UK Commercial Real Estate

Market Outlook
April 2014

Foreword
Paul Coates, Head of Real Estate

Welcome to this first of a series of

notes exploring the outlook for UK
Commercial Real Estate.
In this note we reflect on what the
market is telling us by considering
transaction volumes, pricing and risk
premium. Alongside this, we set out
our capital and rental growth forecasts,
derived from RBS Economics macrolevel outlook for the UK economy. Finally
we highlight the lead indicators of listed
companies share price performance
and analyst recommendations.

Summary
The Wall Street proverb When the ducks quack, feed them is
a good way to set the scene for our UK Commercial Real Estate
(CRE) market outlook.
The sector has been dominated by
accelerating growth over the past 6-12
months. We think this is set fair for the
near-term.

With the prospects for UK CRE intertwined

with the economys recovery we set out
below the RBS Economics forecasts for
GDP, RPI and rates.

Our opening chart highlights the pace of

transaction volumes and capital growth
through 2013, with the former supported
by some notably large lot size deals, for
example Broadgate, More London and
Chiswick Park. Appetite for UK CRE drove
transaction volumes to 53.5bn in 2013,
an increase of 60% on 2012 with Q4-13
reflecting a quarterly increase of c.70%.
This strong tailwind of demand pushed
capital growth for 2013 to 4.6%. The
scale of this growth is highlighted by
the month on month recovery that took
capital growth from negative territory at
the start of the year (-0.2% Jan-13) to
1.4% by Dec-13.

Whilst forecasts of steady growth in

GDP and broadly flat RPI bode well, the
consequential increase in rates (albeit
not forecast until the end of 2015) will
exert upward pressure on CRE yields.
The timing and pace of this inevitable
rise is likely to be the biggest source of
downside valuation risk to UK CRE, even
though it is expected to be off-set, to
some extent, by forecast rental growth.

Looking out to the end of 2017, each economic and rates forecast shows growth

4.5
4.0
3.5
3.0
2.5

(%)

2.0
1.5
1.0
0.5
0.0

2014

2015

2016

2017

Key
GDP

RPI

Base rate

10 yr gilts

5 yr swaps

Source: RBS

Most with experience in the market are

either cautiously optimistic or modestly
pessimistic. Our forecasts point towards
increasing All Property capital growth
for 2014 (1.0%) and 2015 (2.9%), with
mild declines through 2016 (-0.4%)
and 2017 (-1.7%).

Economic Forecasts (Nov - 13)

UK Commercial Real Estate Market Outlook

Before we delve into risk

premium, capital and
rental growth forecasts,
we set the scene with a
snapshot of investment
activity.
UK Commercial Real Estate Market 2013
The accelerating pace of transaction volumes and capital growth
25

1.6
1.4

20

1.2
1.0

15

0.6

10

(%)

0.8

(bn)

0.4
0.2
0.0

Key
Transaction Volume - Quarterly All Property (LHS)
Capital Growth - Monthly All Property (RHS)

Dec-13

Nov-13

Oct-13

Sep-13

Aug-13

Jul-13

Jun-13

May-13

Apr-13

Mar-13

-0.4

Feb-13

Source: Property Data, CBRE

-0.2

Jan-13

If rates are expected to lead the pack in

terms of impact on UK CRE, risk premium
is likely to be a close second. One of the
most striking characteristics of current
forecasts (including RBS) is the reducing
risk premium for the period to the end of
2017. RBS forecasts show a reduction
from c.300bps to c.150bps between the
end of 2014 and 2017. This forecast
reduction absorbs at least some of
the upwards pressure on yields arising
from increased rates and could potentially
underestimate the scale of downside
valuation risk.

UK Commercial Real Estate Market Outlook

Transaction volumes
Whilst each of the metrics covered by this note are linked, we
consider transaction volumes to be the best starting point. This is
because it highlights the dominance of specific investor groups
and the areas of the market for which there is most demand.

