UK CRE looks relatively steady, for now

Despite the political and economic backdrop, investors still see UK commercial property as a safe haven – for the time being.

It may not sound like high praise for the sector, but on a relative value basis, UK commercial property still offers global investors a safe place to park their capital.

Certainly, Brexit-fuelled concerns have affected some investors’ attitudes to the UK – particularly City of London offices – but, generally, when kit goes onto the market, it sells. The political and economic outlook might look unsettling by British standards, but investors seem to still view UK CRE as a steady market underpinned by an economy which has defied expectations to continue to grow.

Figures published by CBRE this week offer context. Prime UK rental values rose by 0.4 percent in the last quarter of 2016. Although this was the lowest quarter for growth last year, it shows the best property remained resilient. Prime yields were largely stable, with just a single basis point drop during Q4, to 5.4 percent at the all-property level.

On the lending side, CBRE’s stats revealed CRE debt, on a gross returns basis, commanded a premium of 2.9 percent over gilts and the gap in gross returns between CRE debt and corporate bonds stood at 1.8 percent in Q4.

Commercial real estate might not be offering investors much capital growth, but as an income-generator amid a low interest rate environment, it looks pretty solid. What could possibly go wrong?

At a Loan Market Association seminar in London this week, a panel of real estate lenders debated the strength of the UK real estate finance market. Lloyds’ global head of CRE lending, John Feeney, agreed “up to a point” that the UK is a safe haven, but warned against complacency: “UK CRE sits within a relative value matrix. Today, London and the UK looks pretty attractive relative to comparable markets such as Milan and Paris, which offer similar cashflows from similar assets. But there is no magic to the UK market. It’s not irreplaceable in an investor’s portfolio and we have to be careful to ensure it remains attractive.”

Although opinions on where we are in the property cycle differ, it’s difficult not to conclude that we are reaching the crest. With some exceptions, significant capital value growth is unlikely. Investors are relying on income, or maybe an element of value-add, to drive their returns. Pricing looks a little toppy.

Another panellist at the LMA event, TH Real Estate’s debt head Christian Janssen, expressed his concerns. “Are CRE investors truly earning enough of a risk premium?” he asked. “Assets are flying off the shelf and some yields are at 4 percent in the City. Does that really make sense? We are likely to see some imported inflation, so although the UK is attractive, valuations are a little high.”

If we are getting slightly long into the cycle, it is important to remember that this is not a debt-fuelled bubble, like 2006’s top-of-the-market. Lenders are resolutely sticking to their guns on leverage (indeed, there’s so much equity in the market that borrowers are not demanding high LTVs) and although some covenants have undoubtedly been relaxed, competitive pressure has largely been fought out by lenders on loan pricing.

Factors external to the dynamics of the market could determine how precarious UK CRE’s ‘safe haven’ status is. Although the market today is very different to that which imploded in 2007-2008, so are the external factors – Brexit, Trump, the strength of the EU – with which it will have to contend.