The case for investing in UK real estate

Market Perspective September 2015 The case for investing in UK real estate By Matthew Richardson, Director of Real Estate Research After a slow economic recovery following the global financial crisis, the UK is growing at a stronger rate than its European neighbours. The positive economic and benign inflation backdrop is a supportive one for real assets, such as real estate. Strong demand for good-quality commercial real estate stock, which is in limited supply in many locations around the UK, supports the positive outlook for the asset class in both absolute terms and relative to other assets such as bonds. An investment in real estate allows investors the opportunity to lock in at relatively high-income yields, while offering capital growth potential from yield compression over the short term, and rental growth potential over the medium term. Following attractive returns in 2014, we forecast that UK real estate will likely generate total returns in the region of 15% this year. INTRODUCTION UK ECONOMY OVERVIEW After a slow economic recovery following the global financial crisis, the UK is growing at a stronger rate than its European neighbours. UK GDP grew at a rate of 2.8% in 2014, which was the fastest pace since 2007, and up from 1.7% in 2013. Although the economy slowed in the first quarter of 2015, the second quarter-on-quarter GDP growth rate came in in at 0.7%. The Office for Budget Responsibility forecast (March 2015) that UK GDP will grow by 2.5% in 2015 and 2.3% in 2016. Headline inflation nudged up from 0.0% in June to 0.1% in July, and it is expected to pick up later this year as the base effect from lower energy prices feeds through as does wage growth. The Bank of England expects inflation will meet its 2% target by 2017. Interest rates remain at a historical low of 0.5%, although rate rises are anticipated in the medium term. The UK s unemployment rate stands at 5.6% and the recent trend in rising real incomes is positive for the economy as a whole, but will raise fears over inflation, unless it is matched with an uptick in still-stagnant productivity. Consumption should continue to pick up pace, thanks in part to the positive impact of lower energy prices. The Asda Income Tracker, 1 a useful barometer of consumer health, shows that the average UK household had 189 a week of discretionary income in June 2015, up by 18 a week on the same month a year before, equating to a 10.4% annual increase. AT A GLANCE The UK economy is growing and the outlook is positive. Economic recovery is spreading from London to the regions Regional real estate is set to benefit from a sizeable capital value uplift Tenant demand across diverse sectors is strengthening Improving tenant quality will support income flows and boost total returns Prime and secondary spreads over government bonds are attractive to income-seeking investors Investors should remain cautious about certain UK risks such as devolution, EU membership, and the UK government s ongoing austerity programme, as well as EU risks related to Greece s bailout. UK 2015 total return likely to be 15% While fundamentals appear relatively solid, there are various risks to the outlook. These include the impact of Greece s bailout on the future of the European Union, UK constitutional questions over devolution and EU membership, and the impact of the government s accelerated austerity programme to clear the structural deficit. The outlook for other economies and financial markets more generally is also critical for the health of cross-border capital flows, which have been a support for parts of the UK economy. UK REGIONAL RECOVERY CONTINUES UK regional economic indicators show that the recovery has been broadening out, with nominal output in 2012 surpassing the pre-downturn level everywhere in the UK except for Northern Ireland, according to data published by the Office for National Statistics. Employment rates have been rising in all regions since early 2012 between February and April 2014, employment rates returned to similar levels to those recorded in February-April 2007. London has outperformed the rest of the UK and the capital s

