This article is part of Morningstar’s Guide to Investing Ideas for 2015, our comprehensive round-up of where the most promising stocks, funds and markets can be found this year.
UK commercial property looks set to be the best returning asset class in 2014 with overall gains for the IPD All Property index likely to be just a little below 20%. Following on from double digit returns in 2013 the scale of the rise surprised many commentators. Given the substantial fall in property yields over the two years, what are the prospects for 2015?
Before looking more closely at the outlook for the coming year, it is worth remembering the tremendous importance of income to UK commercial property total returns. Indeed, over the period 1987 to the end of 2014, the IPD All Property index has produced a total return of 900%, of which, income has contributed nearly 80% and capital values just 20%.
All Property income was 0.49% in October 2014, an annual rate of 5.8%. So, this should provide another solid year of returns, well above cash, even if capital values and rentals are static. From a real yield perspective less core inflation, All Property yields 4.3%, still above the average for the past ten years. Also, compared with a 20-year gilt yield of 2.5%, a 5.8% property yield still looks very attractive with the 330 basis point spread towards the very high end of historical levels.
Indeed, at the peak of the last property cycle, property yields were marginally lower than those of 20-year gilts. As for comparisons with cash, there is a 5% pick up even if the Bank of England base rate is 1% by year end. Overall, the yield attractions for 2015 are nearly as potent as at the start of 2014.
Income Looks Good But What About Capital Values?
After a storming run in 2014, during which IPD All Property capital values are likely to have risen by 12% or so, growth of that magnitude is unlikely to be repeated in 2015 as prime property yields have already fallen to levels only a little above those at the last cycle peak. To put this move into perspective, however, the IPD UK Capital Growth index is 29% above its low but still 28% below the peak in 2007.
Although when walking around London there always appears to be nothing but building sites, the reality couldn’t be more different with very little high grade property currently available and not much in the pipeline from 2015 through to 2017. The consequence is that rents will continue rising over the next few years; Land Securities CEO recently stated that the supply constraints will last for another two years, adding that “there’s nothing anyone can do about it, there simply isn’t enough being built”.
Where are the Opportunities?
UK property managers still see opportunities outside of London and reports from leading agents all indicate the likelihood of further capital value growth in 2015. CBRE recently highlighted the shortage of good quality prime space in the regions, where the availability of ready-to-occupy prime Grade A stock has fallen by nearly 40% across all regional centres over the last four and a half years. The shortage will continue through 2015 although over the next thirty six months an additional five million square foot of prime Grade A supply will come to market. CBRE also pointed out that, in real terms, prime rents in nearly all regions outside the M25 are now more affordable than four years ago.
Obviously, there are risks, probably the main one being the UK economy, the strength of which over the past eighteen months has generated increasingly positive occupier confidence. Interest rates are also expected to rise next year although this may not now be until the fourth quarter and any rise will be very gradual. The May election could also create some uncertainty and deter overseas investors.
Overall though, the background remains supportive with high levels of income and both capital value and rental growth forecast. While 2014 might well prove the banner year, current forecasts of 9-10% total returns for 2015 may well be revised higher as the year progresses. It must be remembered, however, that very few property funds match IPD returns.
