By Alan Sippetts, Investment Director at Heartwood Investment Management
UK commercial property had a strong run in 2014 and it led some investors to question whether valuations were nearing the top of the cycle.
Earlier this year, we took a more contrarian view, believing that UK commercial property was positioned to perform well again in 2015. Year-to-date returns are so far confirming our view, but what has been particularly striking is the UK’s outperformance versus the rest of the world. Why has this been the case?
We have consistently held the view that UK commercial property would be supported by three drivers: 1) international investor demand; 2) income; and 3) rental growth due to low vacancy rates and limited supply. These factors are playing out this year and, moreover, we believe these trends can continue.
First, investment activity, as measured by the total volume of transactions, has risen markedly over the last two years, and much of this increase has been driven by strong overseas interest. In the year-to-date ended 31 August 2015, 50% of investment purchases for UK commercial property were from overseas investors [Source: The Property Investors Bulletin, September, 2015]. Flows have been dominated by North American and Asian investors.
We believe these trends can persist. A key attraction for international investors, especially from institutional buyers in the US and Asia, is the higher liquidity of the UK market versus other international jurisdictions.. The UK has an open, transparent and consistent legal framework which sits above other developed economies. For example, property markets across continental Europe can be less liquid and more complex due to onerous regulations.
Second, a positive economic growth environment, characterised by a robust services sector and an improving labour market, is driving rising demand for office, industrial and distribution buildings. The development of new sites in major cities is still relatively limited, a consequence of the post-crisis era. Between 2010 and 2013 new building activity was relatively depressed and the sector continues to play catch-up, especially given the extended timeframe (anywhere between 12 and 24 months) for constructing new developments.
As a consequence, a favourable balance of supply and demand is contributing to rising rental growth – the third factor. Rents for offices in London have been rising steadily in the first half of this year (+5.2%, according to IPD Central London Office Index) and are on course to surpass full-year 2015 forecasts of 8%. We should also note that this trend is not contained to central London. Rents for offices in other UK cities were falling two years ago, but there has been a sharply reversal of the trend this year. Rising rental growth is important in an environment of low inflation and low interest rates, where investors are broadening their search for income. Quality commercial property continues to yield in excess of other comparable assets available to UK and international investors
So, over the near- to medium-term we remain positive on UK commercial property for its ability to deliver stable income, supported by steady economic growth and favourable supply/demand dynamics. Nevertheless, we are cognisant that our relatively sanguine view of UK commercial property might be challenged longer term by the impending referendum on membership of the European Union.
While a date has not been set (most likely it will be in late 2016/early 2017), the outcome and the implications for markets, particularly property, remain uncertain. Overall, though, regardless of the UK’s terms of membership with Europe, we expect that UK commercial property will retain its attractive investment characteristics for international investors, owing to the UK’s standout legal and political framework that creates a highly liquid, accessible and transparent market.