20
15
10
5
0
-5
-10

Source: Property Data

Others

Financial/
Banks

Occupiers

Private
Individuals

Overseas
Investors

Private
Property
Companies

Quoted
Property
Companies

-20

Institutions

-15

Key
Aquisitions

Sales

Net

Investment Transaction Activity 2013 (Volumes vs. Yield)

Central London Offices accounted for 40% of transactions

25

10
9

20

8
7

15

5
10

(%)

4
3

Transaction Volume (LHS)

Net Initial Yield (RHS)

Leisure

Industial

Shop/
Supermarket

Source: Property Data

Key

Retail
Warehouse

Shopping
Centre

1
0

Rest of
UK Office

Notwithstanding these uncertainties,

the absolute and relative returns from UK
CRE continue to feed investor demand.
In the following section we consider
the income return and risk premium
attractions of the market.

25

Central
London
Office

In addition to CRE fundamentals, whether

Overseas Investor demand is maintained
will be dependent on the known
unknown external factors of, for example,
the actions of international governments,
central banks and regulators, global
economic growth, political and civil
unrest, and FX. Anecdotal evidence and
sentiment from the start of 2014 suggests
Overseas Investor demand is likely to
continue for now. However, any marked
decline in its pace or a switch to net sales
will likely have a material impact on the
UK CRE market.

Overseas Investors accounted for 45% of acquisitions and 32% of disposals

(bn)

The scale of activity by Overseas

Investors with regards to Central London
Offices, and its downward pressure
on yields is so dominant that it can
overshadow the more measured activity
and pricing across the rest of the UK
market. Whilst there is a risk of groupthink pushing the Central London and the
highest quality, large lot size retail markets
to levels dislocated from traditional real
estate investment fundamentals, we do
not think this applies across the market
as a whole.

Investment Transaction Activity 2013

(bn)

Polarisation was a much used word

in 2013. The interaction of dominant
Overseas Investors (across acquisitions
and sales), Central London Office
transaction volumes and yield compression
driven capital growth, is a good example of
the win:win dynamic at play in some of the
most dominant areas of the market.

UK Commercial Real Estate Market Outlook

Risk premium
Both transaction data and IPDs index point to a c.6% All Property
net initial yield as at the end of 2013. This supports the absolute
and relative income return attractions of the UK CRE asset class.

The positive yield gap ranges from 3.2% to 2.4% (as at Dec-13)
9
8
7
6
5
4

(%)

3
2
1
0
-1

Key
All Prop Initial Yield

Initial Yield less 10 Yr Gilts

Initial Yield less Corporate Bonds

Initial Yield less FTSE

Source: Bloomberg, RBS, IPD

Jan-12
May-12
Sep-12
Jan-13
May-13
Sep-13

-2

Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07
May-07
Sep-07
Jan-08
May-08
Sep-08
Jan-09
May-09
Sep-09
Jan-10
May-10
Sep-10
Jan-11
May-11
Sep-11

Forecast Income Return & Risk Premium Attractions of UK CRE

The positive yield gap narrows to between 1.7% and 1.4% by end of 2017
6

1
0
2014Y E

2015Y E

2016Y E

2017Y E

Key
Initial Yield less 10 Year Gilts

Initial Yield less Corporate bonds

Initial Yield less FTSE

All Prop Net Initial Yield

Source: PMA, Bloomberg, RBS

Whilst the spread narrows as we look out

to the end of 2017, it remains positive
at 1.5% (10 year gilts), 1.4% (corporate
bonds) and 1.7% (FTSE dividend yield).
Time will tell whether this level of yield gap
is sufficient to maintain investor demand
for UK CRE. We estimate that a range of
2% - 3% is the long-term average applied
by UK CRE investors. A return towards
this range would be likely to amplify
the downside valuation risks across the
market - especially if combined with a
period of rising rates.

