Property IQ. After a sterling year, what next? Q Authors. Real Estate

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1 Q Real Estate Property IQ After a sterling year, what next? 2014 was an outstanding year for UK commercial property. The latest monthly IPD figures show annual total returns have climbed to 20%, a level not seen over the last 20 years. To date, around 46 billion has been invested in the market this year, one of the highest totals ever. It will be tough for 2015 to match this performance. The consensus view is that returns will roughly halve to a respectable but much less exciting 10% or so. But is this being too pessimistic? Yields have fallen further and faster than was generally expected during 2014 limiting the scope for further falls and therefore also limiting capital growth induced by yield compression. Indeed the IPD All Property equivalent yield fell 86bps over the year to October, compared with just 5bps over the previous twelve months. But below the headline figures there are plenty of subsectors where yields are nowhere near the bottom of their historic ranges and could therefore offer further yield-driven capital growth. These include regional office property, shopping centres and retail warehouses. Authors James Griggs Information Unit Manager jgriggs@deloitte.co.uk +44 (0) Will Matthews Real Estate Insight wmatthews@deloitte.co.uk +44 (0) Deloitte Real Estate Yield Matrix changing sentiment towards yields on prime property Occupier weakness has caused sentiment to fall in the supermarkets subsector Sector Shops Shopping centres Retail warehouses Car showrooms Leisure parks Supermarkets Industrial Offices Category Prime major cities Cathedral cities Market towns Regional dominant Sub regional Major town centre schemes Smaller urban schemes Parks (open A1) Parks (bulky) Solus Let to dealership Let to manufacturer Standalone superstore Distribution (15 year term) Distribution (5 year term) Modern ind. est. (Regional) Modern ind. est. (South East) City West End Midtown West London South East Major cities Out of town Jun 09 Jul 09 Aug 09 Sep 09 Oct 09 Nov 09 Dec 09 Jan 10 Feb 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov 12 Dec 12 Jan 13 Feb 13 Mar 13 Apr 13 May 13 Jun 13 Jul 13 Aug 13 Sep 13 Oct 13 Nov 13 Dec 13 Jan 14 Feb 14 Mar 14 Apri 14 May-14 Jun-14 Jul-14 Aug 14 Sep 14 Oct 14 Sentiment indicator: n Sentiment weakening n No change in sentiment n Sentiment strengthening Source: Deloitte Real Estate Deloitte Insight

2 2 Property IQ After a sterling year, what next? Yields in some parts of the market have fallen to very low levels most notably the central London office submarkets and the potential for further falls would appear to be limited, among other things, by the risk-free rate. However with the five-year swap rate now down to around 1.5% as expectations for a rise in base rates get pushed back into the second half of 2015, this margin remains attractive even as property yields compress. It is also worth remembering that the impact of yield compression on capital values is not linear: a 25bps fall in yield has over twice the impact on values when yields are 3.5% as when they are at 7%. 12-month total returns: by asset class (%) Q1-13 Q2-13 Q3-13 Q4-13 Q1-14 Direct property Property equities Equities all share Gilts 5 to 10 yrs Source: IPD/MSCI Q2-14 Q3-14 And there are other reasons why yields could fall further. Overseas investors were responsible for over 40% of deals this year by value, a share that has been steadily growing from around 20% at the start of the century. Looking to 2015, foreign investment could see another strong year as concerns over emerging market growth prospects promote the safe haven trade, and the pool of countries and their institutions targeting overseas capital deployment continues to grow. Overseas investors share of market 70% 60% 50% 40% 30% 20% 10% 0% 2000.Q Q Q Q Q Q Q Q1 On the other hand, there will be more political factors in play, not least the May general election and the prospect of an EU referendum, which could slow investment activity Q Q Q Q Q Q Q1 Yet there is little doubt that performance will be more reliant on rental growth over the next phase of the cycle. In many sectors this has been slow to recover, but is now taking hold, particularly in prime parts of the market where delivery of new stock has been limited since the downturn. Indeed construction output growth for commercial and industrial new work has slowed since the early summer growing by just 1% over the year to September and the key central London office market looks set to deliver one of the lowest quantities of new space in 2015 in 20 years. With demand for grade A space in London expected to outstrip supply for three more years, headline rents are also forecast to rise over the same period. And of course rental growth in the wider regional market will be supported by the next phase of the economic recovery, which should see a confirmation of corporate expansion and a shift towards stronger consumer spending as wages finally start to show meaningful growth in real terms. Rental growth is rarely as strong a driver of performance as the impact of yield compression, and some of it may have already been accounted for in current pricing, so there is a risk of double counting the benefit of rental growth as it starts to come through more strongly. Initial yields may have fallen to around 6%, but with some further yield-driven capital growth to come, and a period of more widespread rental growth ahead, there are clear reasons to expect higher returns than the current consensus suggests.

