London development on the up despite property sector doubts

As it takes shape high above the skyline at London Bridge, The Shard is the capital's latest iconic office building. It is poised to become the tallest tower in Europe and aspires to charge the highest rents.

The Renzo Piano-designed building could be seen as a barometer of the UK commercial property market in the year ahead. If the economy doesn't trip up, its developers will expect to see it fill quickly with tenants when it completes in 2012, but any sign of a double-dip recession could see those expectations dashed.

In a sign of fresh confidence, the cranes are going back up in the City of London, after the credit crunch brought most new development to a halt in late 2006. In October, two leading UK property firms announced that they were reviving key projects in the City.

British Land is poised to start work on the 47-storey Leadenhall building known as the Cheesegrater, while rival Land Securities is restarting a 37-storey building in nearby Fenchurch Street dubbed the Walkie-Talkie - both due for completion in 2014.
At the same time, the government's public sector spending cuts have been ringing alarm bells throughout the property sector. With up to one million jobs set to go, a lot fewer desks will be needed in government buildings around the country, and a significant number may be vacated or sold.

Even the more bullish commentators concede that overall demand for commercial property is going to be weak in the year ahead.

After property values plummeted through the early stages of the recession, the turning point came in August 2009, and since then overall returns have been positive.

The Investment Property Databank (IPD) index, which measures the total return across the commercial property sector, based on some 3,600 individual properties around the UK, notched up 15 consecutive months of rises to October 2010, with capital values up 12.2% over 12 months.

That recovery has been driven by several factors. "Property yields are closely related to bond yields," says Oliver Gilmartin, senior economist at the Royal Institution of Chartered Surveyors (Rics).

"Property yields shot up to around 8% in the recession, driven by a lack of confidence, particularly with expectation growing that we would have sharply rising unemployment, which would impact on rentals. In the event, we had a soft landing on the rental side, at which point yields started to look attractive compared with gilts."

Yields have stabilised at 6 to 7% over the past six months, giving the 3% premium over gilts that investors expect in return for the risk of holding property.

Much of the hardening of yields - and recovery in capital values - was driven by overseas investors piling in and snapping up properties at bargain prices, made even more attractive by a 25% depreciation in sterling against the euro. "It is a market they have been priced out of for years, so this has been a window of opportunity," says Gilmartin.

The consensus seems to be that the bull run in capital values has now run its course; the monthly increase in October was just 0.1%. "We've had most of the bounce," says Matt Oakley, director of commercial research at property company Savills. "Prices are still some way off their 2007 peaks, but that was an aberration driven by too much debt, so it shouldn't be the benchmark."

Prime properties - in the best locations and with high-quality tenants - have performed best, he says. Office and retail properties in London's West End are back to where they were in 2006.
The general expectation is that investors will now have to look to rental growth to boost returns. In London, rents for prime properties - office and retail - grew 10% in the past 12 months, says Oakley, and other major cities can be expected to follow suit nine to 18 months later.

The outlook in the City of London is also good. "Thanks to the credit crunch, the City is facing its lowest ever level of development completions," he says.

"Normally we would expect to see 3 to 3.5 million square feet of office space complete annually. That's about the total due between 2011 and 2013."

Demand is declining

However, a less rosy picture is painted by chartered surveyors around the country. The Rics quarterly survey of members in November revealed a decline in demand and a downbeat assessment of rental growth, with 16% more surveyors expecting rents to fall over the following three months.
Rics members reported that, in spite of the dearth of new developments throughout the country, property availability is increasing rather than declining, further undermining the market.

The public sector cuts and their impact on jobs is a key factor in determining the level of demand and availability, particularly if office building rentals are given up or not renewed. Oakley argues that public sector employers seldom account for more than 20% of a local office market and that the private sector can take up the slack.
Others are less sanguine. Tim Cockerill, head of research at wealth manager Ashcourt Rowan, says: "If you are losing 20% of your staff, you don't need the same number of properties, so I think there will be some downward pressure on rents.

"Also government departments are seen as high-quality tenants because they won't default. That may still be true, but they may not renew the tenancy."

What's likely to emerge is a two-speed office property market. Prime properties in central London - and other locations where supply is short - should see upward pressure on rents. The picture elsewhere will depend on the strength of the economy in coming months and the employment figures.
In retail, the picture is heavily reliant on consumer sentiment, says Gilmartin. So far, this has held up well, but a rise in joblessness or a fall in house prices could push it down.
Industrial property - business parks, factories, warehouses and other industrial units - could fare best, he predicts, since it is considered higher risk, has higher yields and is less prey to the impact of rising bond yields.
Bond yields - and gilt yields in particular - could rise if expectations of higher inflation, renewed quantitative easing or a faltering of the recovery grow. If bond yields rise, investors in low-yield retail properties may switch their allocation.

On the other hand, commercial property shares could do well if inflation becomes more of a concern, as was the case during previous inflationary periods, because it is considered a good hedge against inflation.

Overall, says Gilmartin, we are entering a testing period. "We could see minor falls in capital values and total returns are likely to remain positive, but only if GDP grows."

Property funds to consider

There are around 50 property funds to choose from. Typical yields are in the 3 to 3.5% range, according to Tim Cockerill of Ashcourt Rowan.

"The important thing is the quality of the properties in the portfolio, which means the quality of the tenants, as well as the locations," he says.

L&G UK Property Trust and SWIP Property are the two main funds Ashcourt Rowan recommends to clients. Open-ended funds do have one downside, says Cockerill, which is that many funds must hold low-yielding cash to be able to service redemptions, and this dilutes the return. Because property is essentially illiquid, difficulties arise if investors want to sell.
Patrick Connolly at financial adviser AWD Chase de Vere recommends three funds: M&G Property Portfolio, Henderson UK Property and L&G UK Property Trust. All focus on properties with strong tenants and long leases, he says.

The average fund in the sector returned 11.5% over the 12 months to 26 November, he says, with around 8% coming from growth in capital values and the remainder from rental income. Future growth is likely to come from rent increases.

This article was originally published in Money Observer - Moneywise's sister publication - in January 2011.

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