5368 RBS BT Real Estate Financebrochure April 14 Single Page

8/9/2019 5368 RBS BT Real Estate Financebrochure April 14 Single Page

1/12

UK Commercial Real EstateMarket OutlookApril 2014


2/12

ForewordPaul Coates, Head of Real Estate

Welcome to this first of a series of

notes exploring the outlook for UKCommercial Real Estate.

In this note we reflect on what themarket is telling us by consideringtransaction volumes, pricing and riskpremium. Alongside this, we set outour capital and rental growth forecasts,

derived from RBS Economics’ macro-level outlook for the UK economy. Finallywe highlight the lead indicators of listedcompanies’ share price performanceand analyst recommendations.


3/12

3

The sector has been dominated by

accelerating growth over the past 6-12

months. We think this is set fair for the

near-term.

Our opening chart highlights the pace of

transaction volumes and capital growth

through 2013, with the former supported

by some notably large lot size deals, for

example Broadgate, More London and

Chiswick Park. Appetite for UK CRE drovetransaction volumes to £53.5bn in 2013,

an increase of 60% on 2012 with Q4-13

reflecting a quarterly increase of c.70%.

This strong tailwind of demand pushed

capital growth for 2013 to 4.6%. The

scale of this growth is highlighted by

the month on month recovery that took

capital growth from negative territory at

the start of the year (-0.2% Jan-13) to

1.4% by Dec-13.

Most with experience in the market are

either cautiously optimistic or modestlypessimistic. Our forecasts point towards

increasing All Property capital growth

for 2014 (1.0%) and 2015 (2.9%), with

mild declines through 2016 (-0.4%)

and 2017 (-1.7%).

With the prospects for UK CRE intertwined

with the economy’s recovery we set out

below the RBS Economics forecasts for

GDP, RPI and rates.

Whilst forecasts of steady growth in

GDP and broadly flat RPI bode well, the

consequential increase in rates (albeit

not forecast until the end of 2015) will

exert upward pressure on CRE yields.

The timing and pace of this inevitablerise is likely to be the biggest source of

downside valuation risk to UK CRE, even

though it is expected to be off-set, to

some extent, by forecast rental growth.

Summary

The Wall Street proverb “When the ducks quack, feed them” isa good way to set the scene for our UK Commercial Real Estate

(CRE) market outlook.

Economic Forecasts (Nov - 13)

Looking out to the end of 2017, each economic and rates forecast shows growth

GDP RPI Base rate 10 yr gilts 5 yr swaps

Key

S o u r c e

: R B S

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2014

( % )

2015 2016 2017


4/12

4

If rates are expected to lead the pack in

terms of impact on UK CRE, risk premium

is likely to be a close second. One of themost striking characteristics of current

forecasts (including RBS) is the reducing

risk premium for the period to the end of

2017. RBS forecasts show a reduction

from c.300bps to c.150bps between the

end of 2014 and 2017. This forecast

reduction absorbs at least some of

the upwards pressure on yields arising

from increased rates and could potentially

underestimate the scale of downside

valuation risk.UK Commercial Real Estate Market 2013

The accelerating pace of transaction volumes and capital growth

S o u r c e : P r o p e r t y D a t a ,

C B

R E

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

( % )

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

O c t - 1 3

N o v - 1 3

D e c - 1 3

0

5

10

15

20

25

( £ b n )

‘‘Before we delve into riskpremium, capital andrental growth forecasts,we set the scene with asnapshot of investmentactivity.

Transaction Volume - Quarterly All Property (LHS)

Capital Growth - Monthly All Property (RHS)

Key

UK Commercial Real Estate Market Outlook


5/12

5

Polarisation was a much used word

in 2013. The interaction of dominant

Overseas Investors (across acquisitions

and sales), Central London Office

transaction volumes and yield compression

driven capital growth, is a good example of

the win:win dynamic at play in some of the

most dominant areas of the market.