3 Property IQ After a sterling year, what next? 3 The economy A year of solid growth expected Changing consensus forecasts for GDP growth Economy continues to show solid growth GDP growth % Despite the rate of GDP growth easing from 0.9% to 0.7% in Q3, the outlook remains robust. Business activity surveys point to a similar rate continuing through Q4 and the consensus view expects growth next year to settle back to a still-strong 2.6%. 0.0 Forecasts made in: Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Continued weakness in the Euro area remains one of the chief risks to growth, which along with the strength of sterling is making life hard for exporters. Source: HM Treasury Risk appetite % of CFOs who think this is a good time to take greater risk onto their balance sheets 80% 70% 60% 50% 40% 30% 20% 10% 0% Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Corporate confidence still high Large corporates appetite for taking further risk onto their balance sheets has reached a seven-year high, according to the Q3 Deloitte CFO survey. However, elsewhere the survey also shows signs of a more cautionary approach among respondents, with defensive overtaking expansionary strategies. Concerns over the strength of emerging economies has risen, alongside those over the Euro area. Source: Deloitte CFO Survey GVA growth 2015 forecast % North West due to perform well in 2015 Greater London Eastern North West South East South West Wales East Midlands West Midlands Scotland Yorks & Humber N Ireland All regions are forecast to show healthy economic growth in London still heads the table, by a margin, but further down the order has a slightly different feel. The North West sits above the South East in the ranking, benefitting from increased business activity in areas such as engineering, wholesale trade and hospitality. This is reflected in the results of Deloitte s recent Businesses leading Britain report, which identifies the East Midlands and the North West as hotspots of growth among medium-sized companies. North East Source: Oxford Economics 0% 1% 2% 3% 4% 5% But over the longer term, demographic and sector employment trends will continue to favour London and the South East.

4 4 Property IQ After a sterling year, what next? UK commercial property Overseas investment drives activity Property investment by quarter ( million) 80,000 60,000 40, investment should be close to record With over 16 billion of investment deals completed during Q3, 2014 s total was almost 20% ahead of 2013 at the same point, and given the traditional volume of activity at the year end, appears on course to match the peak volume of , Q1 Q2 Q3 Q4 Share of investment by investor type Q Overseas investors dominant 18% 2% 2% 46% Owner occupiers Overseas investors Private investors UK institutions Foreign investors saw a significant increase in their share of the market over Q3, from 36% to 46% of all deals by value. This was largely at the expense of UK property companies, whose share fell from 25% to 18%, reflecting a greater degree of selling. 27% 5% UK property companies Others The strength of the UK economy in particular relative to other countries has been one factor in its attractiveness to overseas money. The third quarter saw a range of deals completed over 200 million, including regional portfolios and retail assets, as well as central London shops and offices, with a range of investor types involved. Overseas investment by region but little evidence of moving from London 100% 80% 60% 40% 20% 0% Over three quarters of overseas cash spent on UK commercial property is spent in London, with the West End and City submarkets taking an almost identical share. Despite evidence of an increased share of spending outside London and the South East by overseas investors in 2014 (mainly down to the major retail asset deals) to 17%, up from 10% in 2013, this only brought it back in line with the levels in 2011 and London West End South East London City Rest of UK Rest of London

5 Property IQ After a sterling year, what next? 5 UK commercial property Further growth to come in the regions Alternative sector investment volume by quarter, millions 6,000 5,000 4,000 3,000 2,000 1,000 0 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Leisure Other Alternative assets prove attractive Non-core assets have been strongly targeted by investors this year. Prospects for the hotel sub-sector are positive: a restrained level of new supply, combined with improving operating fundamentals this year and the forecast of increasing economic activity around the regions. Prime leisure parks have seen yields fall 75bps over the last twelve months, with purchasers attracted by the stable income stream provided by relatively long leases. Fall in yields year to date, percentage points (selected sectors) Modern ind estate regional Offices major cities Offices out-of-town Shopping ctrs major town centre Shopping ctrs regional dominant Retail parks Offices South East Offices Midtown Offices West London Prime distribution 15-yr term Shops market town Leisure parks Car showrooms (dealerships) Supermarkets Shops major cities Offices City Source: Deloitte Real Estate 0.00% 0.25% 0.50% 0.75% 1.00% Regional assets see strongest yield compression Over the year to date, the strongest falls in prime yields have generally been seen in the regional markets. In particular, shopping centres have attracted significant investor interest, with demand filtering down from the largest schemes to smaller assets. Retail parks have also benefitted from this sentiment. In the office sector, London Midtown, for a long time showing the largest falls, has been overtaken by business parks and prime offices in the major regional cities. Office annual rental value growth, Q (%) Rental picture still patchy North West North West, 1.2 Wales, 3.2 West Midlands, 1.3 South West, 0.6 Source: IPD/MSCI Scotland, 0.7 South East, 3.3 North East, -0.8 Yorkshire & Humber, 1.8 East Midlands East Midlands, -0.7 East, 3.1 Outer London, 7.0 City, 8.6 Midtown, 11.7 West End, 10.2 As yield compression slows, investors will look to rental growth to support returns. But office rental growth to date remains sharply divided between London and the rest of the country. According to IPD s Q3 figures while West End and Midtown offices are recording annual growth of over 10%, and outer London achieving 7%, the average across the rest of the country is just 1.4%, with the South East and Wales the best at just over 3%. The range of rental performances has widened since Q1, suggesting the regional catch-up has yet to get into full swing. Indeed some regions are still seeing office rents decline. Comparing Q3 with Q1, the fastest pick-up outside London was in Wales, Yorkshire & Humber, and the Eastern region.

