It has been extraordinary to watch the recovery in commercial property since the depths of the aftermath of the credit crunch.
In March, UK commercial property capital values accelerated once again, rising by 1.6%, and producing year to date gains of nearly 4%. In total return terms, UK property returned 2.2% in March and 5.7% year to date, using IPD monthly data.
City office valuations continue to storm ahead, rising 3.8% in March and 7.5% over the first quarter. Shopping centres also performed very well, while industrial is lagging the other sectors.
The decline in yields continues apace with the All Property equivalent yield ending the first quarter of 2010 at 7.1%, a 25bp fall over the quarter, according to property services adviser CB Richard Ellis (CBRE). Of course, this disguises as much as it informs as the prime end of the market accounted for nearly all of the gain and the gap between prime and secondary property has widened significantly. These factors are highlighted in the table below, which compares current property yields with the levels close to the bottom of the cycle and those near the last peak.
As is evident from the table, yields on prime properties have already declined substantially and the average prime yield is now 6.4%, compared to 7.8% a year ago. With gilt yields rising this has meant that the prime property/gilt yield gap has narrowed to 240bp from its 460bp peak in first quarter 2009, although this is still high by historic standards.
Prime rentals are heading upwards again, 0.6% quarter on quarter in 1Q after stabilising in the previous quarter. This was principally due to the Central London office market, however, where rents surged by 6%. London is tending to outperform in all sectors with prime office and shop rents rising while still declining in most other regions. While the growth in capital values is expected to decelerate, the longer-term outlook for prime rentals remains very healthy, especially in London. A recent presentation by King Sturge, for example, forecast that prime West End office rentals, currently at £70/sq ft, would increase by 10% per annum through to 2014, reaching the peak levels of 2007 at £111/sq ft. King Sturge also expect similar progress in City offices but with rentals levelling off after 2013, by which time prime rentals are expected to have reached £67.50/sq ft. compared to the £51.50/sq ft. forecast for the end of 2010.
The number of property sales by UK banks is accelerating, with the latest being a £215 million deal between London & Stamford and Lloyds Banking Group as the formerly HBOS-backed real estate assets are unwound. The properties are modern distribution units with a yield of about 8% at the purchase price. According to CBRE, the current equivalent yield for prime distribution units is 6.5%. Both Lloyds and Royal Bank of Scotland, who also lent to the venture, recouped their loans, although the original HBOS equity was wiped out.
It is interesting to note that the price of the March 2011 IPD property future has picked up again in recent weeks to around 112. This means, over the next 10 months, IPD returns are priced at approximately 12%, of which roughly 7% represents income. The yield pickup over other asset classes still suggests commercial property should continue to outperform both bonds and cash by a wide margin.
Newsflow in UK commercial property continues to improve. Industry specialists have been joined by investors reinvesting in a sector where the yield pickup is still 3% above 10-year gilts. A shortage of prime property is squeezing prices sharply higher at the moment but as 2010 progresses higher capital values may well encourage involuntary holders, such as banks, to further boost supply. Even so, with in excess of double-digit total returns forecast for 2010, property should provide attractive returns relative to the meagre offering from cash and government bonds.
This article first appeared in Investment Week on June 7, 2010.
