UK real estate looks set to offer buoyant returns

The outlook for UK commercial real estate remains positive, helped by strengthening domestic economic activity and expectations that interest rates will remain very low. The global hunt for income is a key driver.

Traditionally, real estate’s ability to provide investors with secure long-term income streams has been a key attribute of the asset class. Often buildings will be leased for relatively long periods, producing steady, predictable income flows. In addition, real estate can provide investors with portfolio diversification, with its cycles often following different patterns to those of other asset classes.

Furthermore, real estate is a physical asset with an intrinsic value that may appeal to investors in search of tangible alternatives to other financial assets. And, unlike many alternative asset types, it can be actively managed to add value; for example, by development activity, lease renegotiations or alterations to the occupier mix.

These long-term strategic attractions are currently complemented by favourable cyclical factors. Real estate is a relatively slow-moving asset class; prices are still adjusting to the low-income return environment created by quantitative easing and highly expansive monetary policy. While parts of the market look expensive in absolute terms, they continue to look attractive against other low-risk, income-generating assets.

Whereas five-year government bonds provide yields of around 1.25 per cent, the IPD monthly index suggests UK property offers equivalent yields of around 6.4 per cent. The spread between the two remains very large by historical standards.

Compared to a wider basket of income-producing asset classes, including high- and low-quality corporate credit, real estate looks cheap by historical standards. An environment of very low interest rates and favourable relative pricing provides more room for yields to fall, generating capital growth.

Meanwhile, occupier markets are improving, helped by the strengthening economy. While uncertainty about the general election may hang over markets and create bouts of volatility, its implications for real estate policy will be modest. Demand from a broad range of investors, including overseas and institutional buyers, remains strong and with credit conditions continuing to ease, demand could be set to rise further. So, with yields set to fall further and additional rental growth on the cards, total returns should stay buoyant.

For 2015-19, we forecast annual ‘all-property’ total returns of 9 per cent – very healthy by historical levels. But the opportunity will not last forever. There will be less room for yields to fall after 2015 as the rally in capital values seen since 2013 cools, and yields move inversely with capital values.

In general, a continued focus on higher-yielding market segments and secondary assets is recommended. There are also merits in taking on additional leasing risk and refurbishing regional offices to improve the quality of assets to meet growing occupier demand. While there is recovery in occupier markets across the country, rental growth is likely to be strongest in London and the south east of England.

Chris Urwin is global real estate research manager at Aviva Investors