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Commercial buildings

Pricing property

09 February 2016

Philip Gadsden of Orchard Street Investment Management argues that UK commercial property offers plenty of long-term prospects, especially for income.

Domestic and international demand for UK commercial property was so strong in 2015 that transaction volumes reached record levels.

Not much new space was constructed and rental values grew through the year, providing a third consecutive year of double-digit returns. It hasn’t just been about London either – almost half the international capital invested in 2015 has been deployed outside London.  So, what next?

To consider this it is helpful to break down total investment returns from commercial property into its key components. The first is capital growth, which is driven by various factors – including pricing relative to other investment classes – but, ultimately, by expectations of future rental income. The second is income, which is derived from rents received from occupiers.

Capital growth

The double-digit returns of the past three years have included a significant portion of capital growth driven by yield compression. In other words, investors have been prepared to accept a lower yield on the purchase price.

It is a dynamic that cannot continue ad infinitum and we do not believe that there will be similar levels of yield compression in the coming three to five years. Capital growth will still be available, but not right across the market. Instead, it will largely come from rental growth. Growth will be strongest for better properties in better locations, particularly if there is scope for ongoing improvements to the assets themselves.

Income

Meanwhile, for a diversified portfolio of good-quality, well-located UK property, the outlook for rental income is strong, and looks well-founded for the long term.

The prospects for the UK economy are benign, thanks to stable government, GDP growth in excess of 2%, and low unemployment. Improved employment has driven occupier demand for commercial property, while speculative development in the past five years has been relatively low.

As a result, there is a shortage of good quality space in the right locations and rental growth in 2015 reached 4%. The income component of property return is likely to dominate total return in the foreseeable future.

Global currents

However, as we are all too aware, the world is not without risk! Despite the added stimulus from the low oil prices and quantitative easing (QE), investment markets are fragile due to worsening geopolitical risks and, of course, China’s slowdown. Has China overstated its recent growth rate and is the slowdown in Chinese economic growth worse than had been expected?

Closer to home, markets continue to hold their breath about how our QE experiment will unwind. Nevertheless, the first US rise in interest rates was well-managed and uneventful.

Later in 2016, UK citizens may all get the opportunity to vote on whether to remain a member of the European Union. If the UK was to vote to leave, the Scottish government could look to advance its ambitions for independence once again.

With all these risks and uncertainties, investors could be forgiven for looking for an asset class that is relatively low-risk, generates stable levels of income, and offers some upside potential for invested capital.

Even after a good three-year run, that means the benefits of UK real estate shouldn’t be ignored. A well-diversified portfolio of commercial property assets remains valid today, so long as investors have a long-term investment horizon and focus on income as the driver of return.

Carefully selected, well-located property assets are typically let on long-term lease contracts and provide a stable rental income stream that is diversified amongst good corporate and public sector bodies. The income from the St. James’s Place property portfolios is diversified across 537 tenants (31/12/2015), vacancy is low at 7.4% (31/12/2015) and our style of active asset management aims to maximise the prospects for further growth in portfolio income.

Most commentators expect UK real estate to produce a total annual return of 6–8% over the next three to five years. Close to 75% of that return would be from quarterly rental income that is immediately available for distribution.

Real estate continues to play a valuable role in a diversified portfolio of assets held for the long term.

 

Past performance is not indicative of future performance. The value of an investment with St. James's Place will be directly linked to the funds selected and may fall as well as rise. You may get back less than the amount invested.

The opinions expressed are those of Philip Gadsden of Orchard Street Investment Management, and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James's Place Wealth Management.

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