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Property bandwagon rolls on

Commercial property values and rents look set to rise further, while the housing shortage will underpin housebuilders
December 19, 2014

Capital values for commercial property in London have continued to grow at a heady pace this year, as demand for office and commercial space accelerates. Institutions and overseas investors have been attracted by the strong growth rates, as rising employment and limited availability, notably in the West End, underpin the rise. What's more, while rents in London are now back to near their 2008 highs, there is every reason to assume that further increases are on the way, given that vacancy rates are below 4 per cent, while supply remains limited.

The market is also bubbling elsewhere in London, notably for companies such as Workspace (WKP), which provides office space for small and medium-sized companies. Last year, for example, net asset value rose by a whopping 43 per cent, and this was followed by another 20 per cent rise in the six months to September. Not surprisingly, its development arm has stretched out to meet demand for quality office accommodation, and the returns are impressive. Previously unfashionable areas have now become acceptable areas to locate to. This reflects an improving economic climate, but also significant improvement in transport links which allow customers to stay close to London without paying London's sky-high rents.

The strength of the market means that companies have little trouble in raising new money. Gone are the days when the major banks held sway; there is now a mountain of institutional money seeking alternative investments away from the paltry returns on offer in cash or government bonds. Nowadays, property companies are more inclined to issue new shares as a means of raising cash.

 

Outside London

This renaissance in the commercial property market in London is steadily starting to percolate through to some of the UK's outer regions. Specifically, the outlook for rent increases is better now than it has been for many years, while appreciation in capital values appears to have some way to run. Rents were depressed in the years following the financial crash, with landlords having to face increasing vacancy levels.

The net result of this depressing scenario is that until recently new construction has been virtually mothballed, and has yet to catch up with the increase in demand. Rents are typically starting from a low base, and growth is now underpinned by rising employment levels. It's not easy, though, to draw an obvious parallel with the last property cycle in order to assess the scope for rental growth this time around. For a start, rising availability of space between 2002 and 2004 meant that it was not until 2006 that a recovery in demand helped to make a dent in vacancy rates, which explains why rental growth was so soft at that time; today, however, supply is much more constrained.

But there are still a few headwinds. A lot of the employment growth has centred on small businesses and start-ups, neither of which will lead to a significant increase in demand for space, especially among new companies still in their infancy. In fact, of the new jobs created in the past couple of years, 40 per cent have been among the self-employed. Productivity could also be a constraint on demand for more space. UK workers consistently fall behind workers in other developed nations when it comes to output per man hour. There is a case therefore that an improvement in productivity would not necessarily lead to faster job creation.

Retail rents hold less promise, not least because of the change in consumer habits. Buying items online is big business and getting bigger, and this is having an inevitable effect on footfall in the regional high street. Further structural challenges arise with the wholesale closure of bank branches as more people are herded towards dealing exclusively online. Land Securities (LAND), for example, recently completed a clearout of its shopping centre portfolio, selling assets in Scotland for £224m. The remaining properties are centred on dominant assets in key cities, where the returns are better. The sale in Scotland, for example, was executed on an initial yield of 6.5 per cent, while the 30 per cent stake in Bluewater purchased earlier this year was at 4 per cent.

So there is plenty of catching up to do outside London. The UK commercial market delivered capital value growth of 13 per cent in 2014 but only by 5 per cent in the major sub-markets. It's also worth noting that, within the 13 per cent increase, only 2 percentage points came from a rise in rental income. The rest reflects a growing willingness by investors to pay more for a steady income stream, thus driving yields lower. And while the broader picture may exude an element of frothiness, it's worth remembering that property yields are still as much as 40 basis points above the apogee in the mid 1990s. The question now is if the rise in capital values starts to decelerate, will rental growth be sufficient to fill the gap? It may be a little early for that. After all, rental growth in some parts of the country is still conspicuous by its absence.

 

What will 2015 bring?

Capital values in prime London spots are likely to rise but at a slower pace, while rents will move higher, simply because demand still outstrips supply. Much the same is likely to happen in prime regional spots such as Manchester. But the revival elsewhere is still patchy, as the rest of the country continues to play catch-up with the vibrant London market.

On the residential side, the entrenched gap between supply and demand throws up an array of problems. In fact, the solution to the chronic housing shortage in the UK is simple; there isn't one. Well, there isn't one single solution, but there is a raft of potential initiatives that, if enacted, could go a long way towards narrowing the gap.

First, put to one side any ideas that the big housebuilders can fill the gap; they can't. Private construction peaked in the 1960s at around 200,000. At that time, local authorities were building around another 150,000 houses each year, but now they build next to nothing, while private construction has all but halved. The decline in council houses can be explained quite simply: local authorities have been drained of funding as central government grants have dried up. To put the shortage into context, new housing registrations in October were the highest since June 2011 and up 10 per cent from September. This is encouraging news, but at just 13,950 the monthly figure is still well short of what is required.

But even if the taps were turned back on, there remains the problem of accessing the right amount of land in the right location. There's no point in building houses in an area where employment is difficult to come by, or where transport links are poor. And outside the big builders there is a chronic lack of support for small and medium-sized builders, who consistently run into barriers when trying to raise any significant amount above £20m to fund a development. Pete Jefferys, senior policy officer at Shelter, reckons that building more garden cities would be a major step forward, much in the same way that land was used to generate the HafenCity in Hamburg. Part of the problem here is achieving a consensus between land owners, planning departments, financial backers and, perhaps most crucial of all, existing homeowners who face being affected by any new development.

Accessing the capital required for any major acceleration in housebuilding must ultimately come from the private sector. Around £20bn has already been raised in bond markets and has been used to bankroll housing associations, and there is plenty more where that came from. Pension funds and institutional investors looking for a decent and yet relatively safe return in today's low interest rate environment have plenty of funds to invest. However, at the moment there is no clearly defined mechanism to pull together those with the cash and those with the expertise. Major hurdles need to be overcome, with formalised risk structured to encourage more private capital into the building sector.

Large housebuilders may understandably prefer the margins available on building a family house in the home counties than those from affordable housing, and besides, any development carries risk. If the economic tide turns, as it did seven years ago, builders can be left with a long development arm, falling house prices and a dearth of new buyers. Avoiding this can be achieved by capping output or spreading the risk. Galliford Try (GFRD), for example, secured a joint venture with Gateshead Council in a so-called local asset-based joint venture. Land on 19 sites will be used to build 2,400 homes, a quarter of which will be classed as affordable homes.

 

Election effect

Inevitably, political considerations are likely to come into play in the run-up to next May's general election. However, it's reassuring to note that the major parties are all singing from the same song sheet when it comes to addressing the housing shortage. But, despite this uneasy consensus, even the most vocal advocates concede that nothing significant is going to happen in the short term. Even solving the capital constraints overnight would leave the industry facing the equally daunting prospect of finding the skills and the raw materials needed to enable a rapid increase in output. Most major housebuilders are employing some form of apprenticeship scheme to attract young people into what has historically been seen as an unattractive sector to work in. This is encouraging, but we're talking years before any modest improvement shows through.

Meanwhile, skill shortages and raw material costs are already pushing up supply side inflation, and increasing output will exacerbate these. So, without a process of collaboration and joint ventures, it is not difficult to see why housebuilders are not stretching themselves. Even if they wanted to, the planning process continues to act as a permanent drag on raising output. Recently announced plans to speed up the planning process and to reduce the burden of Section 106 requirements are all welcome, although galvanising local authorities not to sit on their hands in the run-up to the election could be a daunting task.