The UK real estate market is now entering the next phase of the real estate cycle, where returns are predominantly driven through rental growth rather than valuation yields compressing. With the exception of more secondary real estate in the regions, UK real estate yields have compressed materially from their peak in 2009 and there appears limited scope for further compression from here, despite the comfortably higher yield still offered by UK commercial property relative to other yielding asset classes.
This yield differential should provide a fundamental cushion against a material rise in valuation yields as and when interest rates and bond yields start to rise in the UK, in contrast to 2007 when the average commercial property yield was lower than the 10 year government bond yield. Nonetheless, at this juncture we have a strong preference for real estate that is positioned for rents increasing when there is economic growth. Interest rate rises can be expected in a sustained economic growth environment, but increased borrowing costs can be offset by an increasing rental income stream. Rental growth has been clearly evident in London over the last few years, as the capital benefits from its global appeal as a city where dynamic and enterprising people want to work and live. A notable recent trend is emerging where a number of companies are looking at key regional cities, given the lack of availability in London and how affordable these locations are now in comparison to the capital. With limited construction over the last few years and low base rents, there is now clear rental growth acceleration in the major UK cities.
It is this lack of supply that makes real estate attractive currently. Ironically for real estate, this lack of development is the direct result of the credit crisis and the de-leveraging of the banking sector from real estate lending. Only recently has commercial property development finance been available in regional real estate, and that is to the select few with strong track records and diligent business plans. This lack of supply, combined with increased demand from corporates, sets a fundamentally positive outlook to rents for well positioned real estate in the regions, with the exception being specific segments of the structurally impaired retail market. The London rental market, whilst more advanced in the cycle, is also seeing healthy growth as widespread demand material exceeds supply, with the development pipeline suggesting this dynamic lasting at least the next couple of years.
