What’s the outlook for commercial property?

House-Property-Ladder-Rising-Prices-640.jpg2008 saw the UK commercial property market produce a negative return of more than 20 per cent, which itself followed a negative year in 2007. But since then the asset class has produced a positive return in each calendar year and has produced a double-digit return in four of the past six calendar years including the past three years.

Very low interest rates, very low inflation and improving economic growth following the depths of the financial crisis were key factors behind this performance, as was strong interest from investors looking for an asset class with reasonably low volatility, an expectation of good returns, a competitive level of income and an alternative to some of the traditional asset classes where the outlook was deemed much more uncertain. Looking at net flows into the IA Property sector since the financial crisis what stands out is the very high levels of net inflows in 2014 and 2015.

At the start of 2016 the outlook for the UK commercial property market remained positive but return expectations from market commentators and property fund managers had fallen from the double-digit returns seen in the past few years to around mid-to-high single digits, anywhere from 5 per cent to 9 per cent.

In terms of what would be the key driver of these returns, there was a consensus that capital growth would be significantly reduced and may even fall to zero and that returns would be driven by income, which is always a relatively stable part of property returns, and by improving rental growth. Property values in central London had risen strongly over the past few years, partly due to strong demand from overseas investors, and there were some concerns that this had been overdone and valuations were beginning to look stretched.

This more subdued, although still positive outlook, may have caused many advisers/investors to look at their UK commercial property weighting within portfolios and decide to take some profits and/or reduce their allocations for new money. This was evidenced by the flow of money into the IA Property sector prior to June’s EU referendum. This was a significant turnaround from the past two years in particular.

The fortunes of UK commercial property funds have ebbed and flowed with the flow of money into the asset class generally. The Aviva Property Trust was the first of the mainstream UK commercial property funds to move its pricing basis due to negative fund flows in December 2015. A number of other funds have since followed suit, which led to price falls of around 5% in most cases.

EU Referendum impact

The initial view was that the UK would vote to stay in the EU but concerns had already been expressed about the possible effect of a vote to leave on the UK commercial property market, particularly in London due to the level of overseas investment, based on the level of uncertainty that would exist.

As we all now know, the UK voted to leave the EU and this led to a significant increase in the number of investors looking to exit or reduce their UK commercial property positions. The IA Property sector saw a net outflow on £1.448bn in the month of June, a significant increase from previous months, leading to a liquidity squeeze.

A number of fund management groups suspended dealing on their mainstream UK commercial property funds due to the significant increase in redemption requests, which squeezed the liquidity buffers in their funds. The suspensions were applied in order to protect the interests of existing investors and to prevent a ‘fire sale’ of properties to meet the redemption requests.

A number of these funds also applied a property valuation adjustment, although these have started to reduce very recently. This is effectively an acknowledgement that property prices may reduce in value at their next valuation point but this will not be known until independent valuation reports can reflect what has been happening in the UK commercial property market post-referendum. Where this has been applied, there was a further fall in a fund’s unit price.  Many funds have moved to weekly, from monthly, valuation points to keep a closer eye on current market sentiment and a clearer idea of market pricing.

In the short-term investor sentiment is likely to continue having a large bearing on the direction of the UK commercial property market, which will affect liquidity levels and the ability of investors to get in and out of commercial property funds. How long this will last is impossible to say at present.

Fundamentally however, there are a number of positives for the UK commercial property market, some of which have been strengthened as a result of the reaction to the EU referendum vote:

  • Due to the increased economic uncertainty the Bank of England cut interest rates and introduced more QE, which will keep borrowing rates low
  • The sharp fall in the value of sterling versus overseas currencies improves the attractiveness of the asset class for overseas investors
  • Yields and valuations remain attractive relative to other asset classes
  • Rental growth continues to improve across a large part of the UK

Capital values have been hit in the short-term but, if you believe that the UK economy will survive the referendum result and will improve over the longer-term then the UK commercial property remains a fundamentally solid place to invest.

For investors in suspended property funds this is a very unfortunate situation to be in but they should not panic.  Investor sentiment will be the main determinant as to when these funds will re-open but in terms of the asset class’ performance, fundamentals should eventually re-establish themselves and be the key performance driver.

Stewart Smith is investment research manager at RSMR