John Kelly: ‘New mood of optimism for property’

After a period of disappointing returns commercial property enjoyed a strong revival in 2014. The sector saw a sharp improvement in activity levels and fresh interest from investors keen to lock-in to high yields and depressed valuations in  parts of the sector.

Building on this base, 2015 has started well.  The sustained economic upswing has cemented an improvement in confidence towards a sector where the investment horizon is necessarily long term. There are practical improvements too, with a banking sector both more willing and more able to provide financial support.

The new mood of optimism has resulted in a broadening out of investor interest.  In the early stages of the upswing attention was focused almost exclusively on top quality London assets with secure income streams from long leases.  Now interest is spreading to embrace regional locations and a wider range of asset classes.

Yield compression, a reflection of improved investor confidence and willingness to take on risk, is currently the prime driver of returns for secondary assets and those on short leases.  This is typical in the early stages of an upturn.

However, falling yields are not the only source of rising values.  Less dramatic, but more sustained in its impact, is the effect of rental value growth as valuers begin to factor in rising future income flows.

Realistically, it is too early in the upswing to expect to see this to any extent in secondary areas, but it is now evident in parts of the sector where demand is strongest, for example industrial assets, regional offices and parts of London.

Of course, the pattern is not uniform. Whilst most parts of the sector are noticeably strengthening, in others the pace of improvement is more pedestrian.  The main concern is in the retail sector where there is structural oversupply due to changing shopping patterns and over optimistic expansion in the past. This is inevitably holding back performance.

Unfortunately many of these problems will persist for the medium term. So, whilst there are pockets of value emerging, overall returns from this part of the market are likely to lag the rest of the sector.

Occupier markets have improved although not as rapidly as sentiment.  Void rates are below their peak but still sit close to double figures; lease incentives, whilst less eye watering for asset owners, are still an integral part of most negotiations. We expect the strengthening of conditions to continue gradually in the months ahead.

Looking at potential returns, momentum in the sector is now so well established that we can reasonably expect another year of strong returns. Not at the 20% rate achieved last year, but probably in double figures.  The best performances are expected to come from offices in London and the south east and industrial properties.

John Kelly is head of client investment at CCLA.

*Photo (cropped): by morebyless, Flickr