UKIT. UK Investment Transactions Bulletin Q2 2014

UK Investment Transactions Bulletin Q2 2014

UKIT

www.lsh.co.uk

Even though investment volumes have increased this quarter, the real story is the 35 point inward shift in the transactional yield. On this measure, property is the most expensive it has been since Q2 2008, the tail-end of the last boom.

One of the reasons for the inward shift experienced during this quarter is the strong demand for good quality shopping centres. For example Land Securities’ purchased a 30% stake in the Bluewater Centre for £656m at a yield of 4%. While this is a one-off deal, it does illustrate the depth of demand for these prime assets.

With more and more money flowing in to property funds from retail investors – £491m in May alone – investment from the UK institutions has picked up again in Q2. They are the biggest net-investors into the market since mid 2013 and as a result total net investment has shot up from -£0.5bn in 2012 to just under £5.7bn in the last 12 months. This is reflected in the increased investment in UK

regions, where the institutions are most active. Regional investment totalled £18.6bn in the last 12 months, as

compared to £11.0bn in the previous 12 months and in Q2 accounted for its largest share of the quarterly investment total since Q1 2011.

Outlook

The pick-up and shift in investment market activity over the last 12 months means we have seen a real change in the market. Investment volumes are up, as are capital values; investors – especially UK institutions – are much more active in the regions; and prices outside London are now on the rise.

The rise in prices has been investor driven and vendors have benefitted from 12 months of yield driven increases in capital values. The question is for how much longer can this inward shift be sustained? Certainly the prospect of an increase in the base rate could act to slow it down, as the impact of rising rates from such a low level is an unknown quantity. We anticipate another 6–12 months of hardening yields; however, from mid 2015 onwards rents will have taken over from yields as the main driver of property performance. The prospect for the occupier markets and rental growth is examined in more detail in this edition of UKIT.

•

Quarterly investment in UK commercial property totalled £11.9bn in Q2 2014 –

10% up on the first quarter of the year

•

The all property transactional yield has fallen to 6.06%, which is the lowest level

recorded since Q2 2008

•

Offices and especially Central London offices remain the most heavily invested-in

sector: just over 40% of the quarterly total was invested in office property

UK investment market activity £bn

Source: LSH Research, Property Data, Property Archive

Sector transaction yields & 10 year

government bonds

Economic overview

The strong performance of the UK economy looks to have continued in to the second quarter of the year. The various high frequency data and survey releases support the forecast that the economy grew by 0.8–0.9% in Q2 and will have expanded by around 3% by the end of 2014.

If the forecast is correct, over the last three months the economy will have finally returned to the level of output reached at the peak of the last boom in Q1 2008. While this represents the longest economic downturn recorded since the Second World War, it is a positive sign regarding the economic recovery and future prospects for growth.

Outlook for commercial property is positive

Looking at the main drivers of the commercial property market though, measures like business investment, employment growth, retail sales growth, and data from the services and manufacturing sectors show there are good reasons to be optimistic.

• Business investment increased by 5% in the first quarter of 2014 and is at its highest level since Q3 2008

• Total employment increased by 780,000 in the year to April 2014

• Retail sales volumes were 3.9% higher in May 2014 than in May 2013

• The index of services increased by 3.1% p.a. in May 2014 and the index of manufacturing increased by 4.4% in the year to April 2014

• Credit availability has improved substantially from where we were a year ago and lenders have cut their margins and increased maximum loan-to-value limits, reflecting greater competition in the market

When will rates rise?

The biggest issue in the economy at the moment is the timing and pace of a rise in interest rates. Despite the rate of GDP growth, the inflation outlook is as benign as it has been since the early to mid 2000s. Despite the recent rise in CPI, there is little long-term pressure building on prices and this means that interest rates will probably not increase until early 2015 or late 2014 at the earliest. Even when they do, the rise will not be rapid and the Bank of England Governor Mark Carney has stated that the ‘new norm’ for the base rate could be around 2.5%, not the historical average, which is closer to 5%. The relationship between the base rate and property pricing is often overstated and we think the rise in interest rates will put less upwards pressure on property pricing than might be expected.

Fewer clouds on the horizon

Therefore, while there remain some clouds on the horizon – the continued underperformance of some major European economies, talk of a housing market bubble, a strengthening pound cutting into export demand, debt levels etc. – they look less ominous than has been the case for a number of years.

UK downturns – quarters required to return

to pre-recesison peak

Source: ONS

Interest rates vs. property yields % p.a.

