2016: Choppy seas or steady as she goes?

14 January 2016

So what are the realistic prospects for Commercial UK Real Estate over the next 12 months? The current economic uncertainty suggests that there may be a few headwinds and many would undoubtedly argue that the underlying currents are perhaps not flowing quite as smoothly as we have seen over recent years. The team here at KFIM is certainly hearing a number of different and often contrasting views out in the market place.

On the one hand, some of the larger retail funds are forecasting that 2016 will see an outward yield movement (rise) of between 0.25% and 0.5%. This view is based on the expectation of higher interest rates and lower rental growth. In contrast to this, there is a second group of investors that expect pressure on yields to be maintained, with a third group that continues to sit on the fence.

Recognising that our job as an investment manager is to steer the ship, sitting on the fence is just not an option and the view here at KFIM is that values are likely to appreciate a bit more this year.

So why is this?

The rationale behind our thinking can be demonstrated by comparing the level of yields, growth rates and interest rates today to where they were back in 2007:  

·         In June 2007, the IPD initial yield stood at 4.6%; in contrast, the latest IPD monthly index (November 2015) indicates that this currently stands at 5.1%.

 ·         Rental growth rates in 2007 were running at similar levels to what we see today; 3.9% in 2007 versus 4.0% in 2015.

 ·         However, the really important differentiators are bond yields and interest rates, both of which were much higher in 2007; the five year swap stood at 5.2% with ten year government bond yields at 5.5%, compared to a current swap rate of 1.6% and a ten year bond yield of 1.9%.

Whilst we accept that the next 12 months are likely to see interest rates rise, we believe that any increase will be slow and modest in scale and will still leave a far bigger gap between property yields and the cost of debt than was the case in 2007; if correct, this suggests that the yield re-rate still has a bit further to go. Furthermore, rental values are still rising and we expect that to continue into 2017.

Consequently, KFIM is forecasting reasonably steady waters with a total return for All Property during 2016 of circa 8%-10%. Whilst this is a lot lower than we have seen over recent years, it is still pretty attractive relative to most other investment opportunities. Also, when viewed in real terms (the latest CPI figure was 0.1% p.a.), it remains very strong and, in our view, will be enough to maintain the interest of investors, both UK and overseas.

Ian Whittock
CIO, Knight Frank Investment Management




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