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UK Commercial Property Set for Rebound

There’s a lot of cash on the sidelines waiting to snap up UK property assets once certainty on Brexit is known, according to real estate investment trust managers. However, they warn the market could see some short-term pain in the meantime.

Equity investors have been vocal in putting forward their expectation of cash flowing into the UK stock market once Brexit is resolved, no matter what deal we get. While it’s unlikely to be as dramatic in property, the asset class remains more resilient than many expected.

There’s money waiting to buy UK real estate, predicts Calum Bruce, manager of the Ediston Property Investment Company (EPIC), from both domestic and overseas buyers. “Once there’s some clarity, there will be a period where people will just digest what’s happen, formulate a strategy and then look to implement that strategy,” he tells Morningstar.co.uk.

Simon Marriott, investment director at London & Scottish Investments, agrees, though has sympathy with those continuing to hold off committing just yet. “I’m a believer when there is some certainty, anything other than no-deal, prices are going to get stronger,” he says.

Bruce explains that there is plenty to like about UK property, particularly for overseas investors looking for a safe haven in an uncertain world. “The UK ticks a lot of boxes for these investors,” he adds. These include a stable economy, favourable political climate for the asset class and yields higher than many other cities both in Europe and elsewhere.

“But why would they invest now if they think there’s going to be a slip in value and their euro or dollar will go further in a few months’ time? That’s why we need some clarity so these investors can go ‘right, now’s the time to come in and invest’.”

However, it seems likely it will be some time until that Brexit fog clears. While Prime Minister Theresa May’s extension to the Brexit deadline is flexible, odds are it will, again, go right down to the wire on October 31.

Therefore, this predicted pick-up in activity is likely to be a 2020 phenomena. Indeed, Nick Montgomery, manager of the Schroder Real Estate Investment Trust (SREI), thinks we’ll see a correction before any recovery comes about.

“Are we at the top of the cycle? If you look at the average for the market, we think values will fall,” he explains. “We’re not expecting a return to 2009 where values fell by multiples of 10%, but we are expecting a correction.”

As a result, he’s been selling some of his lower-yielding assets, including most of his retail portfolio, in order to build some cash and give him firepower once that correction comes.

Despite being late-cycle, Montgomery says there are plenty of opportunities around with “immense polarisation” between sectors. Below, we highlight three areas REIT managers are seeing, or expect to see, opportunities in the UK property market.

Regional Offices
Being the big hub, particularly for financial services firms, and capital, London will garner many headlines when it comes to the outlook for UK offices. However, many are now seeing opportunities some of the other larger cities in the UK.

Both businesses and the Government are beginning to spread their workforces around the country. The BBC has recently set up camp in Salford, while accountancy firm PwC has a new 80,000 square foot office in Leeds.

“These cities are not back-office locations anymore,” says Marriott. “These are all high-quality locations in their own right, with highly qualified workers who have made life changes [to] move out to the provinces because it’s closer to where they were brought up or their quality of life is better [than in London].”

With the UK one of the world leaders in artificial intelligence, companies are looking for more office space around university cities, too, like Oxford, Cambridge, Bristol and Durham.

Montgomery says Schroders is one of the biggest owners of commercial real estate in Manchester, having identified it as one of the “winning cities” in the UK moving forward.

“[Manchester has] great public sector leadership and a disproportionate share of public sector investment, which has drawn people into the city centre, with the population doubling over the course of the last 10 years or so,” he explains.

Retail Warehousing
Unsurprisingly, many are downbeat on the future for retail. Structural headwinds, including the increasing move to online shopping, have meant a lot of retail firms have either gone bust or are on shaky ground.

Those that have survived are now looking to downsize their store estate or reduce the rents they pay as shoppers increasingly eschew a trip to the high street or their local shopping centre.

However, there are still opportunities in retail. Bruce is the most bullish, arguing that the doom and gloom headlines don’t tell the whole story. “Retail is evolving; I don’t think it’s in terminal decline,” he says.

True, he cautions, retailers that have failed to adapt, evolve or change to the new environment will fall by the wayside, but others have done so and are well set to take advantage. Indeed, Bruce likes out-of-town retail parks in places like Hull, Barnsley or Sunderland, which lend themselves most to the click-and-collect model..

