est chef économiste de la RICS (Royal Institution of Chartered Surveyors).


United Kingdom: an uncertain recovery in commercial estate

Sentiment towards commercial real estate in the UK has improved markedly over the past year or so after what was the most dramatic downward adjustment in pricing. According to IPD, who compile the most authoritative indices tracking development in the property market, capital values have on average increased by around 15% from the post credit crunch low point. Even so, the All Property index still remains some 35% down on the high water mark touched in the middle of 2007.

Significantly, the recovery in real estate has been far from uniform across the country. Looking at the numbers from a sector perspective, retail has seen the strongest gains with industrial properties a little predictably lagging behind offices. More telling, however, has been the diverging behaviour between prime and secondary estates with the former way ahead of the latter in benefiting from the shift in mood towards property. This has also been reflected in something of a North South divide with London and its environs enjoying the largest downward shift in yields.

The leadership provided by prime real estate is hardly surprising when one looks at who have been the major buyers in the sector over the past twelve to eighteen months. Since the beginning of 2000, overseas investors have accounted for just over a quarter of purchases. However, this figure has jumped to close to 40% in the recent recovery. Typically, as appears to be borne out by these numbers, one would expect foreign interest to focus on the bigger centres for investment.

Meanwhile, domestic buyers of property continue to be handicapped by the more circumspect approach to mortgage lending from the major banks. The Bank of England’s Credit Conditions Survey has noted a slight improvement in the availability of finance to the commercial real estate sector but money is generally still not available without substantial deposits being put down. This may be no bad thing after the tumultuous events of recent years but it does, nevertheless, make it a major challenge to access the market.

Interestingly, the latest RICS survey of the commercial property market suggests that some of the momentum underpinning the recovery in the sector may now be fading. This is particularly evident in the results relating to tenant demand which according to the most recent report turned negative in the second quarter of the year for the first time since the second quarter of 2009. Rental expectations also remain in negative territory, albeit less so than previously, with inducements continuing to rise and lease lengths shortening. These are not the results that we would expect to see if the upswing in the commercial market was set to continue. Significantly, the results on capital value expectations have begun to deteriorate and there also appears to be some easing in the level of investment demand for property.

It is not difficult to rationalise this apparent shift in sentiment. With initial yields approaching 8% in the middle of 2009, there was generally perceived to be good value on offer in the real estate sector particularly when compared with the income available from other assets. However, as the valuation basis has adjusted to what might be considered more normal levels the focus has shifted to the fundamental drivers of property such as the economy, the underlying demand for commercial space and, most importantly, the likelihood of any reversal in the downward drift in rents.

Recent economic news flow has been pretty mixed in the UK but the second quarter GDP was remarkably positive showing a 1.2% gain compared with the first three months of the year. This pace of growth plainly won’t be sustained; indeed there has of late been much talk about the possibility of a double-dip as government spending cuts begin to bite. However, the more reputable forecasters such as the Bank of England are still envisaging growth not that far away from trend in 2011. If this does, indeed, prove to be the case the signs of a loss of momentum in the commercial market recovery may turn out to be little more than a pause for breath. On the other hand, a double dip will inevitably take its toll on the occupier market (as unemployment resumes an upward trend) and raise a question mark over whether current yield basis can be maintained.

At this stage, out inclination to put a higher probability on the former outcome than the latter but even in this environment, the picture across the country will be quite mixed. Those parts of the UK which have typically been more dependent on government largess will inevitability be more at risk as the public sector scales back its activities. Some office space currently taken up by either government or related agencies will be released onto the market while the knock-on effect of weaker regional economies could depress demand for retail and industrial buildings as well as hotels. London and the South East, which has been leading the recovery in real estate is if anything likely to extend its outperformance as the relative health of the private sector propels the capital’s economy forward.

One key risk to the market even if the economic recovery is sustained is the prospect of higher interest rates as this is likely to trigger more in the way of distress sales of property. Recent meetings of the Bank of England’s Monetary Policy Committee have seen some dissent from the no change stance favoured by the majority of decision makers. But the overriding impression of the discussion at these meetings provided through the minutes is that there will be no early change in policy and when the tightening process begins, it is likely to be implemented in a measured way so as to provide some counterweight to the ferocious tightening in the fiscal stance. Moreover, the withdrawal of quantitative easing looks to be even further down the road given the uncertainty over how this would play out in financial markets.

That said, it has been estimated that something in the region of £228bn of property debt is outstanding (after the borrowing binge of the last decade) with around one-fifth of this in what may be broadly described as the problem loan category. In addition, there is a refinancing issue approaching with something in the region of £160bn of debt set to mature over the next five years and close to £20bn of commercial mortgage-backed securities also falling due. It would not be unreasonable to conclude that banks are likely to want over the medium term to scale back their exposure to this sector which suggests that the terms around which they are willing to rollover these loans may be somewhat less generous than was the case when they were initially taken out.

This will provide another obstacle for the real estate sector to overcome and warrants some degree of caution about the outlook. Nevertheless, providing the economy continues to grow and the inflation picture does not justify a sharp uplift in interest rates, the likelihood is that the commercial property market will avoid a meaningful relapse into recession. Indeed, yields particularly in the more dynamic parts of the country could fall a little further over the coming years.
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