May 17, 2019
There is no doubting that we are very late into the current economic cycle, extended by loose global monetary policy, quantitative easing across all key western economies and assorted other Government stimuli the like of which have never previously been seen. All of this takes us into unknown territory for investors seeking to navigate a path to either wealth creation or wealth preservation.
The last decade has seen strong value appreciation for asset owners but in turn an increase in the numbers of people sinking below the poverty line and a re-emergence of the social and political divide. A “normalisation” over the next decade as the economy is gradually weaned off the narcotic of Government support promises to be a difficult process with some bumps along the way and that is before we even mention the “B” word!
So how does core UK commercial real estate investing fit into this backdrop? The answer is rather well for those investing in the right areas with a longer term outlook. For such investors there remains a compelling case for staying active.
With an income yield of c.5.0% per annum on the MSCI/IPD annual index (December 2018), UK commercial real estate continues to do what it says on the tin outstripping other principle asset classes when it comes to delivering a dependable income return. This is key during periods of lower economic growth.
Over an almost four decade period that MSCI/IPD have been measuring UK commercial real estate returns, income has represented the vast majority of the total return. For those patient enough to ride out the cycles this is a very appealing dynamic.
We are approximately nine years into the current market cycle. History tells us that we are overdue a correction. However, quantitative easing across major markets and economies distorts the picture. Notwithstanding economic headwinds and political distractions, key sub-sectors of the market such as CBD offices and industrial continue to show progressive levels of rental growth consistent with sustained occupational demand exceeding new supply. This coupled with a yield margin of up to 200 basis points when measured against comparable major European prime real estate markets means that the UK continues to offer relative value.
Several major UK institutional landlords, in particular the larger open ended funds, are increasing liquidity as a hedge against Brexit. This makes them sellers albeit often away from the glare of an open marketing campaign. To realise cash in a pre-Brexit climate requires pricing flexibility and the disposal of higher quality liquid assets well let to strong tenants in institutional locations. This is starting to create buying opportunities for long term investors holding cash for deployment who are also finding there to be less buying competition.
Sector Themes: Revolution or Evolution?
At Palmer Capital we are very focussed on identifying and following key ‘mega-trends’ which transcend economic cycles and play out over a longer time horizon, thereby offering patient investor capital key thematic drivers for both income and capital growth.
The retail sector, encompassing high street shops, shopping centres and out of town retail assets accounts for approximately 40% of the measured UK commercial real estate market. The underlying retail sector is in the grip of a strategic shift driven by the internet. This is making huge swathes of retail real estate obsolete and irrelevant; particularly so for secondary shopping centres and high street shops where similar value alternative uses simply don’t exist. The future is extremely bleak for investors overweight to these types of assets.
However, on the opposite side of the same coin is the industrial warehousing sector with an altogether sunnier disposition. The sector has been the principle beneficiary of this retail malaise with internet retailing driving strong occupier demand in both urban logistics locations and those areas well served by the motorway network. Amazon alone were responsible for the largest take up of industrial and logistics space over the past three years and this internet theme continues to drive both rental and capital growth. Macro pressures are whipping up what appear to be perfect conditions for those already invested in the sector.
Supply side pressures are also building in a positive way for investors with cross party support in Parliament for the need to build more homes for the UK’s growing population. This pressure is particularly acute in the major cities where the growing population creates land supply issues as ‘brown field’ industrial sites are being lost to residential forever. This is good news for industrial investors and the demand/supply imbalance is not only helping drive rental and capital growth but is also leading to strong residual alternative use values for the underlying land.
This compelling dynamic is informing Palmer Capital’s current commercial real estate investment strategy, leading to continued underweight positions to at risk retail assets and large overweight positions to the growth markets of industrial and logistics.
And What About Technology?
The real estate industry thrives on imperfect knowledge which in turn creates miss-pricing and opportunities. It has been slow to adapt to technological change.
Palmer Capital has stolen a march in this area with a sharp focus on how best to incorporate modern technology into building design and development so as to ensure that the built environment adapts to the requirements of modern day occupiers. This involves working with would be tenants as customers to ensure the delivery of floor space that matches their evolving needs.
This can be seen with our recent construction of a c.100, 000 sq. ft. grade A office building in central Bristol where the procurement process involved the delivery of a ‘smart’ building with automated and zonal climate control together with a drone landing pad on the roof! The building was delivered into an under supplied market and fully pre-let on completion last summer. Occupier needs are evolving rapidly: it is incumbent on landlords and developers to respond to these in order to gain commercial advantage.
There is a lot of change going on across the UK commercial real estate market – much of it unprecedented. This will create opportunities as well as risks and as always there will be winners and losers. Brexit or no Brexit, these longer term themes will drive markets long after the dust has settled on any EU/UK negotiations.
Whilst some investors are currently sitting out the market we see opportunity provided you stick to core underlying themes and take a long term view. During times of rapid change it generally pays to be sitting at the front of the bus rather than tagging along behind.
Originally published by The Wealth Net in May 2019.
Author: Rupert Sheldon, Head of Income REIM at Palmer Capital