Income Return & Risk Premium Attractions of UK CRE

(%)

In addition to the absolute return of a

c.6% yield, the sectors relative attractions
are clearly illustrated by the spot risk
premium against alternative asset
classes. As at December 2013 the spread
relative to 10 year gilts was 3.2%, with
2.4% against corporate bonds and 2.9%
against the FTSE dividend yield.

UK Commercial Real Estate Market Outlook

140
120
100
80
60
40
20

Jan-13

Jan-11

Jan-09

Jan-07

Jan-05

Jan-03

Jan-01

Jan-99

Jan-97

Jan-95

Jan-93

Jan-91

Jan-89

Source: Bloomberg, RBS

With CRE yields

being an important
component of risk
premium, it would be
remiss not to point out
that investor demand
has driven many yields
down to below their
long-term averages.

Whilst there are exceptions, the dominant trend is for CRE yields to follow gilt rates

Jan-87

Risk Premium Timeline: periods when yields rose and equivalent yields fell

(rebased)

Whilst reflecting on the risk premium

applicable to UK CRE, it is important
to keep in mind that history provides
examples of CRE yields falling at the
same time as rising gilts yields. The
longest period was from early 2006 to
mid 2007, for 16 months. This could be
argued to support forecasts that include
a narrowing positive spread, at least in
the near-term. Although it is clear that the
dominant relationship is for rising gilt
rates to be followed by higher CRE yields.

Key
10 yr Gilt Yield

All Property Equivalent Yield

CRE yields falling at the same time as gilts yields are rising

Market Risk Illustration via Equivalent Yield (Long-term average vs. Feb-14)
Many areas of the market point to potential valuation downside

CBRE Prime Industrial Estates

IPD South East Industrial Estates
CBRE Major Provincial Office
IPD Rest UK Office

Yield levels relative to their long-term

average is an established proxy for market
risk. Comparing the long-term average
(back to the late 1980s) and recent yields,
suggests potential valuation downside
across many sectors.

Source: PMA, CBRE

CBRE West End Office

IPD West End Office

IPD City Office

CBRE Retail Warehouse
IPD Retail Warehouses
CBRE Best Secondary SC
CBRE Prime SC
IPD Shopping Centres
3

Having touched on forecasts in the

context of risk premium to illustrate why
UK CRE retains a compelling investment
case, we now set out these numbers in
more detail.

6
7
(% Equivalent Yield)

10

UK Commercial Real Estate Market Outlook

Forecasts
RBS Economics forecast All Property capital growth for 2014 of
1.0%, rising to 2.9% in 2015. Mild declines are forecast through
2016 (-0.4%) and 2017 (-1.7%).
These All Property figures comprise
more volatile forecasts at a sub-sector
level, with Central London Retail leading
the field (18%) and Secondary Shopping
Centres lagging behind (-14.5%) - based
on 4 year compound growth.

Capital Growth Forecast (4 year compound)

All Property forecasts include a wide range of sub-sector performance

20
15
10

Breaking these forecasts down by capital

growth and rental growth shows that
with the exception of Small and Medium
Town Retail, and Secondary Shopping
Centres, ERV growth is expected to be
positive. The balance of capital growth is
much more mixed with c.60% of the submarkets in positive territory.

Source: RBS, PMA

(%)

5
0
-5
-10
-15

Capital and Rental Growth (4 year compound)

Capital Decline
& Rental Growth

Capital Growth
& Rental Growth

19
18
16
11
6

5.0
0.0

45

10

14
13
12

15

17

-5.0

-10.0
-15.0

-10.0

Capital Decline
& Rental Decline

-5t.0

Rest UK

Distribution Warehouse

London

South East

Small & Medium Towns

Secondary Shopping Centres

Prime Smaller Shopping Centres

Big Towns

Retail Warehouses

Retail Parks

Secondary Shopping Centres

11 Rest UK Offices

Small & Medium Town Retail

12 South East Industrial

Prime Smaller Shopping

Centres

13 London Industrial

Industrial Rest UK

14 City Offices

Distribution Warehouses

15 Big Shopping Centres

Big 6 Offices

16 M25 Offices

Ret Warehouses

17 Supermarket

Leisure

18 West End Offices

Business Parks

19 Central London Retail

10 All Property
Source: RBS

Rental Value Growth (%)