Source: Oxford Economics, IPD, LSH Research

Lambert Smith Hampton

Indices of manufacturing and services

Lambert Smith Hampton

Despite a number of large shopping centre deals, the office sector is still attracting the lion’s share of capital deployed by investors in the UK commercial property market. Central London offices (CLOFs) continue to absorb the majority of this and Q2 2014 investment volumes totalled £3.34bn.

Regional offices have found favour

Even though there has been a slow-down in investment in CLOFs in the first half of the year in comparison with the second half of 2013, total investment levels still reached £3.34bn. The quarter’s largest transaction was the purchase of a majority stake in 10 Upper Bank Street in the Docklands by China Life Insurance (70%) and Qatar Holding (20%) for £795m. The acquisition of CLOFs by overseas investors has been one of the defining trends in the market over the last two to three years and once again they accounted for 75% of activity by volume this quarter. In the regions, office investment in the South East and Rest of the UK totalled £1.4bn, which is a 35% q-on-q increase. The investment schedule is dominated by the sale of RBS’s offices at Spinningfields in Manchester to M&G Real Estate for £306m. M&G bought the offices out of administration at a sub 5% yield. Having averaged 8.3% over the course of 2012 and 2013, our regional office yield series has come in to around 6.5% in the first half of 2014, which demonstrates the turn-around in investor sentiment.

Shopping centre investment on the rise

Investor demand for retail space very accurately reflects the changes that have taken place in the retail market as

a whole. Retailers have downsized and concentrated on fewer, but better quality locations and this is the case in the investor universe too. We have recorded 17 shopping centre deals this quarter, with the majority for large, regionally dominant centres. The prime example of this is the purchase of a 30% stake in the Bluewater Centre near Dartford by Land Securities for £656m at a c. 4% yield. This can also be demonstrated in the type of high street assets that have traded. High street transaction volumes are low in comparison with the other asset classes, but those assets that are trading are prime, which is shown by the sub 5% yields.

More investment in the logistics sector

Q2 was another strong quarter for industrial property. Long term investors with liability matching obligations like the pension and insurance funds continue to be in the market for long-let distribution units: this quarter Legal & General have forward funded Waitrose’s new distribution centre in Milton Keynes for £114m at a yield of 4.64%. This is the largest single-asset industrial transaction since Legal & General’s purchase of a big shed let to Tesco in Reading in Q1 2012 for £115m at a yield of 5.4%.

Even more investment in the ‘other’ sectors

The alternative sectors continue to account for a significant chunk of the quarterly investment total. Approximately £430m of student housing transacted, as did £475m of hotels and £190m of medical-related property. We have explored the reasons behind this ongoing trend in previous UKITs and it will continue to account for a substantial part of the market for the foreseeable future.

Sector overview

Transaction yields and volumes

Volume (£bn) Yield (%) 3 month 12 month

movement movement Sector Q2 2014 Q1 2014 2013 Q2 2014 Q1 2014 Q2 2013 (b.p.) (b.p.) Shops £0.82 £0.96 £3.38 4.76% 4.87% 5.22% -11 -47 Shopping Centres £1.67 £1.29 £3.81 5.60% 7.54% 8.06% -194 -246 Retail Warehouse £0.58 £0.38 £2.46 6.60% 6.74% 6.68% -14 -8 All Retail £3.07 £2.62 £9.66 5.76% 6.54% 6.84% -78 -108

Central London Offices £3.34 £2.71 £17.40 4.87% 4.62% 4.43% 26 44 Rest of South East Offices £0.44 £0.39 £2.66 7.82% 8.60% 9.17% -78 -135 Rest of UK Offices £0.98 £0.66 £1.99 6.20% 6.62% 8.22% -42 -202 Office Parks £0.36 £0.93 £0.96 7.70% 9.82% 8.90% -212 -120

All Office £5.12 £4.68 £23.01 5.77% 5.97% 6.05% -20 -28

South East Industrial £0.19 £0.20 £0.81 7.93% 6.62% 8.61% 131 -68 Rest of UK Industrial £0.16 £0.48 £1.00 7.86% 7.12% 8.76% 74 -90 Distribution Warehouse £1.18 £0.47 £2.17 6.69% 7.58% 7.03% -89 -34

All Industrial £1.53 £1.16 £3.99 7.61% 6.98% 8.66% 63 -105

Hotels £0.48 £0.72 £1.58 6.30% 5.65% 6.68% 65 -38

Other(incl. Leisure and Portfolios) £1.75 £1.70 £6.71 5.63% 6.32% 7.26% -69 -163

All Property £11.93 £10.88 £44.94 6.06% 6.42% 6.86% -36 -80

Regional Overview

Quarterly regional investment volumes topped £5bn for the second time since Q4 2013 and as a proportion of total market activity were the highest we have recorded since Q1 2011.