The scale of activity by OverseasInvestors with regards to Central London

Offices, and its downward pressure

on yields is so dominant that it can

overshadow the more measured activity

and pricing across the rest of the UK

market. Whilst there is a risk of group-

think pushing the Central London and the

highest quality, large lot size retail markets

to levels dislocated from traditional real

estate investment fundamentals, we do

not think this applies across the market

as a whole.

In addition to CRE fundamentals, whether

Overseas Investor demand is maintained

will be dependent on the “known

unknown” external factors of, for example,

the actions of international governments,

central banks and regulators, global

economic growth, political and civil

unrest, and FX. Anecdotal evidence and

sentiment from the start of 2014 suggests

Overseas Investor demand is likely to

continue for now. However, any marked

decline in its pace or a switch to net saleswill likely have a material impact on the

UK CRE market.

Notwithstanding these uncertainties,

the absolute and relative returns from UK

CRE continue to feed investor demand.

In the following section we consider

the income return and risk premium

attractions of the market.

Transaction volumes

Whilst each of the metrics covered by this note are linked, weconsider transaction volumes to be the best starting point. This is

because it highlights the dominance of specific investor groupsand the areas of the market for which there is most demand.

Investment Transaction Activity 2013

Overseas Investors accounted for 45% of acquisitions and 32% of disposals

I n s

t i t u t i o n s

Q u o

t e d

P r o p e r t y

C o m p a n

i e s

P r i v a

t e

P r o p e r t y

C o m p a n

i e s

O v e r s e a s

I n v e s

t o r s

P r i v a

t e

I n d i v i d u a

l s

O c c u p

i e r s

F i n a n c

i a l /

B a n

k s

O t h e r s

-20

-15

-10

-5

0

5

10

15

20

25

( £ b n )

Aquisitions Sales Net

Key


S o u r c e : P r o p e r t y D a t a

Investment Transaction Activity 2013 (Volumes vs. Yield)

Central London Offices accounted for 40% of transactions

( % )

C e n t r a l

L o n d o n

O f f i c e

R e s t o f

U K O f f i c e

S h o p p i n g

C e n t r e

R e t a i l

W a r e h o u s e

S h o p /

S u p e r m a r k e t

I n d u s t i a l

L e i s u r e 0

5

10

15

20

25

( £ b n )

0

1

2

3

4

5

6

7

8

9

10

Transaction Volume (LHS)

Net Initial Yield (RHS)

Key

S o u r c e : P r o p e r t y D a t a


6/12

6

In addition to the absolute return of a

c.6% yield, the sector’s relative attractions

are clearly illustrated by the spot risk

premium against alternative asset

classes. As at December 2013 the spread

relative to 10 year gilts was 3.2%, with

2.4% against corporate bonds and 2.9%

against the FTSE dividend yield.

Whilst the spread narrows as we look out

to the end of 2017, it remains positiveat 1.5% (10 year gilts), 1.4% (corporate

bonds) and 1.7% (FTSE dividend yield).

Time will tell whether this level of yield gap

is sufficient to maintain investor demand

for UK CRE. We estimate that a range of

2% - 3% is the long-term average applied

by UK CRE investors. A return towards

this range would be likely to amplify

the downside valuation risks across the

market - especially if combined with a

period of rising rates.

Risk premium

Both transaction data and IPD’s index point to a c.6% All Propertynet initial yield as at the end of 2013. This supports the absolute

and relative income return attractions of the UK CRE asset class.


Income Return & Risk Premium Attractions of UK CRE

The positive yield gap ranges from 3.2% to 2.4% (as at Dec-13)

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

-2

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

S e p - 1 3

-1

0

1

2

3

4

5

6

7

8

9

All Prop Initial Yield Initial Yield less 10 Yr Gilts

Initial Yield less Corporate Bonds Initial Yield less FTSE

Initial Yield less 10 Year Gilts Initial Yield less Corporate bonds

Initial Yield less FTSE All Prop Net Initial Yield

Key

Key

S

o u r c e : B l o o m b e r g ,

R B S ,

I P D

Forecast Income Return & Risk Premium Attractions of UK CRE

The positive yield gap narrows to between 1.7% and 1.4% by end of 2017

0

1

2

3

4

5

6

2014YE 2015YE 2016YE 2017YE

( %

)

S o u r c e : P M A ,

B l o o m b e r g ,

R B S

( % )


7/12

7

Whilst reflecting on the risk premium

applicable to UK CRE, it is important

to keep in mind that history provides

examples of CRE yields falling at the

same time as rising gilts yields. The

longest period was from early 2006 to

mid 2007, for 16 months. This could be

argued to support forecasts that include

a narrowing positive spread, at least in

the near-term. Although it is clear that the

dominant relationship is for rising gilt

rates to be followed by higher CRE yields.