As ever, it’s all about good stock selection, of course: “not all retail warehousing is equal”. While the likes of Next and others are known to be looking at decreasing the rent they pay, they are also happy to increase their costs for units in good, profitable locations.

“We have a retail park in Prestatyn and have completed four rent reviews with River Island, Next, Card Factory and Costa and have got an increase on all of them because it’s a good park in a good location,” says Bruce.

The London & Scottish Investments team, which runs the Regional REIT (RGL), have only a small portion of their portfolio allocated to retail and that is overhang from portfolios they have bought.

Despite taking the decision not to consciously invest in retail when they launched their product back in 2013, they also have no plans to sell their two properties, which comprise a shopping centre in Bletchley and retail park in Swansea, any time soon.

“These are yielding well north of 8% so there’s no reason for us to sell them,” says managing director Derek McDonald. “We’ve got one very small void at Bletchley and none at Swansea and we’ve not had any CVAs, so why rush to sell them when they’re not hurting you?”

Central London Offices
Clearly, this one’s most at the mercy of the outcome of Brexit negotiations – and the UK leaving without a deal would not be positive for the asset.

But Bruce says the office market in the capital has been more resilient than expected. “There are people hedging their bets, but I don’t think it’s been as dramatic an exodus as people expected.”

True, the market has hitherto been too expensive for Bruce to justify getting stuck into, and pricing is still not there just yet. However, he’s encouraged that “more things are coming across our desk which we’re interested in doing something with”.

“Rents are probably under pressure more than they are in other parts of the country, but in the main there’s been pretty good take-up and supply is at a reasonable level.”

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New opportunities and risks in evolving market

It is widely accepted that we have reached a late stage of the property cycle. Some even argue that a downturn has already set in. However, our view is that while values feel pretty full, we certainly aren’t in bubble territory. It is reassuring to note that UK commercial property values have increased half as much as they did during the last cycle and the industry as a whole is nothing like as highly geared as it was in the run-up to the financial crisis a decade ago.

However, as lenders and investors, we can’t afford to be complacent. We remain alert to the risks of lending late in the cycle which today are as much, if not more, of a concern as structural changes in the market. Against this background, we have still been able to find value and we have invested more than £800m over the past 12 months, including our largest transactions to date in both our senior debt and partnership capital strategies, while we have been able to back some very interesting residential development opportunities in London and the South East.

The most obvious risk in today’s market is posed by changes to shopping habits. The inexorable rise of online shopping has already started to bite hard into the retail property market and undoubtedly, values and rents will continue to come under more pressure. We have therefore been reducing our exposure against retail property for some time but we are not turning our backs on the market completely.

”As lenders and investors, we can’t afford to be complacent. We remain alert to late-cycle risks”

While there is clearly trouble ahead for department stores and the centres they anchor, many retail centres will continue to attract shoppers, particularly those in densely populated areas that are focused on convenience shopping. We’ll continue to back borrowers and partners with deep retail experience in this part of the market.

The industrial market presents very different challenges for us. The rise of ecommerce is driving growing occupier demand but this means competition between investors to buy assets and between lenders to fund them is high. We have been active in the industrial market for many years but, with investment yields contracting to record levels, we see better relative value in development than investment and have funded two speculative warehouse schemes in the South East in recent months. Having said that, one of our biggest loans this year, and the largest loan to date in the senior debt programme, was the £125m refinance of an industrial portfolio, predominantly located in the West Midlands.

‘Live-work-play’ situation

The office market is also going through a period of rapid change with TMT tenants driving demand in many parts of the country, not just London, which are often followed by co-working operators, with most looking for that millennial-friendly ‘live-work-play’ situation. We are keen to support borrowers targeting this market, as evidenced by our loan earlier this year to support FORE Partnership’s £51m acquisition of Tower Bridge Court on the South Bank. It was our first office deal in London since 2015 and we are on the lookout for others as pricing for value-add investments in the capital is looking increasingly attractive.

evolving market

Tower Bridge Court £51m acquisition and refurbishment whole loan

We also continue to target the other major UK cities, confident that despite the uncertainty around Brexit, there are good lending opportunities available. The fundamentals of the office market in large UK cities remain healthy. Demand for space is robust; this has been driven by strong employment growth; supply remains tight due to a lack of new development and a similar lack of conversion of secondary office space to residential under development law.

