Writing a quarterly report about Commercial Property has become a bit like Groundhog Day, but in a nice way, with the ‘bricks and mortar’ property unit trusts consistently inching higher every month and last year was no exception. In a difficult and volatile year for most asset classes the B&M funds returned around 4% with minimal volatility. It won’t always be like this and beware any complacency because as 2008 and 2016 showed, illiquid assets in a liquid vehicle can be a recipe for a whole heap of trouble. Nevertheless, the last decade has shown that Commercial Property can bring welcome diversification and decent returns to investment portfolios.
Industrials continue to produce the highest returns, especially well-located smaller distribution units benefitting from the e-commerce boom. The Office market remains weak in Central London but strong in the regional markets. Retail remains the weakest of three big property sectors, no surprise at all given the crisis on UK High Streets which seems to worsen on an almost daily basis.
Rental growth is forecast to be around 1% over 3 years, led by London and South East Industrials. Weakest sectors remain High Street Retail and Central London Offices, though the latter is showing some improvement.
The Commercial Property cycle is long in the tooth, in keeping with the long but shallow economic cycle, but fundamentals remain supportive. Physical supply has been constrained since 2008, as has the supply of credit which typically drives it. Banks have remained cautious since the big crash and leverage still remains relatively benign with LTV’s low, especially in the secondary market. Equity rather than debt financing has played a much larger part in this particular property cycle.
Commercial Property still looks fair value. On an absolute, historical basis the 5% IPD UK All Property yield is starting to look pretty expensive but relative to other income producing asset classes, notably bonds, it remains attractive. The spread between the yield on Commercial Property and 10-year UK Gilts has narrowed from a wide of around 4.5% in 2016 to 3.7% currently but is still historically wide with plenty of headroom.
The forecast from the boffins at M&G for the IPD return over the next four years is grouped around 5.5% per annum. With the income return being around 5% this implies virtually no capital growth over the period.
Summary: The Commercial Property cycle has become increasingly mature and returns will likely be lower going forward, driven almost entirely by rental income rather than capital growth.