nominal gross value added (GVA) rose by 15.4% over the period 2007 to 2012 compared with 6.9% for the rest of the UK. The recent rising trend in real incomes, as demonstrated by the Asda Income Tracker data, points to a positive environment for a broad pick-up in domestic consumption across the UK. The UK government s 2015 Budget decision to devolve Sunday trading laws is generally supportive of this growing consumption trend. The trading laws were relaxed during London 2012 and retailers recorded a significant increase in sales. The New West End Company (NWEC) stated that the new trading laws would help to generate 260 million more in tax receipts for the UK government and help to create 2000 jobs in central London. CAPITAL VALUES ARE GROWING STRONGLY Strong real estate capital growth in 2014, which was comparable with the pre-financial crisis level, drove strong total returns in the asset class, and a similar outcome is expected this year. Chart 1 below shows that London office and retail, and to a lesser extent London City, have recovered considerably from the declines in capital valuations recorded in the aftermath of the financial crisis. Chart 1. UK Regional markets are still below 2004 values IPD Capital Value Index (December 2004=100) UK PROPERTY RETURNS ARE ATRACTIVE TO INVESTORS The total return for All UK property in 2014 was 17.8%, with capital growth of 12.0% and an income return of 5.2%, according to the IPD UK Annual Property Index. Among the sectors, the industrial sector posted the largest return at 23.3% (16.3% from capital growth and a 6.1% in income return), followed by the office sector which delivered a 22.7% return, (with a capital growth of 17.3% and a 4.7% income return). The retail sector generated a total return of 14.2% (from capital growth of 8.5% and 5.4% income growth). 2 In the IPD UK Monthly Property Index July 2015, total return for the month in the office sector was 1.4% (made up of 1.0% capital growth and 0.4% income return); the industrial sector total return was also 1.7% (made up of 1.2% capital growth and 0.5% income return); and total return in retail was 0.7% (made up of 0.2% capital growth and 0.5% income return). Turnover in the UK commercial property market increased by 25% quarter-onquarter, to reach 21 billion in the fourth quarter of 2014. 3 Source: IPD UK Monthly Index, June 30, 2015. However, supporting the case for investing in the regions, capital values in UK regional markets have yet to recover to 2004 levels, despite recent evidence of a broadening economic recovery in the UK. This means there is a potential uplift of between 10-15% if regional markets revert only to their long-term average trend. Effective asset management of existing stock and new acquisitions can improve rental income and often deliver robust levels of capital uplift. Well-executed refurbishments can enhance a property s appeal, increase the rental income and result in higher appraised valuations. STRONG DEMAND IN SECTORS ACROSS THE REGIONS While there remains a strong focus on London prime assets, in the second half of 2014 there was evidence of an increasing number of foreign and domestic investors targeting higheryielding opportunities in high-quality secondary real estate outside of the capital. This year will be another strong year for UK commercial real estate with rental value growth becoming an increasingly important driver of performance. Real estate in the UK regions also offers the potential for sizeable capital uplift. As economic recovery broadens out across the UK, occupier markets are improving with stronger tenant quality, increasing tenant demand and falling vacancy rates. Chart 2 (overleaf) shows an important aspect of the recovery in leading UK regional cities represented here by Birmingham, Edinburgh, Glasgow, Leeds and Manchester where the level of vacant real estate is falling rapidly. There are other major secondary centres, such as Cardiff, Nottingham and Southampton, where office or industrial properties are still benefiting from a supply-and-demand mismatch. Renewed corporate confidence is increasing demand for good-quality, grade-a office space in various regional cities where the supply of quality property is now relatively tight given the general lack of real estate development in many parts of regional UK in recent years.

Chart 2: Regional markets vacancy rates are declining The Big 5 are: Birmingham, Edinburgh, Glasgow, Leeds and Manchester Source: JLL, April 2015. The burgeoning business-to-consumer e-commerce market in the UK, which is the largest by volume of sales in Europe, is creating strong demand in many UK regions for logistics facilities that are strategically located close to motorway networks and other transport hubs. A report by the Centre for Retail Research, Online Retailing: Britain, Europe, US and Canada 2015, found that the UK is the largest online market in Europe with 2014 sales of 45.0 billion, (a 15.8% growth on the previous year), and forecast sales of 52.3 billion in 2015 with 16.2% year-on-year growth. In the booming automotive industry supply chain, which is centred in and around the West Midlands, there is very strong demand for industrial property catering to specialist engineering firms and manufacturers. Reshoring of the automotive supply chain is estimated to have the potential to grow from 1 billion at present to 4 billion, according to an Automotive Council UK report, Growing the Automotive Supply Chain, March 2015. PRIME VERSUS SECONDARY REAL ESTATE In the wake of the global financial crisis, there was a strong and sustained focus on highquality, low-risk assets among investors. Within real estate specifically, this flight of capital to lower-risk assets resulted in heightened demand for prime assets in the UK, inflating asset prices and pushing down yields. However, secondary real estate yields moved higher as investors perceived these assets to be much higher risk. As a result, the yield spread of UK secondary property over UK 10-year Gilts has remained much wider than the spread between UK prime real estate and UK corporate bonds since the global financial crisis unfolded in 2008/9, as Chart 3 below shows. Chart 3: CBRE UK all property and UK corporate bond yields Spread over UK 10-year Gilts % per quarter Source: Fidelity Worldwide Investment, CBRE, Bloomberg, June 30, 2015.

