The following article is written by James Thornton for inclusion in the latest edition of the Quilter Cheviot publication trustEnews
Commercial property remained the highest yielding asset class in the UK in 2017. As a result, it has seen strong interest from a wide range of sources including overseas investors, pension funds and charities. This demand has led to yield compression which combined with rental increases to support capital growth. Overall the UK property market, as measured by the MSCI Monthly Index, returned 11.2% in 2017. This compares to a return on cash of 0.35% (effective), 10-year gilts at 1.2% and UK equities at 13.2% FTSE All Share (including dividends).
The net initial yield on UK property reduced from 6.3% to 6.0% during 2017 but the performance between the subsectors was divergent. Industrials/logistics returned over 21% compared to 7.7% returns for retail and 8.5% returns for offices. In this segment regional offices returns exceeded Central London, although in the wake of the Brexit decision Central London has performed much better than expected. During 2017 international investors further bid yields down in Central London to secure prime trophy assets. Indeed, there were two transactions exceeding £1bn each including the UK’s largest ever single asset deal.
Office rents in London were generally flat and the expectation is that they may fall in some submarkets this year. London’s occupational market has diversified away from financial services which is no longer the biggest employer. Based on Oxford Economics data the number of tech workers in London (448,100) now outnumber the number of financial and insurance sector workers (383,600). Major tech occupiers have been expanding, companies like Facebook, Google and Apple, as well as many smaller companies.
Take-up figures in Central London last year were strong but were flattered by flexible office providers who took 2.2m sq ft of office space, equivalent to 20% of all leasing deals. Of this total WeWork alone took 1.4m sq ft. They now have 2.5m sq ft in London in 34 separate locations making them comfortably the largest single private occupier.
The trend towards flexible working has occurred rapidly. Approximately 4% of all office floorspace in London is now occupied by flexible workspace providers, the highest proportion globally. Significant employment growth in small and medium enterprises (SMEs) and occupier demand for flexibility have aided the sector as has the increasingly footloose nature of talent which is now able to work from anywhere. As a result, offices must be user-focussed and amenity-rich, providing employees with choice about how and where they work. Flexible workspace providers have a strong experience-based environment well aligned to modern occupier requirements. It remains to be seen how well all these providers perform with evidence to suggest that some landlords have been happy to let their building to such operators even though there is no established financial track record. At a time of Brexit uncertainty however, notably in the City market, the letting of small suites has been affected with some tenants preferring flexible leasing arrangements to longer term, fixed term contracts.
The changing profile of the London occupation market is just one of several evolving trends in the market. The rise of e-commerce continues with 16% of retail sales now taking place online. This has supported demand for logistics and distribution warehousing which recorded rental growth of 4.5% last year, the strongest rate of any sector. Occupational demand for logistics stock came not only from the retailers directly but also from third party logistics operators on their behalf. As a result of investor demand, industrial yields reduced by 60 basis points over the year.
Online growth has come at the expense of high street retail with parts of the sector particularly threatened by this consumer shift. Department stores, shopping centres which lack a supermarket anchor and secondary high street retail look to be most exposed. The e-commerce trend has further to run with penetration rates expected to increase to 23% by 2022, accordingly to PMA.
Given the polarisation in sector returns, portfolio positioning is as critical as stock selection. Whilst charities enjoy exemption from Stamp Duty, for most investors the ‘round-trip’ costs of buying and selling property are high at approximately 8%. In a low-growth and low interest rate environment, mistakes can be costly, with several years needed to recover book cost. This means decisions must be correct the first time.
A highly thematic approach to investing based on technology, demography and infrastructure can generate out-performance. A focus on these occupational trends means acquiring assets which fit the requirements of the occupiers of tomorrow, not just the occupiers of today.
The expansion of the creative and tech industries in the UK and the preference for city centre working is one example which falls under the technology theme. Technology creates winning and losing locations. A number of business parks are now at risk of functional as well as physical obsolescence, as occupiers increasingly prefer city centre locations with more vibrancy and work-life appeal.
The second investment theme of demography points to the changing structure of the UK’s population. Over the next 15 years the population aged over 65 will increase by 50% and the population above 85 will more than double. This has implications for new types of empty nester residential properties, retirement and senior living facilities and healthcare.
Conversely Generation Z, those people lucky enough to have been born between the mid-1990s to early-2000s, are living and working independently for the first time. This is driving demand in for build-to-rent residential product and a focus on experience within the office and retail sectors.
The final investment theme is infrastructure given its ability to alter the spatial distribution of occupational demand. We currently track over 130 infrastructure projects in the UK which vary from runway extensions and new rail links through to new bus networks and road dualling.
Overall, we expect UK commercial property to return around 6% in 2018, with significant divergence between sectors and geographies. Broadly flat yields are anticipated given low, but slowly increasing, interest rates. With the UK economy set to grow at around 1.5%, a lack of commercial development in most markets means that conditions for rental growth exist. Rental increases are expected to be the major driver of capital growth this year with active asset management capable of boosting returns.
Double figure returns might be behind us for the moment but for charities the property sector remains an attractive and tax-efficient source of income and risk diversification. Geopolitical risks remain but by investing thematically, based on structural change, there is the ability to maintain, grow and create attractive income streams from investing in property.
James A Thornton
Chief Executive, Mayfair Capital Investment Management Limited and Fund Director of the Property Income Trust for Charities