Commercial property in London and the south east has been buzzing for some time, but now the rest of the UK is catching up. In fact, returns from regional investments look set to outpace those in the south east as Britain's economic recovery gathers further momentum.
So with demand for offices, industrial units and even shops outside London showing no sign of abating - particularly as new supply has still to regain sufficient momentum to meet that demand - why are some people starting to become a little more wary about investing in such assets?
There are a number of 'what ifs' that could see prices retreat. Most obviously, returns on property have been boosted by institutional tourists from fixed-income markets looking for a better return. This has inflated values, a trend that will reverse when interest rates start to rise meaningfully. This is unlikely to happen for a year or two at least, but property investment is a multi-year game.
The traditional cycle in the wake of an economic downturn sees rents and capital values rise in London and the south east, and as economic confidence takes root the gains percolate out into the provinces. In the current cycle this process is not that far advanced, because capital and rental growth nationwide is still some way behind that seen in London. So calling a top on the commercial property market would leave most people outside London baffled.
Interest from overseas investors is very strong. In 2013 in Birmingham, for example, total inward investment was just £70m. This year so far that figure stands at around £500m. Rental growth has yet to gain real traction, too, even after a seven-year drought on new developments. As Edward Gamble of commercial real estate adviser CBRE points out, the difference in rental yield between regional property and prime London real estate is currently about 150 basis points - three times the historic average of about 50 basis points.
How offices performed
However, the regional revival remains patchy in terms of both location and asset class. The ravages of the last cycle are still leaving their mark. As analyst Mike Prew of Jefferies International points out, excessive lending to speculative property investors inflated prices in real terms by a third between January 2004 and the peak in July 2007; rents over the same period rose by just 3 per cent. As the bubble burst, prices fell by nearly a half. This prompted the banks to pull up the drawbridge on loans, so that outstanding loans to property companies now total around £135bn - little more than half their value in 2009.
Commercial property values have now bounced by a fifth since their trough in 2013, but remain 37 per cent below their 2007 peak. With banks still taking a back seat, the vacuum has been filled by foreign investors investing at first in London and then in the regions. However, the revival is not broadly based. Retail property has been slowest to recover as e-commerce has undermined the traditional bricks-and-mortar shop model. The same trend has boosted demand for distribution warehouses, however, while prime office space in good regional locations remains at a premium.
In particular, big regional centres such as Manchester and Leeds are attracting both developers and tenants as London sites become more and more expensive. Many argue that there has been a fundamental shift in big regional cities, underpinned by improved transport links, a fashion for urban living and cheaper property. Manchester, for example, has attracted more than £1bn of property investment in the last few years.
Other cities are only now starting to see their first significant levels of investment since the recession. In Leeds, Singaporean fund Heeton this summer made its first UK investment outside London. It bought a scheme with planning consent for more than 1m sq ft of space, including 843 city-centre apartments - the first to be built since 2012 in a city that became synomymous with the pre-crisis buy-to-let bubble. Office construction in Leeds last year more than trebled from the previous year, spurred on by demand from companies such as Npower, which is looking for 275,000 sq ft of space.
But Birmingham continues to outpace all the other major cities outside London. It is on course to add over 1m sq ft of office space this year. Much of this is tied up in Eastside Locks, a 13-acre canal-side regeneration project that will provide 650,000 sq ft of top-quality office space. The area is right next to the proposed high-speed rail link that will bring the journey time to London down to just 49 minutes.
Beyond urban redevelopment, changes in consumer habits have been one of the key drivers behind new construction. Major retailers have needed distribution centres to meet the growing appetite for online shopping and home deliveries. Ideally, these large warehouses need to be as close to suburban areas as possible - but far enough away to avoid inner-city rents.
Rents in the UK industrial sector - a point of specialisation for both Segro (SGRO) and Tritax Big Box REIT (BBOX) - rose by 3.8 per cent year on year in the second quarter. That's two and a half times faster than a year earlier, and is consistent with the strong job creation in the wholesale and distribution sector. Such is the strength of this demand that economic consultancy Capital Economics pointed out that demand is reducing the amount of available space at the fastest rate on record. To meet this demand, investment in new developments reached nearly £500m in the second quarter - a total only surpassed once before. This will help to reduce the imbalance between supply and demand, but is expected to slow rather than stall the rental recovery. Capital Economics is forecasting rental growth this year of around 4 per cent, slowing to 3 per cent next year.
IC VIEW:
It is too easy to dismiss the regional recovery in commercial property as being driven by foreign investors looking for better returns. They are looking for better returns, of course, but the reason for investing in the regions is also coming from a fundamental change in the way that the regions are developing. Even without the added incentive of not having to pay London prices and rents, big cities outside London are becoming more attractive places for people both young and old to live and do business. Ultimately, any sustained property recovery will correlate closely with the economic recovery. With growth rates set fair for now, investing in the regions makes a lot of sense.
FAVOURITES:
LondonMetric (LMP) started repositioning its property portfolio a couple of years ago, moving out of residential and offices and into the market for distribution assets. Asset disposals helped to boost the coffers, with net initial yields on out-of-town retail parks and retail distribution warehouses acquired comfortably exceeding the average yield achieved on disposals. Meanwhile, NewRiver Retail (NRR) has been adept at wringing high returns out of the unpromising retail sector, in part by investing in convenience store assets - again a response to changing consumer habits. Acquisitions include 202 pubs from Marstons and, more recently, 158 pubs from Punch Taverns. Some of these will continue as pubs, but excess land is being used to develop a string of convenience stores.
OUTSIDERS:
Property companies investing in the regions are all doing pretty well, but most of the weakest performers can be found in the retail sector, where growth has been slower than elsewhere. Intu Properties (INTU) has some very strong assets, such as the Intu Trafford Centre in Manchester, but a series of major lease maturities together with limited scope to increase gearing mean that it has been slow to refresh its centres. As a result, growth in like-for-like net rental income is expected to be relatively modest compared with peers'. Better value can be found elsewhere.
