Whilst the more liquid equities and fixed income markets continue to re-price the pace of the economic recovery in the face of the latest dark clouds of sovereign debt risk and deficits, the UK commercial real estate market continues to recover from the steep drop in values from Q4 2008 to Q3 2009.
The key themes we have observed in recent weeks include;
§ Underlying performance measured via GDP growth continues to show improvement but it is clear that the economic recovery is facing a number of challenges.
§ Equity markets continue to remain exceptionally volatile, characterised by 100 point swings, with the FTSE below 5,000 and Dow beneath 10,000 at the time of writing.
§ Real estate lending remains constrained as banks repair their balance sheets across the market, borrowers can leverage but have to try harder and know where to look.
§ Property derivative pricing sees continued improvement in sentiment, rising to a 10% plus growth expectation in 2010
§ Investment activity continues to increase MOM, overseas investors still driving the market in Central London, less so in the regions
The economy remains on track to expand again in Q2, not least because retail sales posted a solid increase of 0.6%m/m in May. However, the labour market remains fragile and the Budget measures will hit households’ finances pretty hard. Of course, the flipside of soft economic activity is that inflation and interest rates will remain low and we believe for some time, through 2010 and most of 2011.
Market intelligence last month showed that, despite negative net lending flows over the past year, lenders’ exposure to commercial property remains very high. A key reason for the failure of property debt levels to be cut by a more appreciable amount is the “delay and pray” approach of lenders which, as illustrated by the latest De Montfort survey, remains prominent. This was covered in our recent CMBS paper.
CPI inflation dropped further than anticipated in February, to 3.0%, underpinning the BoE view that inflation is not of great concern and should continue to fall throughout the year.
Further good news came in the retail sales figures which showed February had been a strong month, albeit following an appalling snow covered January. The overall spending picture remains muted, but not worrying. Yet. House prices are seemingly rather more erratic. Although reflecting markedly different rates on both a monthly and annual basis, both the Halifax and Nationwide indices do at least agree that Q1 saw much slower growth than that achieved in Q4. Many commentators still anticipate negative or, at best, no growth in 2010.
Of all the key indicators, it is the outlook for sterling that is the greatest worry. Continuing uncertainty about who’s going to be running the country is not going to help this anytime soon.
Unsurprisingly, rates were held at 0.5% in April. Although the Q4 GDP figure has been revised up yet again, his time to 0.4%, the recovery is still perceived as having only a tentative foothold. In any event, rates were unlikely to change until the election is out of the way. Similarly, further QE measures remain unutilised but still possible. The next MPC meeting has been moved from its original date of 6th May until the 12th. As Parliament will be absent at the time, perhaps the MPC will get giddy with power and do something radical. Then again, perhaps not.
As at 8th April, LIBOR has remained relatively unchanged at 0.65% while 5 year swap rates have increased marginally but remain below the 3% threshold, at 2.90%.
Propertydata.com’s preliminary figures showed that investment market activity was 27% higher in May than in April, rising from £1.5bn to £1.9bn. Given that past years have seen a fairly even split between rises and falls in investment market activity in May, the latest result was reasonably strong. Indeed, it helped to push up the 12-month rolling total to £26.3bn, the highest level since August 2008.
Of course, the investment market remains far more subdued than in the boom years of 2004- 07. Turnover levels are soft in all three main sectors, though perhaps most notably in the office sector. London’s West End market was especially quiet in May, with just two deals (worth a total of £24m) completed. That said, with rental prospects improving, investor demand for offices may strengthen in the months ahead. Of course, it is another matter whether there will be willing sellers.
After modest net sales in April, overseas investors made net purchases of UK property in May of £170m. As Chart 3 shows, European investors made the biggest, positive contribution to that net total, with the most notable transaction being Ramsbury’s (a Swedish fund) purchase of an office/retail block on London’s Regent Street for £220m.
UK-based investing institutions also made net property purchases in May, totalling £270m. In the past few months, publicly listed property companies have also been active buyers. This competition for the limited amount of property on the market may help to explain why transactions by private individuals have recently faded.
Capital growth continued to rebound in February, putting in a monthly increase of 1.27%. Again, this was all about yield shift, with rental growth declining by -0.15% and running at an annual rate of -7.1%.
The total return over 12 months is now a fairly impressive 11.1%. This is the first time we’ve seen double digits on the right side of the line since it all went pear-shaped in the summer of 2007. Purchasing volumes remain relatively muted, however. Q1’s total of £4.8bn was little more than half that seen in Q4, and more comparable with the downturn levels during Q2 08 to Q2 09. Nonetheless, the pressure on yields has continued. Only the average initial yield for retail remains above its long-term average, in large part due to the slower improvement in the shopping centre sector.
Expectations for the outturn in 2010 rose yet again during March. Clearly the election isn’t weighing on everyone’s minds – or, at least, not in terms of its impact on performance this year. By the end of last month, pricing had increased to reflect a return of 10.75%. It was the first time for 6 months that the expectation for 2010 had reached double digits. The medium-term outlook remains fairly benign with a hint of gloomy, keeping returns within the 6% to 7% patch throughout the next five years.
Real Estate Lending
Net commercial property lending flows remained negative in May, reflecting the fact that banks’ and building societies’ exposure to the sector is still very high. Further negative lending flows are likely in the months ahead. On a brighter note, UK investing institutions remain active buyers of commercial property.
Total net lending by banks and building societies was £1bn in May. However, given April’s weak figure of minus £16bn, net lending remains on target to be negative for the fifth consecutive quarter in Q2. Low gross lending and some increase in borrowers’ repayments are both likely to have contributed to weak net lending flows.
In the property sector specifically, net new lending flows were minus £50m in May. This was an improvement on April’s figure of minus £1bn but still suggests that Q2 will see the weakest net lending flows to property since the credit crunch began. (See Chart.) The data contradict recent anecdotal evidence that lenders’ wariness of the commercial property sector may have started to ease.
Looking ahead, Thursday’s Credit Conditions Survey from the Bank of England should provide some insight into the near-term prospects for property lending. However, with banks’ exposure to the market still very high, there seems little chance of a material loosening in the availability of new credit anytime soon.
Also released this morning were Q1’s data on net asset purchases by UK investing institutions. Unsurprisingly, given the problems in Greece and a rise in risk aversion, there were substantial net sales (£11bn) of equities in Q1 but strong net purchases of UK government bonds (£12bn).
There was also net buying of commercial property (£3bn) in Q1. What’s more, Propertydata.com’s data show that UK institutions made further net property purchases in April and May. In the near-term, with these investors still reported to have equity to be spent, property yields probably still have a little further to fall.
The Safe Haven : Yielding Assets
The opportunity exists to earn low volatility, annual equity returns of 8-15% (received quarterly) by acquiring UK commercial real estate assets let to excellent covenants (UK Government, Tesco leases etc) for 5-10 years with a 10-15% annual IRR.
We believe in the current, limited visibility environment this represents an extremely interesting low risk, real asset investment strategy. As a defensive play, the potential returns profile compares well with other defensive alternatives such as cash/gold/treasuries. The strategy offers investors low volatility, transparent returns with in-built inflation protection at a time when GBP borrowing costs are low (2.5% for a 5 year fix and 4.04% for a 30 year fix) and exchange rates favourable relative to USD.
Real assets offering the following investment characteristics;
§ 8-15% Fixed annual equity return (received quarterly)
§ 10-15% Annual IRR
§ Fixed income with annual increases (RPI/CPI/Fixed)
§ FRI Income (All costs, management, insurance, maintenance, paid by tenants)
§ Strong residual value driven by quality of asset and location
Disclosure: No positions