It is immediately apparent that there has been a real shift in investors’ attitudes towards regional property in the last 12 months. Regional investment volumes in the last three quarters totalled £15.1bn, which is the same as in the previous six. There are a number of reasons for this: • London is expensive: capital values in the West End

are back to the peak levels seen in mid 2007. This is pushing investors in to other markets.

• The economic recovery is well entrenched and even though London’s economy continues to outperform the regions, they are all forecast to grow at around 2.5% p.a. over the next five years.

• The domestic institutions, who are experienced regional players, have money to invest after huge net-inflows in to their retail funds.

• The risk premium for regional property is, on a historical level, still attractive despite the inward yield shifts. • Credit availability to investors and developers, as shown

by the Bank of England’s credit conditions survey, has improved over the last 12 months.

South East the most active regional market

The quarterly investment volumes by region can be rather volatile, but it is clear that, aside from London, the South East is the most active regional market. Investment in the South East totalled £2.5bn in the first six months of 2014. The majority of this activity has been focused on the retail

market, with the £656m Bluewater deal providing a real boost to the statistics. The next placed regions are the North West and West Midlands, where the figures have also been boosted by a handful of particularly large deals.

Volumes still high in London

In London, investment levels remain high on a relative and absolute measure. This is despite the drop in investment in the first half of 2014 in comparison in the second half of 2013, when the market saw the most active six months on record. Investment reached £10.3bn in the first half of 2014, with 70% of this spent on offices. Overseas investors are still the biggest buyers of London commercial real estate, also accounting for 70% of the market in H1 2014. The inward shift in yields and the good performance of the rental market in London means capital values in some sectors of the London market – West End offices and Central London retail – are level with or above their pre-recession peak. In both sectors initial yields are as low as we have ever seen, but even when they do flatten out and possibly start to soften, positive rental growth prospects mean capital values should continue to grow – albeit at a slower pace.

Lambert Smith Hampton

UK regions

London and regional breakdown £m

UK regions

London

Source: LSH Research, Property Data, Property Archive

Total investment

Regional investment volumes £bn

Buyers and sellers

Spurred by the heavy inflows from retail investors in to their funds, the UK institutions are playing a bigger part in the market than they have done since the end of the global financial crisis. They accounted for 35% of quarterly acquisitions – the most since 2010 – and were net investors to the tune of £2.1bn.

Big inflows in to the retail funds driving institutional investment

Net inflows in to UK property funds totalled £1.2bn in the three months to May and just under £3bn in the 12 months to May. This weight of money, combined with the improvements in the economy means there has been a sustained uplift in institutional investment over the last year. Institutional investment averaged £1.7bn a quarter in the eighteen months to Q2 2013, but since then has increased to average £3.8bn a quarter.

The increase in investment from the institutions has been a major contributor to the uplift in regional investment levels. The overseas investors who dominate the big ticket lots at the top of the market are generally less experienced and less active in the markets outside London and, to a lesser extent, the South East. For example, this quarter overseas investors spent £432m on regional property, whereas the UK institutions spent £2.88bn.

Overseas money remains in London

Clearly therefore, overseas money is still concentrated in London and primarily Central London offices. This has driven average transactional yields down to below 5%, a level at which they have been since the start of 2013.

These values are being sustained by the strong demand and positive prospects for the key occupier markets, where we expect rents to keep on their current upwards path. In terms of the origin of this overseas money, it is the US private equity firms and the Far Eastern insurance and pension funds that have dominated the first half of 2014. In contrast, investment from the European players has been comparatively muted.

£700m of distressed sales in Q2

Elsewhere in the market, the REITs and property companies remain net sellers, as they were on aggregate in 2013, and the banks are still providing a decent amount of stock to the market in the form of distressed sales.We recorded over £700m of distressed sales in Q2, with the biggest of these the sale of the RBS offices at Spinningfields in Manchester for £320m to M&G Real Estate. The company that owned these assets was placed in to administration in April 2014.

3.85

bn

0.75bn

Global Investment in to UK CRE H1 2014 £bn

0.29bn

2.85

bn

Purchases and sales by investor type £bn

Lambert Smith Hampton

The recent expansion in the investment market has been driven by investor sentiment: they have moved into property in their greatest numbers since the last boom and have been taking on more risk, whether by geography, tenant or property grade. However, looking at the current performance of some occupier markets, you might wonder whether investors are getting ahead of themselves. The latest numbers from IPD show that growth in property values has accelerated from 0% p.a. in September 2013 to 10.3% p.a. in just nine months. The main driver of this has been inward yield shift: all property rents are growing at just 1.9% p.a., whereas the yield impact on capital values is running at 9.6%.

