21 December 2015

Paul Clark: Time for shrewd investors to exercise caution

Sometimes we forget, but all markets are cyclical and commercial real estate is no exception. Particularly in London, but increasingly around the UK as a whole, the capital markets have enjoyed a sustained period of rising values.

Looking back to the start of the year, market sentiment was still overwhelmingly bullish, with pretty much all commentators feeling optimistic about UK real estate returns in 2015. That optimism will no doubt prove to have been well placed. The UK is enjoying record low interest rates, significant amounts of QE, relatively strong GDP growth (albeit after a brutal recession), and encouraging employment and wage growth. All this, allied to a reputation for stability, makes it very attractive to global capital.

"However, when the justification for current pricing rests more on the relative attraction of real estate and market sentiment than the underlying returns from the asset class itself, we are moving into more uncertain times.”

Paul Clark, Chief Investment Officer

Although yields in central London and some other sectors are now at or approaching record levels, this bull run may still have some legs. In particular, geopolitical instability, combined with areas of weakness in the global economy especially China and the BRIC countries, are likely see interest rates remain lower for longer and continue to encourage the flow of international capital into UK real estate. All of which has the capacity to elongate the current cycle. Furthermore, the occupational markets are generally at an earlier point in their cycle and this will also support market momentum.

However, when the justification for current pricing rests more on the relative attraction of real estate and market sentiment than the underlying returns from the asset class itself, we are moving into more uncertain times.

So let’s consider the other side of the argument; we are certainly closer to a rise in interest rates (although probably pretty modest), the UK economy remains imbalanced (over dependent on rising personal debt, the finance sector and climbing house prices), wage growth is still anaemic by historic standards and we have a major balance of payments issue. It is also likely that the rental growth assumptions, implicit in the yields currently being paid for some assets, will prove overly bullish. In addition, existential threats are also looming larger, with an EU referendum almost certain to cause at least a modest hiatus in market activity.

All of these dynamics are reflected in the fact that REIT shares are showing less upward momentum, a strong historic indicator that we’re at a high point in the cycle. Similarly, flows of money into retail funds are slowing, and deals that would have happened a year ago are being shelved as investors consider what makes commercial sense in the current market context.

The Crown Estate hasn’t bought a substantial standing asset since Fosse Park in summer 2014, reflecting our view that now is the time for investors to exercise some caution by focusing on defensive assets and keeping gearing as modest as possible. For our portfolio, which is substantially unleveraged, we have spent the last year or so concentrating on our development pipeline, where we see the potential for better risk adjusted returns, both in central London and regionally, rather than acquisitions of standing assets. We’re currently committed to the largest development pipeline in our history, incorporating the regeneration of our West End portfolio, with an increasing focus on redeveloping or extending our regional shopping parks and shopping centres.

In case this is all starting to sound rather gloomy, I should say that whilst a correction in the capital markets may be moving closer, it is hard to see a dramatic downturn in commercial property values. Interest rates are likely to peak at no more than 2-3% and unlike some previous cycles, the sector hasn’t overdeveloped nor is it overburdened with debt. Besides, there is far more equity out there than there used to be and so the global saving glut in itself will support pricing. In any case, bull runs and corrections are normal and healthy features of a cyclical market. Investors should be prepared to embrace these realities, see them as opportunities, and structure their portfolios and activities accordingly.

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