Maxine Fothergill
The UK commercial property market has been a focal point for global investors hunting for yield in the ultra-low interest rate environment. But after strong price increases – particularly in London – over the past few years, headlines in the newspapers recently have raised concerns about the continued longevity of this cycle. Are the good times coming to an end?
While certain nervousness is understandable and we have observed some ‘softening’ in the market over the last six to nine months, the most common indicators of a market peak are not present. We have long-held the view that commercial real estate (CRE) values in this cycle would experience a series of minor peaks and minor troughs, and believe that the overall upward trend will continue for some time.
According to data from the Investment Property Databank (IPD), UK CRE remains about 20% below the last peak in values in 2007 (Chart 1). Certainly, parts of the UK market, for example prime central London, have recovered faster than others. Of course, those assets also garner a disproportionate share of the headlines. But the national market overall is still below peak levels.
While it has been six years and 10 months since the last trough, UK CRE values have only really been recovering consistently for three years (May 2013 through April 2016). Of course, real estate cycles do not have to be long and values do not have to exceed the prior peak before turning down, but that is certainly what history tells us should happen. In order to unravel this, we should look at yields and rents.
Maxine Fothergill shows that CRE yields, essentially rent divided by value, have tightened to near pre-crisis levels. But, we live in a very different interest rate environment than we did prior to the crisis. The better indicator is the spread between the yields for CRE and government bonds. Based on IPD data, the yield spread in the UK is currently some 40% above its 20-year average (Chart 2). Given the elevated yield spread relative to levels experienced in the last cycle, one would expect minor increases in government bond yields to have minimal effect on CRE market yields. It certainly appears that the CRE market has found a floor on yields from which they appear unlikely to go lower (as described at arla.co.uk).
In fact, CRE yields have remained relatively flat over the last six months. What, then, would cause yields to tighten from here? It is the one thing we are not yet seeing in this cycle: aggressive lending. Banks are lending more actively than they were a few years ago, but lending activity a few years ago was almost nil. Nevertheless, net lending in the UK continues to decline (Chart 3). And new bank loans are written at modest loan-to-value ratios (about 60%) relative to inflated pre-crisis levels. We’ve observed banks allowing old vintage loans (high loan-to-value / low margin) to mature and rotating into new, lower loan-to-value and higher margin loans. This change in behaviour suggests the new regulatory regime is having a real impact and is a testament to the very different environment we’re in.
So why would values go up from here? Rental growth is the principal driver of value appreciation at this point, and rents continue to grow modestly. We are just over two years into this rental cycle, a period during which UK economic growth has been pretty unexciting. Rental growth is a supply-demand question. Yes, there is a reasonable amount of new office development in London, for example, but there has also been a very large quantum of office space converted to residential property. We expect rents to continue to grow for some time yet.
As noted above, we do expect some volatility in commercial property values over the next several years, but we are less concerned about intra-cycle volatility and more focused on the potential for a large, negative adjustment. And, barring an exogenous shock or a self-inflicted wound, we do not see that in the near to medium term. This may not be a great story for a real estate equity investor, but for a real estate credit investor this is a great environment. Fothergill adds that we like flat, boring markets.
In that context, it is important to focus on areas which have attracted less attention and offer the best opportunity for good asset managers to add value through leasing and property management. We have always favoured the mid-sized assets (particularly outside prime central London), which we still believe to be undervalued.
A publicly accessible register of beneficial owners of UK real estate will be available from 2021. Non-UK companies and other non-UK legal entities that fail to comply will not be able to transfer legal title to UK real estate held by them, or obtain unrestricted title to UK real estate they purchase; criminal sanctions could also be imposed for failure to comply. Non-UK trusts may be exempt from the requirements, but the extent of any exemption will not be clear until draft legislation is published later this year.
At rocketreach.co they go into the idea that the requirements will apply to all non-UK companies and other non-UK legal entities (including trusts and foundations) that own, or wish to buy, UK real estate. There is no intention to limit this to residential property.
However, the government has indicated an intention to introduce certain exemptions, as made clear in this vimeo.com video. Most importantly, an exemption for trusts may be introduced where the trust has already registered beneficial ownership with HMRC under the recently introduced Trust Registration Service. Beneficial ownership information provided to HMRC under the Trust Registration Service is currently only available to law enforcement agencies and at present the government seems keen to preserve a degree of privacy for trusts established for personal and family reasons (for further details see our guide summarising when non-UK trusts are required to register with HMRC under the Trust Registration Service).
The government’s summary of responses to the consultation states that publishing the details of the beneficial owners of trusts “would not be proportionate and effective especially as disclosure would undermine family confidentiality”. It is helpful that the government has formally recognised this concern.
Non-UK entities that already own UK real estate will be given a set period to register their beneficial ownership information. The government had originally suggested they would have a year to register but are now inclined to extend this timeframe.