It is therefore getting more expensive for investors to access the market and the UKIT Q2 2014 all property transactional yield is at its lowest level since Q2 2008. The prices now being paid by buyers to access stock in a very competitive market means they are having to price in a decent chunk of rental growth in order to achieve target returns. Therefore, are investors right to be so bullish about the occupier markets?

Offices

In London, the prospect for continued rental growth in the main submarkets is good: demand drivers are strong and the amount of supply coming through is not sufficient to dampen rental growth prospects.

In nominal terms, regional office rents are still 15% below 2008 levels, but there are a number of grounds for optimism: vacancy rates are falling; demand indicators point towards an increase in take-up; and in real terms rents are at historical lows in many centres. However, the market is not yet booming. Take-up in many markets in the first half of the year has been surprisingly slow – in the Thames Valley we have recorded 520,000 sq ft of lettings in Q1 and Q2, as compared to 1.6m sq ft in the second half of 2013.

Because the macroeconomic drivers of demand for office space are positive and many markets are beginning to see constrictions in good quality supply, we do expect office rents, on average, to grow at around 5% p.a. over the next five years. However, the risks to the forecast, especially in the regions, are on the downside and we would like to see real growth in occupier take-up in order to drive price increases in these markets.

Industrial

Thinking about the drivers of demand in the industrial market, factors like business investment, internet retailing, the drive for efficiencies in logistics operations, and manufacturing output are, like in the office market, indicative of an expansion.

Therefore, coupled with the current restrictions on supply – less than 10% of available space is grade A – industrial rents should grow by around 4% p.a. over the next five years. Thinking about the sub-markets, the London and South East multi-let markets are the ones set to outperform the rest of the industrial sector, including logistics. Here, demand will be strongest and supply of industrial property at its scarcest, driving up rental values.

What about rental growth?

Rental growth forecasts % p.a. 2014–2019

Source: Lambert Smith Hampton, Real Estate Strategies

UK property market performance % p.a

Retail

The trends that have changed the retail market out of recognition – cost-cutting, store-closures, rationalisation, move towards the internet etc. – continue to impact upon property demand, availability and therefore rents. Overall, retail rents are expected to grow by just 2.5% p.a. through to 2019, which is the weakest performance of the three main property sectors.

The forecasts show Central London and South East standard retail rents will continue to outperform standard retail in the rest of the UK. The best performing shopping centres and retail parks will benefit from the trend towards agglomeration, as the smaller, secondary centres and parks with higher voids struggle.

Broadly therefore, the outlook is positive. However, there are a number of important issues to consider. In all three main sectors average rental growth outside London is either low or still negative and it will take an increase in occupier demand to push these markets back in to growth territory. Some one-off factors, like the office to residential conversion trend and low speculative development levels will provide a boost. Ultimately though, on average, these tend to be low growth markets, therefore good, local, micro-market knowledge will be one of the main routes to success.

Lambert Smith Hampton

We are at a particularly interesting point in the market. Volumes are increasing, buyers are taking on more risk, regional markets are seeing a real expansion in investor activity, retail investors are piling in, and prices are rising. However, can this exuberance be sustained beyond the short term? The economic recovery has provided a solid back drop for the expansion the investment markets have seen over the last 12 months. The UK economy is growing at its fastest pace since 2007 and is forecast to keep on growing at around 2.5% p.a. over the next five years, which should provide an excellent base from which to invest in commercial property. However, property yields have come-in substantially in the last 12 months alone and parts of the market already look to be close to fully-priced.

Given that initial yields in parts of the market are close to their historic peak, intuitively we would say that the current bout of yield-driven increases in capital values cannot last too much longer. Investors are paying above valuation in order to access stock, which would support this. The rise in interest rates might not have a huge effect, but will provide a degree of uncertainty that could just check the market. There is also some political risk surrounding the 2015 General Election, which might also slow the market’s progress.

Therefore, investors will have to rely on rental growth to drive property performance in the medium term. This is primarily where the risks in the market currently lie: rental growth prospects are good in light of the macroeconomic backdrop, but investors who are paying low yields for stock must be confident about the prospects for the local occupier market in order to achieve their desired returns.

Outlook

Total return forecasts % p.a

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Due to space constraints within the report, it has not been possible to include both imperial and metric measurements. © Lambert Smith Hampton July 2014.

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