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Can UK commercial property still provide an income shelter?

Can UK commercial property still provide an income shelter?

UK commercial property is being tipped to be one of the bright spots this year as it benefits from the improving economy and sentiment, as investors seek yield superior to that available from cash and government bonds.

The asset class has already rebounded considerably. In 2013, transactions in central London commercial property hit their highest level since before the bubble burst for the sector in 2007. This trend has spilled over into this year, with a queue of deals waiting to go through. Meanwhile, in its latest report, the Investment Property Forum forecast an average total return of 9.3% for 2014, up from an already strong 8.6% in 2013.

It seems the investment community expects this trend to continue, with the Association of Investment Companies (AIC) noting that in a recent poll, 10% of its members picked commercial property as the sector most likely to outperform in 2014, up from 3% at the market’s peak.

Ainslie McLennan (pictured), co-manager of the Henderson UK Property unit trust, notes the strong flows into the asset class in 2013 were driven by investors searching for income and stability, which remain key themes this year.

‘Interest should continue as a result of the sector’s strong fundamentals, namely solid levels of rental income and steady returns, at a time when other asset classes are likely to experience periods of volatility,‘ she said.

Fund manager Simon Gergel, who invests in property shares through the Allianz UK Equity Income fund and the Merchants Trust, agrees there are still opportunities in the asset class.

However, he argues investors have to be selective about which parts of the sector to go for, following its recent rally, and he favours industrial over retail property for 2014.

‘The thing we are worried about in retail is the structural changes going on in the industry,’ he told Wealth Manager.

‘There is less footfall on the high street and more on the internet. I think big shopping centres will be fine, as they are destinations people want to go to, but on the high street, trading is fairly poor.’

Last year, the strongest region for property was London. Transactions worth £19.9 billion took place in central London commercial property, the highest figure since 2007 and an almost 50% increase on the year before, according to real estate services firm Cushman & Wakefield.

This demand shows no signs of diminishing, with approximately £1.3 billion worth of transactions pending in the City and Docklands alone in the first quarter of 2014.

‘The market is now entering the era of a return to property fundamentals in light of economic recovery – principally that of property rental growth, with a controlled supply pipeline and increasing occupier sentiment, decision-making and demand,’ said Bill Tyser, head of City investment at Cushman & Wakefield.

But while overall the asset class looks healthy going in to 2014, he noted some observers are concerned the market now looks ‘opportunity constrained’ due to ‘possible bond yield increases which might result in yield expansion’.

Chris Urwin, real estate global research manager at Aviva Investors, believes despite this strong performance, there is now less opportunity for capital growth in London.

‘Performance remains strong in central London but there is limited scope for yields to fall further,’ he said. ‘With government bond yields likely to rise, we expect central London yields to be on an upward trajectory by 2016. Therefore, over the medium term, we continue to view central London markets as relatively unappealing on a risk-adjusted basis.’

London rental looking good

Phil Clark, Kames Capital’s head of property investment, is also looking to diversify into regional assets to find returns. Conversely, he believes rental growth in London could be a potential highlight of the property market in 2014.

‘The predominant investment themes of 2014 look likely to be threefold: strong returns in good quality regional property; increasing investment into ‘alternative’ property sectors; and, perhaps the boldest prediction of all, rental growth to begin to surprise on the upside as the supply of good quality office space diminishes,’ he said.

‘I’d put my money into good quality regional property in the first half of the year and look for a blend of alternative sectors to secure both long term income and diversification. Such sectors still driven by demand include healthcare and student accommodation.’

While momentum within the property sector is continuing to build, a concentration in demand for primary properties and a likely rise in gilt yields mean that managers are looking increasingly to secondary, regional assets to boost returns.

Although prices have risen, capital values are still around 30% off peak levels, leading property managers to suggest there is room for further capital growth, and fears of another property bubble are some way away.

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