Real Insights Issue 4

REAL INSIGHTS

ROYAL LONDON ASSET MANAGEMENT • QUARTERLY PROPERTY REVIEW • ISSUE FOUR

This issueTransactions in 2015An insight into last year’s buying and selling strategy

Latest Hot PropertyRedevelopment in Fitzrovia, near new Crossrail station

The Big PictureThe national picture viewed by our team of experts

55-59 Long Acre, London, WC2

For professional investors and advisors only

2 • ISSUE FOUR • REAL INSIGHTS

-5

0

5

10

15

20

Real Estate (asset)Real Estate (listed)EquitiesBonds

1 year 3 year 5 years 10 years

1.0

5.4 4.8

12.3

10.3

5.64.7

1.1

5.5

-2.2

5.1

13.1

2.3

5.2

15.113.8

City of London office space dueto complete by 2018

Office sector – Annual rental growth rates (%)

Performance across UK asset classes

Total amount of office space proposed for City core

4.6m sq ft 1.3m sq ft

Total 6.8m sq ft

141210

86420

-2-4Jan ’12 Jan ’13 Jan ’14 Jan ’15 Jan ’16

All O�ceMid Town & West EndRest of UK

CityRest South East

London’s position as a global leading city and a key destination for foreign investors has seen a swathe of new schemes and ambitious projects come forward.The development response at the start of the current cycle was initially slow. This has contributed to the strong levels of rental growth we’ve seen in the chart above. In the last couple of years, development activity has accelerated considerably. There is now nearly 6 million square feet of office space due to complete in the City alone, in the next two years, with a further 6.8 million sq ft proposed, but not yet under construction.

LATEST TRENDS

On this page, we summarise some of the latest news and developments in the UK property market

The recent strong performance of UK Real Estate as an asset class has been well publicised. Data produced by MSCI demonstrates the track record over 1, 3, 5 & 10 years.Over a ten year period to December 2015, directly held, ungeared Real Estate has delivered an annualised return of 5.5%. This compares favourably with UK equities at 4.7% and just behind bonds at 5.6%.On a one, three and five year horizon property (both listed and asset level) has outperformed.

London is the powerhouse of the UK economy and this has been reflected in recent demand for Central London office space, from both property investors and occupiers.Over the last 5 years Central and Inner London office have delivered an annualised total return of 16%. Some of this performance has been driven by yield compression; however the majority has come from rising rental values. Since June 2014, the rate of rental growth in the City and West End markets has run in excess of 10% per annum.

Source: Cluttons Central London Office Report

Source: MSCI as at 31 December 2015

n City core n Old Street & Shoreditch

Source: IPD UK Monthly Index

REAL INSIGHTS • ISSUE FOUR • 3

15 Rathbone Place, London W1Royal London Property Fund (RLPF) developing in FitzroviaThe area to the north of Oxford Street and to the west of Tottenham Court Road is undergoing huge positive change ahead of the opening of Crossrail in 2018. RLPF is currently on site developing a 22,500 sq ft Grade A office building behind a retained façade, in order to benefit from this major infrastructure investment. Situated at the heart of Fitzrovia, 15 Rathbone Place is in a desirable location. The newly developed building’s fully renovated period façade brings classic architectural status to this modern development. Organised over five upper floors it boasts private terraces, outstanding views and design details that enhance the character of this development. A fully glazed ground floor ensures visibility from the street and excellent levels of natural light within.

The building is being transformed using of-the-moment architecture firm Buckley Gray Yeoman. The redevelopment contains balconies and roof terraces on the upper floors. The scheme is directly opposite Rathbone Square, the old Royal Mail site that Great Portland Estates is turning into a mixed-use scheme. In September 2015, Facebook signed for 227,324 sq ft of office space for 15 years at the GPE scheme. At the time of the letting, Robert Cookson, Facebook’s head of EMEA and Americas Real Estate, said of the new HQ: “This is a fantastic opportunity to occupy a high quality new development in the heart of the West End”. The location of 15 Rathbone Place has excellent amenities and connectivity, with the very best London has to offer right on the doorstep including Crossrail once it is established.

This image shows how 15 Rathbone Place will look upon completion, retaining the period façade. The development is scheduled for completion later in 2016. RLAM have appointed JLL and Edward Charles and Partners as joint letting agents on this exciting new project.

PAST, PRESENT,FUTURECommentary from our Head of Property

Hot PropertyLatest asset management activity in our portfolio

In contrast to the positive tones of his Autumn Statement, recent comments by George Osborne highlighted a “cocktail” of economic risks to the UK. Tension in the

Middle East, slowing growth in China and low commodity prices are all weighing on global confidence. So the year begins with a greater focus on the macroeconomic challenges ahead and a more cautious outlook than we might have anticipated only a few weeks earlier.

Despite this, sentiment in the UK property market remains comparatively upbeat. 2015 was a record year in terms of investment volumes, with transactions totalling over £70bn. Investment performance continued to impress. The IPD Monthly Index delivered total returns of 13.8%, which marked the third consecutive year of double digit returns.

Off the back of three strong years, pricing in many parts of the market does now look expensive, with yields approaching levels not seen since 2007. Capital growth rates slowed in the second half of the year, as sentiment cooled, but with yields on ten year UK government bonds at 1.8%, property continues to offer investors an attractive level of income, currently running at an average of 5.0%.

Furthermore, construction price inflation has hindered the development pipeline and many projects have stalled or been pushed back. Occupier demand remains healthy and a shortage in supply in the prime end of the market continues to push up rents, particularly in the Office and Industrial sectors.

