Commercial Property - UK market reflections21 February 2019
Despite the variety of sectors within commercial property, each with its own characteristics and risk profiles, 2018 proved remarkably consistent – in contrast to the volatility and weakness of equity and bond markets
Volumes have broadly been the same as the previous two years with £60 billion of transactions and yields – retail excepted – barely changed. This stability has made for a liquid market. The occupational market has been strong, with London offices – always a bellwether for the market – having only a 6% vacancy rate – not the lowest ever, but lower than the long-term average. Of offices under construction, 49% are pre-let, which is higher than normal and is counter to the Brexit gloom that has been the narrative of the last two years. The total return (income and capital gain) has been an average of 5.6% in 2018.
In case this sounds too complacent, some colour on who is buying and why might be helpful.
In general, the further from the UK you are, the less Brexit is the topic of conversation. So it’s not surprising that Asian investors have been the dominant buyers – almost 50% of the London market. They tend to buy big and modern, and the London office market ticks both those boxes. Yields, low by domestic standards, are high compared with many property markets in Asia and a weak sterling has only added to the UK’s attractions.
The other big buyer has been local authorities. A surprising buyer, driven to the higher yields of the commercial property market by derisory returns on their customary investment of choice – Gilts – and the need to generate income to compensate for reduced central government funding. The principle of property investment is not bad in itself, but too many have been restricting purchases to their own back garden and take no, little or poor advice. Spelthorne Borough Council alone spent £1 billion in 2018 and Barking set aside a £1 billion war chest. Currently, their cost of borrowings is very low – lower than anyone in the private sector at 2.5% over 50 years. The market is split between those taking fees to facilitate this overpaying for sub-optimal property and those looking on in dismay at a future car crash.
Will the market sustain its transaction volumes and current pricing? Probably not, and early evidence of outflows from the largest funds certainly suggests a desire for disinvestment. If local authorities acknowledge that they have frequently overpaid by 10-20% and cease being the market makers, or if sterling recovers, or tenants become less inclined to commit to leases, then there is a risk that pockets of the market will start to decline as strength in numbers will not be there. Investment volumes (by value) are high but the number of deals is not. The market is more concentrated than is immediately obvious.
Most investment agents aren’t sufficiently busy as there aren’t enough active buyers – other than for industrial property – and fewer bids are being received due to the lack of depth in demand. At the same time, demand from tenants is thinning. Even the star performer of the last three years, South East industrial property, is witnessing a reduction in tenant demand and West End offices occasionally receive a solitary leasing offer. As a consequence rent-free periods are getting longer and more generous. ‘Headline rents’ are being artificially maintained but the underlying story is weakening.
A poor time to buy then? If the objective is short-term capital gain then, as we have been saying for a little while, it would be better to keep the powder dry. For those with a long-term requirement for income from a carefully chosen portfolio, perhaps with inbuilt inflation protection, it’s still attractive compared to many of the alternatives.
It is a market where selecting the right property sectors and canny asset management – adding value and income by working tenants and buildings – have never been more important or valuable.