2014: A year of outstanding property performance - what next?

Published on Friday, 16 January 2015 11:30
Written by Charlotte Tolfree

As another year begins, I started to wonder how 2014 will be remembered in the world of real estate investment. Certainly, it will go down as a year of exceptional performance, especially from the Central London office market.

Undoubtedly, it was the year in which the tide turned for rental growth following five years of falls. It was also a year that witnessed significant levels of UK property market investment transactions. Overall, I think there are two key themes that emerged; these not only demonstrated where we currently sit in the market cycle but will also have a significant influence in the year to come.

The first theme concerns the interest rate environment. Looking back 12 months, it may be surprising to recall that the 10 year gilt yield was 3.25% and market expectations were for a December 2014 base rate rise. In contrast to these expectations, Gilts have now fallen to a super-low 1.8%, and the first rate rise is not expected until late 2015. So why has this happened? And what implications does it have for property investment? Clearly, political tensions in Russia and The Ukraine as well as the Middle East have pushed gilts down but, perhaps more importantly, the expectation is that interest rates will now remain unchanged for longer than most of us had anticipated. Given that inflation has come in from 2% at the start of the year to its current 1% (largely on the back of oil price falls), the Bank of England is under little pressure to raise rates anytime soon. As long as this is the case, gilt yields too will remain low.

For property, this provides even more support to current pricing. The spread between gilt and property yields, which we consider to be a key measure of value and risk, is now wider than it was at the start 2014 having risen by 70 bps to its current 350 bps; I cannot remember anyone forecasting this 12 months ago! In addition, the acceleration that we are now seeing in the rate of rental growth is another justification for current yields. Looking forward, whilst interest rates can only move one way, our expectation is that the new "normal" for interest rates will be close to 3%, rather than the historic trend of 5%. This changes the level of required return across all asset classes and suggests that yields, both for property and for other asset classes, will be structurally lower in the future.

The other trend that emerged this year was the broadening of the rental recovery. Twelve months ago the only markets enjoying noteworthy rates of rental growth were Central London offices and retail. This is now changing with Industrial rental growth running at an encouraging 2.7% per annum, and South East (excluding Central London) office rents growing at a rate in excess of 6% per annum. Whilst the retail sector continues to lag, rents appear to have reached a floor in most geographies. Overall we expect the recovery to continue to strengthen and for rental growth to move higher over the coming 3-4 years. The key risk to this recovery is a weakening in economic fundamentals, which is of course possible given the slowdown in global growth. For now though, the economic projections that drive our property forecasts remain stable.

The 2014 total return for UK property is likely to be close to 20% - among the highest on record. So where can it go from here? Whilst 2015 is likely to prove to be less heady, our projected return of around 10 to 12% is still highly appealing (not least because half of the return is derived from income something which is seriously lacking from most other asset classes). Rents will continue to grow, yields will continue to fall and the higher income return will continue drawing investors into the market.

So all in all, a great end to 2014 and an exciting year in prospect!

Charlotte Tolfree is head of research at KFIM

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