Central London assets continue to drive the strong performance of commercial property.
At the start of 2015 a major acceleration of global growth was expected, supported by persisting soft oil prices. During 2015, as worldwide oil inventories remained high and OPEC appeared to be unable to agree to any co-ordinated cuts in production, the oil price fell from $50 to below $30 per barrel. Cheaper oil was supposed to boost the world economy as oil importers benefitted albeit at the expense of oil exporters. The World Bank, however, reported that economic growth in 2015 slowed to 2.4% in 2015, from 2.6% in 2014.
Economic growth maintained momentum in the UK and USA and strengthened in the Eurozone from 0.9% in 2014 to 1.5% in 2015 but disappointed in Japan. BRIC economic growth declined to 3.9% from 5.1% in 2014 as the Russian and Brazilian economies shrank by more than 3.5% while Chinese growth disappointed by decreasing from 7.3% in 2014 to 6.9%.
In 2015 stock markets in the USA delivered variable performance. The S&P 500 declined 0.7% in the year weighed down by significant falls amongst oil and commodities stocks. This was its worst showing since the financial crisis in 2008 when it dropped by nearly 40%.
The Nasdaq Composite focused on fast-growing technology and consumer companies rose nearly 6%, supported by the ‘Fangs’— Facebook, Amazon, Netflix and Google; and the ‘nifty nine’, which adds Priceline, eBay, Starbucks, Microsoft and Salesforce. Video streaming website Netflix has surged 134% to lead the Fangs as its subscriber base has continued growing strongly. Facebook is up 34%, while Amazon has gained 118%. Google has risen by 45%.
European stock markets performed satisfactorily in 2015. The pick of them being Italy’s FTSE MIB which rose 12.7% in local currency terms but given the euro’s weakness was only 1.1% higher in US dollar terms. The fall in commodites drove the FTSE 100, down 4.9% on the year. Anglo American fell 75% and Glencore dropped 70%. In contrast, the domestically focused FTSE 250 ended up 8.4%.
In the Far East, the Shanghai Composite ended the year 9.4% higher after a particularly volatile year and Japan’s Nikkei was up 9.1% which was 8.5% higher in dollar terms thanks to a stable yen.
The return on government bonds in 2015 was unexciting. In the USA and UK expectations of some tightening of monetary policy led to an increase in yields. The Barclays US Treasury index registered a total return for the year of 0.84% and the long-dated Treasury index was down 1.2%. The total return on Barclay’s Eurozone Aggregate Treasury index was 1.7% and the FT Gilt 5-15 yr total return index rose just 1.1% (see Chart 2).
Rewarding investors prepared to move further out along the risk curve, Ukrainian, Russian and Greek government bonds offered some of the best returns in 2015. Ukraine and Greece came within a whisker of defaulting, and the prices of their bonds plummeted amid fraught negotiations with their creditors. But when they finally struck deals, their bonds soared.
Supported by the continued strength of the domestic economic recovery, UK commercial property once again produced outstanding relative performance. As the year started, IPF Consensus forecasts were for commercial property to provide total returns of 10.8% in 2015. These expectations were on the low side. Rental growth rose to 4.2%, the highest in any 12-month period since mid-2001, as yields compressed by a further 35 bps. The outcome being that All Property total returns amounted to 13.8% in 2015.
Once again, the best performing segments of the UK commercial property market in 2015 were Central London shops and Rest of London offices. City, Midtown and West End offices and London industrials were once again amongst the top performers reflecting the London centric nature of the economic recovery (see Chart 2).
Outside of London the best performing office markets were Leicester, Cambridge, Bristol, Southampton and Leeds. Leicester and Cambridge office total returns for the year to September were greater than 20%.
The best performing industrial centres were Liverpool, Leicester, Edinburgh, Manchester and Birmingham. In each of these industrial centres, total returns were greater than 20% for the year to September.
Retail property continued to flounder. Central London shops was the only retail segment to outperform the All Property average. The worst performing segment was Retail Warehousing, where capital values increased by 2% and rental values increased by 1%. Shopping Centres and Rest of UK shops also had another weak year as rental values continued to slip.
All Property capital values have increased by 26% in the last three years. The values of Central London shops are now 66% higher than their precrash peak; Midtown and West End offices are 31% higher; London industrials are 8% higher; and City offices 3% higher. But they are the only four segments of the market to have recovered all the ground lost since 2007.
The initial yield on IPD’s monthly index now stands at 5.0% having hardened by 8 bps in Q4. The capitalization rate is now at a level last seen in March 2006; 15 months before the top of the last cycle. But All Property capital values remain 21% lower than their peak levels. Current UK wide pricing levels are considered to be either at or below fair value by 85% of respondents to the RICS survey.
In this era of low interest rates, the asset class is still attractively priced relative to risk free rates. Gilt yields rose by 28 bps in Q4 in anticipation of a tightening of monetary policy. But the current property initial/gilt yield gap of 3.1% continues to compare favourably to the long run average of 2.5%.
The Investment Property Forum’s latest consensus forecast published in November shows total return expectations of 9.5% in 2016 and 4.7% in 2017 and an annualised average of 7% in the 3 years to 2018. The long run annual average total return since 1980 is 9.8%.
However, the UK economy is reliant on spending by households and exposed to growing risks from external forces. Sterling is 9% higher than it was 3 years ago and the manufacturing sector is in recession. The FTSE100 has fallen 20% since the market peaked in May last year reflecting concerns regarding the outlook for the global economy. A sharp slow-down in economic growth could restrain rental growth causing yields to soften. We also remain concerned that uncertainty created by the proposed referendum on membership of the EU could result in the withdrawal of foreign money from UK commercial property.