With CRE yieldsbeing an importantcomponent of risk

premium, it would beremiss not to point outthat investor demandhas driven many yieldsdown to below theirlong-term averages.

Yield levels relative to their long-term

average is an established proxy for market

risk. Comparing the long-term average

(back to the late 1980s) and recent yields,

suggests potential valuation downside

across many sectors.

Having touched on forecasts in the

context of risk premium to illustrate why

UK CRE retains a compelling investment

case, we now set out these numbers in

more detail.


Risk Premium Timeline: periods when yields rose and equivalent yields fell

Whilst there are exceptions, the dominant trend is for CRE yields to follow gilt rates

J a n - 8 7

J a n - 8 9

J a n - 9 1

J a n - 9 3

J a n - 9 5

J a n - 9 7

J a n - 9 9

J a n - 0 1

J a n - 0 3

J a n - 0 5

J a n - 0 7

J a n - 0 9

J a n - 1 1

J a n - 1 3

0

20

40

60

80

100

120

140

( r e b a s e d )

10 yr Gilt Yield All Property Equivalent Yield

CRE yields falling at the same time as gilts yields are rising

Key

S o u r c e : B l o o m b e r g ,

R B S

Market Risk Illustration via Equivalent Yield (Long-term average vs. Feb-14)

Many areas of the market point to potential valuation downside

3

(% Equivalent Yield)

4 5 6 7 8 9 10

CBRE Prime Industrial Estates

IPD South East Industrial Estates

CBRE Major Provincial Office

IPD Rest UK Office

CBRE West End Office

IPD West End Office

IPD City Office

CBRE Retail Warehouse

IPD Retail Warehouses

CBRE Best Secondary SC

CBRE Prime SCIPD Shopping Centres

S o u r c e : P M A ,

C B R E

‘‘


8/12

8

These All Property figures comprise

more volatile forecasts at a sub-sector

level, with Central London Retail leading

the field (18%) and Secondary Shopping

Centres lagging behind (-14.5%) - based

on 4 year compound growth.

Breaking these forecasts down by capital

growth and rental growth shows that

with the exception of Small and Medium

Town Retail, and Secondary ShoppingCentres, ERV growth is expected to be

positive. The balance of capital growth is

much more mixed with c.60% of the sub-

markets in positive territory.

It is important to recognise that rental

growth has been increasingly positive

for the past two years. Whilst this growth

is forecast to continue, higher rents are

not expected to off-set the dominant

downward pressure on asset values

from yield expansion. This is illustrated

by the capital declines forecast from2016 onwards.

Forecasts

RBS Economics forecast All Property capital growth for 2014 of1.0%, rising to 2.9% in 2015. Mild declines are forecast through

2016 (-0.4%) and 2017 (-1.7%).


Capital Growth Forecast (4 year compound)

All Property forecasts include a wide range of sub-sector performance

A l l P r o p

0

5

( % )