Alternatives also look more attractive than ever. In an environment where Brexit brings an uncertain economic outlook, it clearly makes sense to be lending and investing in sectors where demand isn’t tied to the economic cycle. One such example is data centres; demand for data is set to grow exponentially but there are a very limited number of locations that can meet data centres’ specific requirements for connectivity or power. As well as backing student accommodation and hotels, which have been our alternatives bread and butter since 2011, we have been providing finance for data centres as well as a number of other non-traditional assets this year.

Indeed, we made our biggest-ever loan across the business this year in the alternatives sector – a £200m whole loan to Royale, an operator of permanent park homes aimed at the over-50s. The loan was backed by 27 individual parks and 3,500 plots, providing a good level of granularity. We also like the fact that the number of over-50s is set to grow at twice the rate of the whole population.

This year, ICG-Longbow expanded its direct investment activities with the launch of our build-to-rent business, through the Wise Living joint venture with SDL Group, and a pan-European sale-and-leaseback strategy. Growing both will be a key focus for us in 2019. Increasing demand for private rented housing gives us confidence in the outlook for build-to-rent, particularly as our focus is on family housing, which is an undersupplied part of the market. The sale-and-leaseback business is also an exciting venture for us that brings together ICG-Longbow’s property expertise with ICG Group’s 29-year track record of investing in European corporate credit deals.

We also plan to expand our partnership capital lending and investing activity into continental Europe in due course. For us, it’s a natural progression for the business and doesn’t mean we’re any less interested in the UK. Although the UK market faces challenges, not least Brexit, we are still firm believers that there are plenty of good opportunities out there.

Healthy sign for the market

Looking at the supply of capital to the market, we see that banks remain cautious and have lowered their LTVs. However, we see this as a healthy sign for the market as a whole and they at least remain active. From our perspective, the fact they have pulled back somewhat is helpful for obvious reasons. When it comes to our senior lending, we used to compete with the banks mainly on our flexibility and speed, whereas now there is usually substantial clear water between our terms and the banks on leverage, while in the higher LTV whole loan market there are only a handful of lenders equipped to underwrite more complex property strategies, including value-add and development.

Finally, in the residential construction market, we have seen more activity from other non-bank lenders, but in our opinion this has been more than offset by a couple of UK banks pulling back from the market, while the volume of debt capital available still remains low relative to financing requirements.

With positive occupational fundamentals in all but retail, we look ahead to 2019 with confidence that there will be plenty of attractive lending opportunities, despite (or even potentially resulting from) the ongoing political uncertainty. Having raised nearly £900m across our senior debt, partnership capital and residential development strategies this year and with fundraising efforts still ongoing, we have plenty of firepower coming into the new year and we look forward to continuing to support our customers with our flexible capital and partnership approach going forward.

Source: Property Week

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How is the UK commercial property sector performing?

The UK commercial property market is rapidly changing and facing highly uncertain times in the face of Brexit. We have a look at how the industry is evolving and what commercial property stocks to watch.

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Demand by investors for UK commercial property remains strong

The level of demand for UK commercial property remains strong, despite continued lack of clarity over Brexit.

According to the latest GVA review of commercial property investment market, European investors were more risk averse to the UK market because of the uncertainty caused by Brexit but demand from overseas investors, particular from China and the Far East, strengthened in 2018.

Domestic investors have also made a ‘come-back’ to the UK market and have accounted for approximately 12 percent more acquisitions in 2018, compared to the previous year.

In the North East, the lack of availability of investment property is one of the biggest factors affecting growth and there remains strong competition, particularly for prime well let assets.

Regardless of political uncertainty, the fundamentals of the UK commercial property market will continue to make it an attractive place to invest, with London remaining the number one priority target of investors outside of Europe.

Overall, the report concludes, the UK commercial property market will remain attractive with the exception of retail.

Source: Workplace Insight

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Are ‘imperfect valuations’ of commercial property driven by high rent levels?

The true value of many commercial properties is an understanding that a surveyor struggles to appreciate, one property finance specialist has claimed.

A recent poll conducted by Bridging & Commercial found that 58% of respondents did not believe that the UK commercial property market was currently being valued fairly.

A quarter (25%) felt opposite, while 17% claimed it was partly valued fairly.

Why do people believe commercial property isn’t currently being valued fairly?