6 6 Property IQ After a sterling year, what next? UK commercial property Positive outlook across the sectors UK consumer sentiment about personal situation 0% For retail, consumer confidence is up, though caution remains -10% -20% -30% -40% -50% Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Consumer confidence continues to pick up, as wage growth finally gathers pace and employment numbers improve. However the overall response is still one of caution, with sentiment about levels of debt and disposable income, as measured by the Deloitte Consumer Tracker, still negative. Household disposable income Source: Deloitte CFO Survey Q Level of debt Retail warehouses have performed strongly this year, achieving the best annual capital growth at the Q3 point among the main retail sub-sectors, driven by one of the sharpest yields compressions since the start of the year. As our Yield Matrix table at the front shows, sentiment in the supermarket subsector has weakened in the light of concerns over margin levels and rental growth prospects. Service sector: balance of business activity Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Service sector activity Source: Markit/CIPS Jul-11 Oct-11 Jan-12 All Property total return outlook Annual total returns % Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul = no change on previous month Oct-14 Office sector supported by employment growth Service sector business activity measures indicate that output in office-type activities is set to grow, and together with rising regional employment levels in this sector, this supports a positive outlook for office rental growth. Outside London, construction of new office space is expected to pick up during Developer confidence in the regions is re-emerging, and speculative office schemes are back on the agenda as levels of available space continue to fall. Manchester, for example, has seen 325,000 sq ft of new office space start in 2014, with a further 1.5 million sq ft in the pipeline. Industrial favoured over medium term With its stronger income component, industrial property is expected now to produce the highest returns over the 5-year forecast horizon, an annualised 10.5% compared with All Property s 9.2% The consensus view published by the IPF sees All Property total returns falling back to just below 11% in 2015 and below 7% in 2016, as the effect of yield compression gives way to rental growth as the main driver. IPD historic IPF consensus central forecast Source: IPF Consensus Forecast Report November 2014 Range

7 Property IQ After a sterling year, what next? 7 Recent research Recent publications UK Futures: Businesses Leading Britain 2014: A new lens on growth London Office Crane Survey Winter 2014: Building momentum The State of the State : Government s inflection point London Futures: Agiletown the relentless march of technology and London s response Deloitte CFO Survey Q London Industrial: Taking stock of the capital Deloitte Consumer Tracker Q Shed of the Future: E-commerce its impact on warehouses London Business Footprint Mapping change in the office market Deloitte Real Estate has undertaken a comprehensive study of office occupation in central London over the ten year period 2004 to Creating a database of over 18,000 records of businesses and the office space they utilise, has enabled us to show how the market has changed, at both a macro and micro level. Even amongst the broadest categories of businesses, there have been some notable migration patterns across London s main office markets. This report demonstrates the fluidity of the central London office market and outlines what some of the drivers of future change will be. Shaun Dawson Research +44 (0) sdawson@deloitte.co.uk

8 8 Property IQ After a sterling year, what next? Key contacts Julian Stocks Head of UK Markets jstocks@deloitte.co.uk +44 (0) Philip Parnell Head of Management and Valuation pparnell@deloitte.co.uk +44 (0) Anthony Duggan Head of Real Estate Strategy aduggan@deloitte.co.uk +44 (0) Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited ( DTTL ), a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see for a detailed description of the legal structure of DTTL and its member firms. Deloitte LLP is the United Kingdom member firm of DTTL. This publication has been written in general terms and therefore cannot be relied on to cover specific situations; application of the principles set out will depend upon the particular circumstances involved and we recommend that you obtain professional advice before acting or refraining from acting on any of the contents of this publication. Deloitte LLP would be pleased to advise readers on how to apply the principles set out in this publication to their specific circumstances. Deloitte LLP accepts no duty of care or liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication Deloitte LLP. All rights reserved. Deloitte LLP is a limited liability partnership registered in England and Wales with registered number OC and its registered office at 2 New Street Square, London EC4A 3BZ, United Kingdom. Tel: +44 (0) Fax: +44 (0) Designed and produced by The Creative Studio at Deloitte, London A