W e s

t E n

d

M 2 5

C i t y

R e s

t U K

B i g 6 C i t i e s

B u s

i n e s s

P a r k s

C e n

t r a

l L o n

d o n

S u p e r m a r k e

t s

B i g S h o p p

i n g

C e n

t r e s

L e

i s u r e

L o n

d o n

S u

b u r b s

R e

t a i l P a r k s

B i g T o w n s

R e

t a i l W a r e

h o u s e s

P r i m e

S m a

l l e r

S h o p p

i n g

C e n

t r e s

S m a

l l & M e

d i u m

T o w n s

S e c o n

d a r y

S h o p p

i n g

C e n

t r e s

L o n

d o n

S o u

t h E a s

t

D i s t r i b u

t i o n

W a r e

h o u s e

R e s

t U K

10

15

20

-5

-10

-15

Offices Retail Industrial

S o u r c e : R B S ,

P M A

1 Secondary Shopping Centres 11 Rest UK Offices

2 Small & Medium Town Retail 12 South East Industrial

3 Prime Smaller Shopping

Centres13 London Industrial

4 Industrial Rest UK 14 City Offices

5 Distribution Warehouses 15 Big Shopping Centres

6 Big 6 Offices 16 M25 Offices

7 Ret Warehouses 17 Supermarket

8 Leisure 18 West End Offices

9 Business Parks 19 Central London Retail

10 All Property

Key

S o u r c e : R B S

Capital and Rental Growth (4 year compound)

Positive capital and rental growth dominates sub-sector forecasts

-15.0 -10.0 -5t.0 -0.0 5.0 10.0 15.0 20.0-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Capital Growth (%)

R e n t a l V a l u e G r o w t h ( % )

1

2

3

4 5

6 7

8

910

11

12

13

1415 17

16

18

19

Capital Decline& Rental Growth

Capital Growth& Rental Growth

Capital Growth& Rental Decline

Capital Decline& Rental Decline

We have confidence in our forecasts to show the

trajectory and quantum of CRE valuation changes,

without any expectation that they will be bang on.

To aid the identification of forthcoming valuation

movements across the market, we consider the

listed sector to be a good guide.


9/12

9

2013 was a strong year for UK listed

stocks’ share prices, up 21%, with 2014

YTD recording c.7% growth already.

A snapshot of analyst recommendations

applied to the UK listed CRE sector

suggests continued confidence in

the market’s performance. The chart

summarises the position at January

2014, since when recommendations

have moved to be mildly more positive

at 53% Buyers, 36% Holders and only

11% Sellers.

Lead indicators

Share prices across the UK listed CRE sector have been a usefulforward indicator for capital growth in the direct market. Shareprices topped out in December 2006, six months ahead of the AllProperty Capital Growth Index, and started to recover in February2009, again six months ahead of the direct market.


All Property Capital Growth vs. UK Listed Sector

Share prices have shown themselves to be a lead indicator

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

0

20

40

60

80

100

120

I n d e x e d : 1 0 0 = J a n - 0 6

All Property Capital Growth UK Listed CRE Sector

Key

S o u

r c e : B l o o m b e r g ,

I P D

Analyst Recommendations (Jan-14)

The continued dominance of BUY recommendations suggests confidence in a positive outlook

0

10

20

30

40

50

60

Sell

( % )

HoldBuy

Jan-14 Jan-13 Jan-12

Key

S o u r c e : B l o o m b e r g


10/12

10

The conditions appear set for investor

demand to be maintained by the current

virtuous circle of attractive income returns,

transaction volumes, yield compression

and capital growth. Specifically, the

attractions of UK CRE’s income return and

capital growth potential have and continue

to be sufficient to attract strong demand -

especially from overseas investors. Whilst

there is a risk of group-think pushing the

Central London and the highest quality,

large lot size retail markets to levels

dislocated from traditional real estate

investment fundamentals, we do not think

this applies across the market as a whole.

Rate rises and the level of risk premium

investors will accept will continue to be

key determinants to the market’s progress

through this cyclical upswing. With the

former an inevitable consequence of a

sustained economic recovery, consistent

with positive rental growth forecasts,

we expect the practice of rate watching

and associated chatter to continue to

grow in popularity.

Conclusion

Whilst we can see potential downside risks to valuations formingacross some areas of the market, we consider the near-term

outlook to be set fair.

A clear warning sign will be commentarysuggesting that this time things will bedifferent, and specifically that the outlook

for UK CRE will be able to immunise itselffrom rate increases.

‘‘



11/12


12/12

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5368 RBS BT Real Estate Financebrochure April 14 Single Page