from their peak. Cordea Savills’ Prime Rent Monitor, which analyses prime rents of the three main sectors for eight key UK cities, suggests that year-on-year rent changes are stabilising, with more office and industrial centres experiencing rental increases than falls in the first quarter of this year. This is supporting rental yield, which compared with other asset classes offers investors an attractive income return.
Confidence is certainly improving generally. Although traditional lenders, such as banks and building societies are still cutting their exposure to commercial property, lending flows have started to increase from new entrants, such as debt funds, pension funds and life insurers. Cordea Savills expect this trend to continue and as lending from banks stabilises, we expect total net lending to turn positive by the latter half of this year.
Another positive indicator is the buoyancy in property equity prices. This is supported by the better than expected results from the real estate investment trusts (REITs), especially those that have a higher-than-industry average exposure to London. At the height of the financial crisis there were discounts of more than 30% on REITs but there are now premiums.
We see positive signs across all property sectors in the UK except for retail, which has structural issues because of the emergence of eCommerce, and stock selection remains key. But the services sector is seeing a strong recovery and this will be particularly positive for office take-up and rental growth going forwards, especially for assets in central London.
A winning formula in property is to buy well located assets that provide reliable income streams, which can be improved by active management. This could involve, for example, increasing net lettable area, possible change of use and improving lease terms.
In summary, the recovery in UK real estate is gaining momentum: the economy is strengthening, albeit slowly, and rents seem to have found a floor for offices and industrials. There is now a weight of money chasing yields and which is now stretching out to the main established centres outside London. Investor confidence is rising and net lending is set to return. At present there is a real opportunity to enter the commercial property market just at its turning point, supported by an attractive income distribution versus what is achievable in other asset classes but with the prospect of improved income growth. UK property as an asset class could be in the ascendancy.
Irfan Younus, Research & Strategy, Cordea Savills
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