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IPD have yet to publish its annual figures for UK commercial property returns but the quarterly data records the total return at 13.1% following 17.9% in 2014, driven by capital value growth of 7.8%. One of the key factors behind the still strong returns was the upturn in rental values which grew by 4% in 2015, the highest growth rate since the last recession, according to CBRE.
The downward trend in capital values is generally forecast to continue in 2016 and, with growing uncertainty over global and UK economic growth and the Brexit referendum, UK commercial property total returns may now struggle to reach current consensus expectations of 9% or so. Capital values have soared in excess of 25% over the past three years and prime yields have begun to stabilise in recent months.
The Cushman & Wakefield All Property headline average prime yield, at around 4.7%, is substantially below historic averages although still above pre-crisis levels but by just 25 basis points. Even so, the industry background remains reasonably positive; currently few of the usual catalysts causing downturns appear in place with the UK economy expected to grow at 2% or so over the next few years, borrowings are not excessive, prices are not generally overinflated, there is no oversupply, rents are rising, interest rates are unlikely to rise in 2016, while 10-year gilts are close to their lows for the cycle at near 1.5%, resulting in the prime yield premium to gilts being well over twice long term average of 155 basis points over the past twenty years. In this environment further modest yield compression is probable.
So, while not over, the cycle is likely in its later stages. Capital value growth is slowing and it is the property equivalent of “stock picking” i.e. adding value through asset management, location, prospects for rental growth, tenant security, etc., that will deliver performance going forward. Essentially, modest capital growth will be driven mainly by rising rents and investment activity will also likely ease against the background of a slowing economy and EU referendum uncertainty. One thing is certain, oil-based sovereign wealth funds will not be overpaying for trophy assets and indeed, some may even be willing sellers.
What About Property Funds?
One important change for 2016, however, is the outlook for investors in UK direct property funds. In the past two years or so, those investors who bought into the property story have reaped considerable rewards as the IPD All Property index has surged some 36%, while the average directly invested fund has returned around 23%. This compares with just 2% for UK equities and 10% for the FTSE WMA Balanced fund index.
This period of substantial absolute returns is coming to an end and the overweight recommendation in UK property is rescinded. Certainly property funds could still generate reasonable returns, generally around half to two thirds of that produced by the IPD All Property index in the latest upcycle. This suggests gains of 5% or so may be possible but dividend yields are generally lower than prime property yields at a time of slowing capital value growth.
A key risk is fund unit pricing, however, as outflows can result in investment houses reverting to bid/cancellation pricing. Given the scale of flows into property funds in recent years and the prospect of investors wishing to lock-in profits, the risk of this occurring is growing. Indeed, the Threadneedle fund can and does impose exit penalties, while the Aberdeen Property Trust, some £3.5 billion in assets, recently changed its pricing structure, moving from an offer to a mid price basis, generating a 3.8% loss for those exiting the fund. Yet, this is at a time when the trust’s investor protection committee predicted “broadly neutral” fund flows. Given the lower expected returns from property this year noted above, returns could all but be wiped out by changes to the pricing basis. Indeed, year to date returns from most funds are around 0.5%, yet the Aberdeen fund is down 3.9%. There is obviously a risk that others will follow Aberdeen’s lead and the decision for investors, therefore, is whether to stay in for the long haul. Even this has risks, however, as many commentators believe capital value growth could possibly be negative come 2017/18.
In addition, it is worth noting that property shares have begun to underperform. Indeed, the UK REITs sector peaked in relative terms in late September and by end January was down some 9%. For what it is worth, this is the largest sustained decline since the six months before IPD All Property capital values began to subside from 2012 to mid-2013, in the second half of 2011 the REITs sector underperformed by just over 20%.
