Attractive UK commercial property yields
With London office rents already rising, we are confident that the market has stabilised. Yet, rental yields remain at a considerable premium to the cost of money, and thus provide an attractive income to investors. This large yield premium partly reflects the industry’s huge debt overhang, which will require significant sums of new equity capital over many years to refinance. However, we do not believe this process will prove disorderly given government support for the financial system. The market is also now clearly aware of the risks related to property investment. Overall, rental yields rather than capital gains will drive the high single digit returns that we foresee.
Average yields of 7% (according to the Investment Property Database) are close to the historical mean, but are considerably above the ‘risk-free’ benchmark provided by 10-year gilts or the five-year swap rate for financing. These yields appear attractive now that rental levels seem to be stabilising. Indeed, office rents in central London are now rising again (after sharp falls). In addition, new projects are once again on the agenda, following the collapse of new construction - to record low levels - over the past two years. However, a number of factors are likely to weigh on rental growth outside of central London. Unemployment, for example, is likely to remain high – job cuts in the public sector will outweigh a tentative recovery in private sector employment. Jobs growth in the retail sector is also likely to prove sluggish as consumer spending remains subdued. While the outlook for industrial production is better than for consumer spending, the investible sector is focused on distribution warehousing. However, despite Coutts’ relatively downbeat appraisal for the UK economy, our forecast for an overall stabilisation of the rental market is positive - investors can discount future rental income streams with greater confidence.
Due to current tax treatment and the different drivers of the UK residential property market, many investors are focused on capital performance. However, the scope for further capital appreciation in the commercial property market appears limited - following a 14% bounce-back from the lows seen in 2009. If history provides a guide, capital gains in the property sector may return later in the investment cycle. Meanwhile, the sector’s huge debt burden (highlighted by the latest Commercial Property Lending Report from De Monfort University) may drag on commercial property prices. This would suggest that yields will have to remain high for an extended period, if the necessary new capital required for the refinancing process is to flow into the sector. However, despite the prospect of weak capital growth, the rental income stream still offers attractive returns, especially to investors focused on income.
UK commercial property yields, in common with those provided by Investment Grade and High Yield corporate bonds, appear attractive in the current environment. Good yields provide an element of stability to returns. They are not dependent on capital appreciation, and offer favourable rates of return to investors in an environment of constrained growth. The prospect that fiscal tightening will prolong the era of low interest rates will only enhance the attractiveness of these yields.
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