Alan Sippetts, Investment Director at Heartwood Investment Management is reporting this week that the UK property sector has comfortably outperformed all other major asset classes in the year-to-date, although the sector has been under pressure over the last month. Inevitably, as the cycle matures, questions are being asked as to whether UK property can keep delivering the strong returns that investors have become accustomed to seeing since 2013.
Prospects of higher UK interest rates will undoubtedly create more volatility than we have seen in recent years and investors will have to be more selective in their investment choices. The threat of higher rates and waning international flows into UK residential property, due to slowing Asian growth and emerging market currency weakness, argue that some parts of the property market are fully valued. However, this pessimism has spilled across the broader sector and in certain areas it appears overdone.
Sippetts view on UK commercial property remains positive, although his preference remains for the niche areas of office and industrial space. The outlook for retail, which includes shopping centres and to some extent distribution centres, is less supportive due to excess supply.
Within the office and industrial space, he expects this positive momentum to be sustained by two principal drivers:
Rental growth: The income component of commercial property will be an important contributor to future potential returns, given there is limited room for capital growth. The supply - demand balance remains favorable and should support ongoing rental growth. Between 2010 and 2013 new building activity was depressed, resulting in the current low vacancy rates. The sector continues to play catch-up, especially given the extended timeframe of completion for new developments anywhere between 12 and 24 months. 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%. He also noted that this trend is not contained to central London. Rents for offices in other UK cities were falling two years ago, but we have seen a sharp reversal this year.
Ongoing international investor demand: Rising rental growth is a key attraction for income-seeking investors globally in a low interest rate environment. And this has been shown through strong investment activity in the last two years. Quality commercial property continues to yield in excess of other comparable assets available to investors. Indeed, 50% of investment purchases for UK commercial property were from overseas investors in the year-to-date ended 31 August 2015 [Source: The Property Investors Bulletin, September, 2015]. North American and Asian institutional investors, such as life insurers and pension funds, have been particularly active. Compared with other international jurisdictions, the UK commercial property market is highly liquid and that is maintaining strong international investor interest. Furthermore, the UK's open, transparent and consistent legal framework sits above other developed economies.
What are the risks?
The two obvious risks are higher UK interest rates and 'Brexit'. First, looming interest rate hikes would be negative in a normal cycle; but the current environment is atypical versus recent history. The interest rate tightening cycles in both the UK and the US are expected to be relatively benign and shallow, which should maintain investors' interest in higher income assets such as property. Moreover, developers are less leveraged compared with previous cycles. Indeed, a turn in the UK rate cycle should be taken as a sign of confidence in the UK economy, which should benefit higher yielding assets.
A date has not yet been set for deciding Britain's membership of the European Union (most likely it will be in late 2016/early 2017), but it is likely to create some uncertainty across UK asset markets, especially property. Global security issues and the European Union migrant crisis call for a coordinated international response and arguably strengthen the case for Britain staying in Europe. Most likely, therefore, we will probably see a renegotiation of the terms of Britain's membership. Whatever the outcome, we continue to believe that UK commercial property will retain its attractive investment characteristics for international investors because of the UK's standout legal and political framework, which allows for a highly liquid, accessible and transparent market.
Sippetts expects a more challenging environment in 2016, given the prospects of rising interest rates and potential headline risk surrounding Brexit, which are likely to impact sentiment. But the fundamental factors remain supportive and we remain of the view that select areas of UK commercial property will continue to deliver stable income in an environment of steady economic growth and favorable supply - demand dynamics. Sippetts currently holds a full weighting in the sector and expect to maintain this exposure. However, we do not anticipate adding to our exposure in the near- to medium term, given how far the UK property cycle has progressed.