“Many commercial properties’ true value is an understanding that a surveyor struggles to appreciate and quantify, especially when there is growth or development potential,” said Chris Oatway, director at LDNfinance.

Shahil Kotecha, CEO at Pivot, highlighted that so-called ‘imperfect valuations’ were down to seemingly high levels of rents.

“Since the financial crisis of 2008, commercial property landlords have sought hard to keep their premises tenanted and also [the] level of rents in the lease agreements high.

“They do this by offering tenants lots of incentives at the beginning of the lease, such as rent-free periods, stepped rents, capital payments, help with fitting out etc.

“These incentives lead to higher rents being paid after the inducements to let have expired than would be the case if rents had been paid from day one of the lease.

“Investors believe that valuation surveyors pay heed to only these headline rents, thus leading to imperfect valuations and the belief that the valuation is not fair.”

Ludo Mackenzie, head of commercial property at Octopus Property, pointed out that the commercial property market had enjoyed nine years of growth, during which yields had returned to levels last seen at the tail end of the last cycle.

“Inevitably, people feel that value is hard to find and the probability of a correction is somewhat higher than the probability of further yield compression.

“The opposing view is that UK commercial property pricing looks attractive against 10-year gilt yields, offering secured income returns in a low yield environment.”

However, Philip Treadwell, associate director at De Villiers Surveyors, felt that the valuation of property could be opinionated with an applicant’s expectations perhaps sometimes higher than the market would pay.

“This can lead to disparity over the perception of fairness in a valuation.

“This is being highlighted more in the current market with De Villiers’ commercial valuers receiving feedback from buyers and selling agents of a general uncertainty, with interest rates poised to rise and Brexit on the horizon.

“Consequently, some valuation expectations are falling a little further, but this will only reflect what buyers are likely to pay at the current time.”

What impacts commercial property valuations?

Damien Druce, director and head of intermediary sales at Assetz Capital, said that from his conversations with intermediaries, they felt that surveyors still approached commercial property particularly cautiously, and that this was a legacy issue from the global economic crash.

“The valuers may well have a good point, however, as the valuation levels reached for tenanted property around 2007 were far above their vacant possession value and caused huge losses at lenders when some tenants failed in the crisis.

“Taking a more sensible approach on yields is a good thing we feel on the whole and, in the end, will be to the benefit of investors and lenders alike.

“However, on the unhelpful side is that valuations are now tending to be caveated with the unknown impact of Brexit, which can lead to lender uncertainty over the security offered and that isn’t supportive to a well-functioning lending market.”

Shahil added that Brexit negotiations were clouding the outlook for commercial real estate.

“A fear that businesses are looking to relocate away from the UK in droves has led to mark down in asset values.

“In reality, with barely a year to go to Brexit, there is no evidence of droves of businesses preparing in earnest to relocate away from the UK.”

Meanwhile, Paul Riddell, head of marketing and communications at Lendy, said commercial properties tended not to be traded with openly quoted prices, unlike residential properties.

“Valuers provide an ‘opinion’ of value [based] upon their own commercial acumen, market data, local knowledge and financial information about the property in question.

“While a particular commercial property may be attractive to one purchaser/investor, it may not be attractive to another.

“This is not different to the residential property market, where sentiment and supply and demand can affect value.”

Can improvements be made to commercial property valuations?

“The inclusion of a conversion-to-residential value could help give some additional strength to a commercial valuation report – given the strength of the residential market – and give all parties in the transaction further options and potentially improved perceived security as circumstances and times may change in the future,” said Damien.

Philip said that valuation methods had remained relatively unchanged for a number of years, with most guidance provided by the RICS.

“We try to ensure our valuations are as fair and robust as possible and, to achieve this, we will speak to local commercial agents and include high levels of relevant comparable evidence within our reports so both the bank and applicant can see how the figure has been concluded.

“Formulating any valuation is based on transactional evidence and, unlike residential property, commercial evidence is far more complex and less numerous.

“An improved clarity of transactional information would be welcome, and perhaps standardising the way property is marketed and subsequently reported upon post-sale will allow a greater degree of accuracy.

“De Villiers, as do most surveying practices, use peer review, so no valuation will be released without at least two surveyors agreeing to the conclusion of value.”

Source: Bridging and Commercial