20.0

Leisure

25.0

10.0

Industrial

Key

Positive capital and rental growth dominates sub-sector forecasts

15.0

London Suburbs

Supermarkets

Big Shopping Centres

Big 6 Cities

Central London

Retail
Business Parks

City

Rest UK

M25

All Prop

It is important to recognise that rental

growth has been increasingly positive
for the past two years. Whilst this growth
is forecast to continue, higher rents are
not expected to off-set the dominant
downward pressure on asset values
from yield expansion. This is illustrated
by the capital declines forecast from
2016 onwards.

West End

Offices

-0.0
5.0
Capital Growth (%)

10.0

15.0

20.0

Capital Growth
& Rental Decline

We have confidence in our forecasts to show the

trajectory and quantum of CRE valuation changes,
without any expectation that they will be bang on.
To aid the identification of forthcoming valuation
movements across the market, we consider the
listed sector to be a good guide.

UK Commercial Real Estate Market Outlook

Lead indicators
Share prices across the UK listed CRE sector have been a useful
forward indicator for capital growth in the direct market. Share
prices topped out in December 2006, six months ahead of the All
Property Capital Growth Index, and started to recover in February
2009, again six months ahead of the direct market.

Share prices have shown themselves to be a lead indicator

120
100

Indexed: 100 = Jan-06

80

60

40

Key
All Property Capital Growth

UK Listed CRE Sector

Jan-13

May-13

Sep-12

Jan-12

May-12

Sep-11

Jan-11

May-11

Sep-10

Jan-10

May-10

Sep-09

Jan-09

May-09

Sep-08

Jan-08

May-08

Sep-07

Jan-07

May-07

Sep-06

Jan-06

Source: Bloomberg, IPD

20

May-06

Analyst Recommendations (Jan-14)

The continued dominance of BUY recommendations suggests confidence in a positive outlook

60

50

40

30

20

10
0
Buy

Hold

Sell

Key
Jan-14

Jan-13

Jan-12

Source: Bloomberg

A snapshot of analyst recommendations

applied to the UK listed CRE sector
suggests continued confidence in
the markets performance. The chart
summarises the position at January
2014, since when recommendations
have moved to be mildly more positive
at 53% Buyers, 36% Holders and only
11% Sellers.

All Property Capital Growth vs. UK Listed Sector

(%)

2013 was a strong year for UK listed

stocks share prices, up 21%, with 2014
YTD recording c.7% growth already.

UK Commercial Real Estate Market Outlook

Conclusion
Whilst we can see potential downside risks to valuations forming
across some areas of the market, we consider the near-term
outlook to be set fair.
The conditions appear set for investor
demand to be maintained by the current
virtuous circle of attractive income returns,
transaction volumes, yield compression
and capital growth. Specifically, the
attractions of UK CREs income return and
capital growth potential have and continue
to be sufficient to attract strong demand especially from overseas investors. Whilst
there is a risk of group-think pushing the
Central London and the highest quality,
large lot size retail markets to levels
dislocated from traditional real estate
investment fundamentals, we do not think
this applies across the market as a whole.

Rate rises and the level of risk premium

investors will accept will continue to be
key determinants to the markets progress
through this cyclical upswing. With the
former an inevitable consequence of a
sustained economic recovery, consistent
with positive rental growth forecasts,
we expect the practice of rate watching
and associated chatter to continue to
grow in popularity.

A clear warning sign will be commentary

suggesting that this time things will be
different, and specifically that the outlook
for UK CRE will be able to immunise itself
from rate increases.

10

Contact:
Charlie Foster
T: 0207 672 4942
E: charlie.foster@rbs.co.uk

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