The IPD UK All Properties Index continues to chug away, up around 3.5 ytd led by Industrials, especially well-located ‘fulfilment centres’ and smaller distribution units resulting from the e-commerce boom. Returns for the Office market have been divergent, weak in Central London but strong in the regional markets. Retail remains weak
with the well-publicised troubles on the UK High Street and only a few strong segments, once again those driven by e-commerce as online businesses appreciate they need a physical presence to satisfy click and collect customers.
Rents are still growing, forecast to be around 1% over 3 years, led by London and South East Industrials rental growth which is forecast to be 5% over this period. Weakest sectors remain High Street Retail and Central London Offices, though the latter has seen a couple of positive months so far this year after declines throughout 2017.
I have always quoted the IPD index as the most accurate index for Commercial Property returns so I thought it appropriate to explain exactly what it measures. The index dates from 1986 and measures unleveraged total returns tracking the performance of 2.953 properties with a total value of nearly £50bn. By sector it is split 35% Retail, 32% Office and 26% Industrial with Hotels and other odds and ends making up the balance. Since inception the annualised return is 9.1% which with a relatively low volatility and correlation to other asset classes making Commercial Property a very useful constituent of a long term portfolio.
This has been a much extended Commercial Property cycle but fundamentals remain supportive. Physical supply has been constrained since 2008 in line with the old saw ‘it is the supply of credit that really drives the cycle’ as this in itself drives the physical supply. Banks have remained cautious since the big crash and leverage still remains relatively benign with LTV’s low, especially in the secondary market. Equity rather than debt financing has played a much larger part in this particular property cycle.
Commercial Property still looks fair value despite last year’s 11% rise in the IDP index. On an absolute, historical basis the 5% IPD yield is starting to look pretty expensive but relative to other income producing asset classes, notably bonds, it is remains attractive. The spread between the yield on Commercial Property and 10 year UK Gilts has narrowed from 4% to 3.5% but is still historically wide and with plenty of headroom. It is reliant of course on bond yields remaining low but this remains the most likely ongoing environment.
The forecast from the boffins at M&G for the IPD return over the next five years is grouped around 5.5% per annum, though with a dip to closer to 4% in 2019. With the income return being around 5% this implies virtually no capital growth over the period.
Summary: The Commercial Property cycle has become increasingly mature and returns will likely be lower going forward, driven almost entirely by rental income rather than capital growth.