Commercial property: More but less

Property values and rental income both grew strongly in 2015, as the real-estate sector continued to recover some of the significant ground lost in the wake of the financial crash. And a quick glance would suggest the coming year will bring further advances.

However, it is an axiomatic function of market watchers to question when the next downturn in property values will take place. Given that the last clear rout was prompted by irresponsibility in the banking sector, it's not that easy to find a peg on which to hang the next change in sentiment, given that banks now operate in a much tougher regulatory regime that rules out profligate lending on speculative developments. That the real estate market will turn down at some point goes without saying. Its nature and timing, however, are difficult to predict and, having been woefully ill prepared for the traumatic events triggered by the Northern Rock bailout, there is a temptation among market watchers to be really prepared for the next downturn, and forecasts predicting the timing of another turn appear with regularity.

Asset values and rental income

Commercial real estate is a broad church, encompassing offices, warehouses, retail outlets, doctors' surgeries, student accommodation and a sprinkling of residential assets, and the market itself is more or less clearly defined by area into London's West End, central London, the south-east and the rest of the country. Up to a point, this is a generalisation because there are regional hotspots developing as improved communications and expensive rates in the south-east allow demand to percolate out into the provinces.

Underpinning the whole sector are rental income and the value of capital assets. When the market is functioning well, as it has done over the past year, asset values and rental income move higher, although not necessarily at the same time. Asset values will increase first, primarily a function of the gap between supply and demand. Increases in rental income tend to occur later in the cycle as existing leases come to an end or as new clients move into newly constructed assets. Bellwether indicators to gauge the relative strength of the property market include yield compression, which basically measures rental income as a percentage of the value of an asset. So, if values rise faster than rents, which they inevitably do, the return on an asset declines as the value of the asset increases - hence compressing the yield. This has consequences for investors because the return on capital invested remains a key factor in attracting future investment. Fresh investment offering such relatively low yields has to be made with two considerations in mind. Will asset values continue to appreciate, and will rental income accelerate? For the coming year, the answer is probably yes, but asset inflation is likely to slow.

Another key pillar of support in the past year has been the continued inflow of investor funds. In the post-recession low interest rate environment, more traditional fixed-rate investments have been shunned as investors look for a more attractive rate of return. And the core parts of the UK real-estate market have provided bumper returns in the past few years. Property is also relatively safe over the longer term, and funds from overseas, notably from areas where financial security is less than robust, have beat a steady path to the UK property market.

The bullish view is not one that is universally held, though. Mike Prew, equity analyst at Jefferies is one of the more notable figures to call time on real estate, forecasting that commercial property values in 2016 will start to deflate. According to Mr Prew, we have been pricing real estate as a fixed income investment in a world starved of yield. That’s all well and good, but what happens when interest rates start to rise? Money that has been pouring into the sector could rapidly find a new home as institutional tourists and overseas investors revert to more traditional fixed-income avenues as yields improve.

The Reit path

Other factors highlighted as possible signs of the real estate cycle maturing may seem to be contrarian but contain an element of credibility nonetheless. These include the fact that virtually everyone is bullish on real-estate investment trusts (Reits) at the moment. And the last time that Reits were this good, they needed rights issues nine months later. Other factors that suggest an apogee could be fast approaching include the fact that prime office yields for the City of London at 4 per cent and the West End at 3.5 per cent are now lower than they were 45 years ago. Furthermore, the tap that has provided so much of the explosion in global liquidity is slowly being turned off by central banks.

Another worry is a proposal being mulled over by the OECD which could restrict the tax shield on debt to a fixed ratio. At the moment, interest on debt is generally deductible from taxable income, thus providing companies with an incentive to finance their operations through debt rather than equity. If this allowance is capped at a fixed ratio, the consequences for real-estate companies - typically highly geared - could be significant. Land Securities (LAND) has also injected a note of caution, effectively limiting its development arm to next year, with little on the horizon after that. It has also been recycling its assets and using the proceeds to fund development projects, but it's still pulling in more money from disposals than it is spending, and this disinvestment is expected to continue for the rest of the year.

After the explosive performances logged in 2015, Workspace (WRK), for example, has nearly doubled its net asset value in just two years. Most property companies expect to see a slowing in capital appreciation, with growth coming through rising rental income. Industrial property values are likely to remain underpinned by the supply/demand imbalance. Delivery of new assets is picking up, but has a long way to go to compensate for the almost complete lack of construction following the financial crash. Demand is also being underpinned by changes in consumer habits, including greater use of the internet, and click and collect services. Big retailers such as Primark have been moving into larger, purpose-built distribution warehouses to cater for these trends. And while new supply is coming on stream, it will take a year or two yet before the imbalance is narrowed significantly. Office space is also expected to remain in demand, notably in supply-constrained areas such as London, and this will have the added effect of pushing up rents.

Property companies such as Unite (UTG) operating in student accommodation, and those like Assura (AGR) operating doctor surgeries and healthcare centres should continue to show an improvement, mainly because both areas are poorly served with bespoke facilities. A majority of surgeries are not fit for purpose when it comes to embracing the concept of a broader medical centre designed to remove some of the workload from mainstream hospitals, while lifting the cap on overseas student numbers promises to encourage strong demand for bespoke student accommodation. Investment in both of these areas is expected to accelerate in the year ahead.

Perhaps the key exception to the bullish tone is the retail sector, or more specifically very big supermarkets as consumer habits change to favour the smaller, more convenience type of outlet. These superstores have become a millstone around the neck of big companies such as Tesco, already embroiled in a price war with discount operators such as Aldi and Lidl. The big shopping malls are likely to experience greater footfall, and premier spots will see some rental growth. Much depends on how adept landlords show themselves to be at catering for changes in consumer habits - installing WiFi and turning a collection of shops into a leisure experience, for example. So as big operators such as Primark build up a network of distribution centres to cater for next-day delivery, companies such as LondonMetric (LMP) will capitalise on these trends by accelerating the construction of large distribution sites.

Outlook for 2016

Ultimately, any further gains bear a close correlation with economic growth. With growth and wages outpacing inflation, conditions to support further momentum in the property sector look encouraging. Asset inflation is almost certain to moderate, but as long as property companies can keep a tight hold on the development side, and not be left with a string of new capacity just as demand declines, the near-term outlook remains encouraging, especially as new developments are completed and start to generate fresh rental income. And it is rental income that is expected to be the key driver in the coming year as asset price inflation starts to moderate. And until either the level of new-build accelerates sufficiently to fill the gap, or demand for space falls, rental growth looks fairly well underpinned.

Are there any skeletons in the cupboard? Higher interest rates will at some point start to erode the attractions of property as an investment asset, but this will take time. The only other factor that could upset the apple cart is the question of the UK's continued participation in the EU. The jury will continue to remain firmly out on this one, but there is a risk that the UK opting out could encourage some larger institutions to look elsewhere. This is especially true in the productive areas outside London, where some large producers - notably in the car manufacturing sector - would find it less compelling to operate their EU operations from a country based outside the EU.

For now, though, the effects of the EU referendum are confined to an element of uncertainty rather than prompting any structural shifts in investment patterns. Within the real estate market as a whole, the bullish trend looks set to continue. Borrowing from banks is a lot harder than it used to be, but if asset inflation and rental growth moderate to a sustainable level, the cycle can be extended beyond the time span associated with usual boom and bust cycle.