Typically when the yield on an asset rises, it suggests a deterioration of the asset s fundamentals, and hence a higher risk premium. However, occasionally, there may be no indication of any significant deterioration in an asset s fundamentals when adverse price and yield movements largely reflect increased investor risk-aversion. The significantly higher yields that have been available in UK secondary real estate since the financial crisis have overcompensated for the perceived risks associated with these assets. Secondary property covers a wide range of investment risk from vacant buildings in average locations to high-quality, fully let buildings in major UK cities. This is a very diverse segment of the real estate market, catering to various investor risk appetites and return expectations. Individual asset selection is a more critical determinant of success in secondary real estate investing, and within that due consideration should be given to tenant risk, lease structure and refurbishment/reuse potential. ATTRACTIVE YIELD OPPORTUNITIES PREVAIL During the so-called normalisation of the UK real estate market in 2012-14, investors began to recognise the value in property more generally, but investor appetite for prime property still remains very strong and this continues to drive prime yields even lower. Although average yields fell across the whole property market, pushing values up, the gap between prime and secondary real estate did not narrow as much as might have been expected. The mispricing opportunity of secondary assets has become more widely recognised as more investors consider the real estate asset class, and secondary assets in particular, in pursuit of higher yields. Nevertheless, the current yield on secondary real estate assets remains very attractive at a level of more than 600 basis points over 10-year Gilts (the black dots denote the current yield for each asset class), as Chart 4 illustrates. In current market conditions, where investors are challenged by a relative paucity of attractive income-paying investments, commercial real estate is garnering wider appeal for its income-generating characteristics, having been historically (mis)treated by some investors as primarily a capital-growth play. Income typically makes up two-thirds of UK commercial real estate total returns, according to IPD, and the fact that commercial real estate is showing a very healthy premium to bond yields is a key support factor for property bull market proponents. This is true even for prime property, which in some cases is now trading at yield levels below 4%. While this level of income yield represents all-time lows, the premium over AAA-rated sovereign bonds and many investment grade corporate bonds remains very wide. The current yields for prime and secondary real estate are considerably more favourable relative to history than UK government and corporate bonds, as Chart 4 below shows. Chart 4: Current yield vs. long-term range in UK asset classes 12% 10% 8% 6% 4% 2% 0% Cash 1 mth UK 10Y Government UK Corporate Bonds UK Equities UK Prime Real UK Secondary Estate Real Estate Note: Long-term range covers 15-year period. Source: Fidelity Worldwide Investment, DataStream, Bloomberg, CBRE, June 30, 2015.

RENTAL GROWTH WILL BOOST TOTAL RETURNS Real estate income has historically been relatively stable, yet today it also offers some attractive growth potential a particularly attractive feature given income typically accounts for a large part of total returns. Chart 5 shows how stable UK commercial real estate income return has been since the 1980s. Chart 5: IPD UK Annual Index components of performance All Property Total Returns income and capital growth 1981 to 2014 (% pa) % per annum 40 30 20 10 0-10 -20-30 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 Income Return Capital Growth Source: FIL Limited, IPD December 2014. The improving economic outlook in many UK regions, combined with relatively tight supply of real estate stock, will support medium-term rental growth potential. Rental growth in the range of 3-4% over the next five years is likely in the UK s main regional centres (see Chart 6 below). Chart 6: Regional property % rental growth by market 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 3.7 3.7 3.5 3.6 3.7 3.5 3.0 3.1 2.9 2.8 2.3 1.4 2014 2015 2016 2017 2018 2019 Major regional centres are Manchester, Birmingham, Glasgow, Edinburgh, Leeds, Bristol, Cardiff and Newcastle. Major Regional Office Centres Other Regional Office Centres Note: 2014 data is actual data. Data is forecast for the years 2015 to 2019. Source: Fidelity Worldwide Investment, December 2014. Rental income is likely to grow thanks to a combination of a very low level of stock, the positive outlook for the UK economy and improving tenant businesses together these suggest greater ability to put through rent rises after a period of post-crisis stability. The current rate of additions to office stock is only about 1%, which is the lowest level it has been since the late 1970s. The amount of grade-a stock, in particular, is very limited and rents in many locations are still too low to justify the construction of new developments. The income component of property returns tends to be significantly more stable than the capital component typically around 90% of the total return volatility of UK property is accounted for by capital volatility. This is clearly visible in the relative stability of the income component (blue bars) in Chart 5 compared to the capital component (black bars). Commercial real estate offers the prospect of an attractive stable income return for long-term investors.

SUMMARY The positive outlook for the UK economy generally supports forecasts for a robustly performing commercial real estate asset class this year. We can expect to see good levels of demand for the relatively scarce supply of top-quality property in various economically vibrant cities and regions. With the spread over 10-year bonds relatively attractive on a historical basis for prime and secondary real estate, investors can secure appealing yields while at the same time benefiting from capital growth potential from yield compression over the short term and income growth over the medium term. On the back of stellar total returns in UK real estate last year, we believe that investors can expect to be rewarded with an attractive return in the region of 15% in 2015. REFERENCES 1. Produced by the Centre for Economic and Business Research, July 2015. UK workers have seen wage growth accelerate since June 2014. 2. Multi-period capital growth and income return may not sum perfectly to total return due to the cross product that occurs when capital and income returns are combined within compounded total returns. Source: IPD. 3. Source: Propertydata, January 2015

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