Associate Director, Private Office
Strategy & economics
The biggest surprise since the 2016 referendum has been the strength of tenant demand, particularly for office space
Commercial property has traditionally been seen as sitting somewhere between equities and bonds in terms of both its investor characteristics and its performance. This is certainly true over the long term, at least on a simple visual measure.
Indeed, taken over this very long term the average annual total return from the three main asset classes is remarkably similar, with gilts showing 9.3%pa, equities 8.1%pa and property 9.7%pa.
This feels a very rational place for real estate to sit, as it is less liquid than equities – and offers less security (but more upside) than bonds. Commercial property has several other reasons to recommend itself to the professional investor.
An increasing number of private family offices and high net worth individuals have been attracted to commercial property in recent years by the low returns on offer from sovereign bonds, and the fact that property is a physical asset offering comparatively long and stable income returns.
While lease lengths have undoubtedly shortened in the commercial property market over the last decade (and will continue to do so), leases of ten years or more are not uncommon, and the quirks of the UK commercial property lease make the asset comparatively landlord–friendly.
For many private investors it is the stability of the income that is the chief driver of their weighting towards this asset class, though if you time your entry and exit right then the movements in capital values can provide a significant boost to total returns.
The long-term average income return that has been delivered from UK commercial property has been a healthy 7%pa – but capital value growth has cooled since the referendum on EU membership.
At present there are a number of push and pull factors that are affecting both tenant and investor demand for UK commercial property, and slowing economic growth is definitely one of them.
Tenant demand for offices, shops and warehouses is closely linked to business confidence and economic growth, and there is no doubt that both of these measures have weakened since July 2016.
However, there are also other factors to consider if you are thinking of investing in commercial property at the moment, most notably where we are in a notoriously cyclical market and also how commercial property markets are being disrupted by external factors such as the rise of internet shopping and flexible office provision.
The biggest surprise since 2016 has actually been how strong tenant demand has been for commercial property, particularly in the office market.
While the news flow in 2017 was all around how many bankers might be forced to leave London, the reality has been dramatically different.
In the central London office market 2017 and 2018 was actually the second strongest period of office leasing activity since records began. Outside London, last year was the strongest ever for office leasing activity in the top nine regional cities.
This would seem completely counterintuitive in what has undoubtedly been a period of exceptional business and political uncertainty.
While tenant demand from the banking and financial services sector has been muted, this has been more than compensated for by a dramatic growth in demand for office space from the technology and serviced offices sectors.
For example, in central London alone, since the referendum major tech companies have acquired more than four million square feet of office space. WeWork, the co-working operator, has acquired more than three million square feet.
This strong tenant demand has come at a time when developers and lenders have been exceptionally cautious, leading to an undersupply of Grade A office space across the UK, which in turn has pushed up rents.
Risk-averse private investors of all nationalities have in recent years been attracted to the central London office market, drawn by its transparency and liquidity.
For many clients the key question is not merely “can I get invested?” but also, quite sensibly, “is the market liquid enough that I can sell when necessary?’” One area of the commercial property market that has fallen out of favour is retail.
The inexorable swing from less than 5% of retail sales being online in 2007 to nearly 20% in 2018 has driven a surge in retailer failures.
This has coincided with growing demand for logistic centres (primarily to satisfy the demands of internet shopping), and this means that for the first time ever UK logistics property yields are lower than those being achieved on offices and shops.
There is no doubt that the UK is oversupplied with retail property, and that retailers are generally struggling in the face of both high rents and business rates.
However, the canny investor would do well not to forget that 80% of retail sales still occur in stores, and once you add back in click-and-collect and returns there is still a strong need for shops.
We believe that now might be an exceptionally good time for the opportunistic investor to have a look at UK retail, as there is little competition for the best assets, and prices have fallen around 30% from their peak.
What are the “best assets”? The answer is simple: they are places that people want to shop in. They could be highly experiential shopping destinations or convenience-orientated – the key is finding a scheme or asset that fits the shoppers' needs.
The decline in both tenant and investor demand for retail property has led to a surge in demand for logistics or warehouse property globally.
Not only has the rise of Amazon and its peers driven record levels of leasing activity across the UK in the last five years, but investors have also swung into this sector with the average annual transactional volume rising from £2.8bn in 2000-2005 to £7.7bn in 2014-2018.
Private investors have actually been relatively inactive in this sector, despite the generally very long leases that are available. While pricing is undoubtedly keen, there are still pockets of opportunity, most notably close to major population centres.
Looking ahead to the next few years we do not expect a significant change to any of the themes outlined above. Retailers will continue to struggle and logistics operators will be the beneficiaries of this.
Source: Savills Private Office
Office markets are generally undersupplied with good quality space, and we expect that rental growth will be stronger outside London than within it.
Some commercial property investors will remain cautious about the potential impacts of political uncertainty, but the post-2016 trends suggest that the commercial property space has been more resilient than the residential markets. However, pricing on both office and logistics property is aggressive, with yields in many markets at or close to record lows.
While the returns on offer are still comparatively attractive against both sovereign bonds and equities, investors must focus on whether these low yields are supported by future rental growth prospects, and for this a detailed understanding of the local market dynamics is essential.
As ever, out-performance will come from local market knowledge, an understanding of the structural changes that are affecting the occupational demand for real-estate, and an ability to look behind the headlines and focus on fundamentals.
The views expressed above are those of the author and/or Savills and do not represent the opinion of Cazenove Capital
Associate Director, Private Office
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