The collapse of Lehman Brothers in September 2008 triggered the near collapse of the banking system and the start of the “Great Recession”, the recovery from which has been slow and halting. The world economy, however, had a good 2013 as the year saw more signs that a corner might have been turned. The Eurozone had one of its quieter of recent years. European government deficits have fallen by half. Productivity is improving, unit labour costs are falling and once-large current-account deficits in Italy, Spain and Portugal are disappearing, enabling investors to strike “euro debt woes” off their list of possible risks for 2014.
The USA was the scene for the two biggest financial events of 2013.
In May the US Federal Reserve hinted that the $85bn a month bond-buying stimulus could be wound down. Investors took fright and US stock market and bond prices plunged. In December, when the Fed announced a modest $10bn a month trimming of the stimulus, markets soared.
In October the US government was shut down for 16 days as Congress failed to agree a budget for 2014. As many as 700,000 federal workers were sent home. President Barack Obama said the shutdown caused “completely unnecessary damage” to the world’s largest economy. The cost to the US economy was $24bn, a loss of 0.6% of output for the quarter
Major stock markets ended the year at record highs as they benefited from record low interest rates in the US and Europe and a benign outlook for inflation.
The FTSE All World Index ended the year on a new high. It was up almost 20% for the year – its biggest annual advance since 2009. Government bond prices, meanwhile, dropped and yields rose as investors sought higher returns on riskier assets. Gold also suffered heavy losses, recording the biggest falls for three decades.
On Wall Street, the S&P 500 was up almost 30% on the year. In Europe, the FTSE Eurofirst marked up an annual gain of 16%, with Germany’s Xetra Dax, finishing 26% higher, making it the best performer of the major European markets. London’s FTSE 100 closed the year with gains for 2013 of 14.4%. The FTSE 250 index, more exposed to the domestic economy than the FTSE 100, is ended the year 29% higher.
UK commercial property was another asset class to benefit from the improving economic conditions. As the year started, IPF Consensus forecasts were for commercial property to provide total returns of 6.4% in 2013. As it turns out, these expectations were on the low side. Rental growth of 0.6%, which was the highest in a calendar year since the end of 2007, together with yield compression of 32 bps meant that All Property total returns amounted to 10.9% in 2013.
The best performing segments of the UK commercial property market in 2013 were once again Central London shops and Midtown and West End offices. But there the similarities with the last few years ended. As the recovery extended beyond London, South East offices and industrials benefitted from capital growth of more than 6%; and the values of Rest of UK industrials and South East shops grew by almost 5%.
Retail property outside London and the South East continued to flounder. Rest of UK shop values fell by almost 1% and the worst performing segment was Rest of UK shopping centres where values fell more than 3%. Rest of UK offices also had another weak year as they struggled to cope with high vacancy rates and a strictly limited supply of new Grade A space to drive occupier demand.
Asset allocators have been presented with an unusual economic background in 2014 that presents them with a series of problems that could be solved by real estate. Firstly, that a policy of “financial repression” will seek to maintain low real interest rates and use inflation to reduce the real value of debt relative to GDP. Secondly, that tighter regulation of the banking system will limit the availability of derivative products that investors have become accustomed to using to hedge against inflation risks. Lastly, that aging populations and the closing of defined benefit schemes will require a switch out of growth to income producing assets.
In the context of these issues property’s great advantage is its income return. The initial yield on the IPD index is 6.0%. The yield on the FTSE Actuaries 5-15 year gilt index is 2.8% and the dividend yield on the FTSE100 index is 3.5%. In fact income provides 70% of the total return on UK commercial real estate.
In the last 10 years alternative property investments have grown from 3% of IPD funds to 8%. Such assets are typically hotels, care homes, residential apartments and student accommodation. They are let on long leases, the average unexpired lease term is 26 years; and with index linked rents. As such they are a useful vehicle for long term asset liability matching and inflation hedging. There is a view that the number of such properties owned by IPD funds will grow in the next few years until they represent at least 15% of the index.
2014 should see a different investment environment to that prevailing over the last three years.
Secondary investment markets will benefit from the improvement in investor confidence. Yields in these markets will re-rate and starting in the South East, performance in the rest of the country will catch up and eventually surpass Central London.
Retail markets will continue to underperform. The growth of on-line sales has fundamentally changed the structure of retailing. Some traditional retailers are successfully competing against pure internet retailers by combining a strong web presence with traditional high street outlets through click and collect strategies. However, as result of the growth of internet shopping from computers, tablets and mobile phones, the number of stores required by a national multiple retailer to cover the UK market has decreased from 150 to 50.
Risks remain as the global economy is not likely to return to the pre-2007 world of constant growth and low inflation. Tightening of monetary policy through unwinding quantitative easing or raising interest rates could result in increased volatility in markets and unexpected events. Core Central London residential and commercial property markets are currently supported by overseas money. Higher interest rates in the USA could cause international investors to switch capital out of London.