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Commercial Property Sector Outlook – Q4 2016

Friday 16th December 2016

We have allocated to the sector for several years now and the recent period has been a good one from a total return perspective. Not only have there been decent yields on offer (4-6% on average) but with reasonable economic growth, capital values have also been strong. The outlook for the UK market however was hurt by the EU referendum result in June. The sector has managed to pick up its performance in the months following the Brexit vote, as the short term liquidity event was worked through. However, it has inevitably raised the question regarding long term assets and funds offering short term liquidity. A repeat of the commercial property exodus which accompanied the financial crisis was always unlikely. Crucially, gearing ratios comparing funds’ debt with total assets are much lower now than they were during the crisis, when large scale redemptions from UK property funds last occurred.

While UK investors may have taken pause this summer, appetite from overseas investors has actually increased. Net investment from abroad was higher last month – at £855m – than the three which preceded it, as weaker sterling has given foreign buyers greater purchasing power in the UK. Moreover, commercial property continues to offer diversification and income at a time when other asset classes don’t. If unemployment remains below 6%, employment growth should remain robust, supporting demand for both housing and office space, although London commercial prices could be hit if firms move activities to elsewhere in the region. Cycles within the sector are notorious, with overbuilding and high gearing, just two of the most common structural features.

Average price falls have been modest, although there are clear signs that many investors have been sitting on their hands with low transaction volumes reported. UK values dropped 3.3% in July but the decline slowed to 0.5% in August and 0.2% in September, according to CBRE, the world’s leading property agency. The size of individual deals also fell over this period to just short of £14m, this was the lowest level since the financial crisis in 2009. Central London office transactions declined by a staggering 66% from 2015, with only one deal being recorded larger than £100m. It is not only Brexit that has made the sector nervous, many investors are also looking at the recent rise in Gilt yields. This could make the sector yield less appealing on a relative basis. It also impacts those using leverage, as the cost of borrowing will rise, albeit from historically low levels.

In the US, levels of deal activity will continue to decline into 2017 and any rises in price levels are likely to slow down due to modest economic growth and ongoing political uncertainty. Once again the rising level of Treasury yields will also act as a material headwind. Investors are mostly focusing on primary markets and high-growth secondary markets in the United States. For context, the respected Green Street Advisors Commercial Property Price Index advanced 5.7% on a yearly basis during the third quarter of 2016. Office vacancy levels are likely to continue to fall below the 10% level, heading towards 8%. The industrial availability is even tighter with only 6.9% of vacant space, whilst the retail sector still has levels comfortably over 11%. The level of foreign ownership remains an important swing factor for the market. In 2009, foreign purchases of U.S. real estate assets was a mere $4.7 billion, by 2015 this had risen to a staggering $87 billion.

In Continental Europe there have also been strong returns in recent years in the sector and, although the cycle is maturing, it is far from over. The ECB’s QE programme continues to encourage a transfer of capital from the periphery to the core Eurozone, and this capital is chasing high-quality real assets in core Europe, especially Germany. The German economy will grow at around the same rate as the Eurozone as a whole in 2017, namely around 1.5%, which is somewhat slower than in 2016. Office space remains very tight, with typical vacancy rates as low as 5%. This could lead to an increase in the demand for peripheral areas. Another sector forecast to do well is logistics, it is estimated that more than 4 million square metres of new logistics space will be completed again in 2017. Overall, prime yields could still have scope to fall towards the 3% level. Office yields are likely to stabilise around 4% generally, with focus on high quality cash flow streams.

The picture in Asia is somewhat more mixed with the latest quarterly data showing prime commercial rents increased 0.6% quarter on quarter and 1% year on year at the end of the third quarter of 2016. Of the nineteen markets covered, whilst eight saw rising rents, there were six in decline. Tokyo led the upside with a 6.5% growth, whilst Singapore in contrast saw declines of nearly 3%. Some of the amounts of new supply, notably in China, are staggering with 250,000 square metres coming into the Beijing market almost every quarter!