Looking forward, the UK economic fundamentals in isolation appear to be holding up well. Latest PMI data would suggest that economic growth has moderated with the manufacturing sector continuing to struggle. In spite of this though, the labour market continues to impress and household incomes have grown in real terms, helped by low commodities prices and a supermarket price war, which shows no immediate signs of abating.

The first interest rate rise since 2007 could come this year, but we expect the pace and scale of monetary tightening to be slow and gradual. Indeed any decision may be put on hold until the Brexit referendum date and terms become clearer.

So in comparison to where we were in previous cycles, the current state of the property market appears to be more balanced and should continue to deliver positive performance in the near term. We are currently forecasting total returns for the year ahead of 7.5%, with momentum gradually slowing and income becoming the main driver of returns.

Gareth Dickinson


RLAM’S TRANSACTION RECORD FOR 2015 – wHAT, wHERE AND wHy?RLAM completed over £500m of property transactions during 2015. This follows two previous years of £277m and £540m respectively.

Transactions are driven by a number of factors – our overall view on the property market and the wider economic environment, whether the funds themselves are seeing inflows or outflows and lastly by asset specific issues (i.e. are individual properties at a stage of their life cycle which we believe is appropriate to exit and re-cycle the proceeds into new stock).

We undertake a regular cycle of Property Market; Forecast; Strategy and Property Level Business plan meetings to monitor these various aspects and to help shape our activity for both acquisitions and disposals. There were a number of over-riding trends which our analysis, forecast and strategy processes identified and which formed the backbone to our transactions in 2015. These were:

n A belief that certain sectors (especially within the Industrial and Office markets) would see rental growth and that capturing occupational demand would provide outperformance

One of our transactions involved funding a ‘speculative’ (i.e. vacant) industrial development near Stansted where the Fund will take all the letting risk.

We completed a similar purchase in Q3 2014 for an estate in Chessington. The estate is now fully let and the rents achieved on the final few letting’s were 10.5% above the rents we originally used to appraise the development purchase. The added advantage of these types of deals is that there should be a very attractive yield impact once the scheme is fully let up.

n Buyers seeking assets which could be converted to alternative uses, including residential or student accommodation would pay extremely strong prices, even without a planning consent in place.

We capitalised on this trend by selling a number of assets in Soho, Bristol and Manchester to buyers who were likely to convert these properties for alternative uses. All these assets were sold considerably in excess of their book value, as buyers paid premium prices for these opportunities.

0

100

200

300

400

£m

500

600Purchases Sales

2015(£508m)

2014(£277m)

2013(£540m)

360

180219

58

211

293

83% increase in transactions from 2014

Portland Street, Manchester

Vision, Stansted

Source: RLAM as at 31 December 2015


n Yield compression would plateau in coming years and that performance will need to come from active management rather than relying on inward yield movement

Centrum Retail Park, Cheltenham. This asset was particularly interesting as it comprises two elements - a retail warehouse park and a small multi-let industrial estate. Both elements are likely to lead to possible asset management opportunities as we look to potentially downsize some of the retailers on the park and change the use of other units.

Vision Park, Cambridge – we already own a number of office properties on the park and we sought to increase our holdings to both facilitate and to take advantage of the ongoing programme of asset management that was taking place on the rest of the park.

We also purchased two multi-let industrial parks in Welwyn Garden City and Basildon. Both of these estates offer the opportunity to actively manage the assets as we look to increase rents, extend lease terms or improve the tenant line up in order to create added value for the Fund.

Brunel House, Bristol

Centrum Retail Park, Cheltenham

Vision Park, Cambridge

Quadrant Park, Welwyn Garden City

Scimitar Park, Basildon

2 Soho Square, London


n Retail assets in poor towns and/or in weak locations would continue to struggle going forward but that there was still some investor demand for these types of assets

In terms of our sales, the strategy was to take advantage of the increased demand for secondary assets. Issue 3 of our newsletter had a special report on the significant success we had achieved by selling three portfolios (two of retail assets and one in Ireland) which tapped into this market.

Outside of the portfolio sales, the rest of the sales programme was centred on small lot sizes or assets where we had identified a special purchaser.

Mainly we completed single asset sales but we did offer a number of holdings at the same time to enable buyers to “bulk up” if they wished. Again, this proved attractive to the market place and we achieved considerable success with this approach.

Most of these sales were for assets below £5m and the locations ranged from York and Taunton to Glasgow and Cheltenham.

n We were happy to take a more “bullish” view on the lease lengths and look to buy shorter lease terms

Whilst one can achieve rental growth at rent reviews, to take full advantage of the movement in market rents, properties do need to be exposed to the letting market. Two offices, in Hammersmith and Reading were bought with relatively short unexpired lease terms (let to 2019 and 2017 respectively) but we believe that the open market rent is higher than the current passing rents. Exposing these properties to the letting market should allow the fund to capture the very strong rental growth which these office markets have shown.

Renfield Street, Glasgow

St. Sampsons Square, York Promenade, Cheltenham

Fore Street, Taunton

Argentum, Hammersmith


n There was an attractive “risk premium” attached to forward funding opportunities

These are arrangements whereby the Fund either agrees to provide capital to developers during the construction process and then take control of the asset or where there is an agreement to buy the asset once completed at a pre-agreed price – these assets can either be pre-let or “speculatively” developed. This “risk premium” rationale underpinned a pre-let forward funding opportunity in Tamworth that we completed in 2015. Even though the unit was pre-let, there was still a reasonable margin between the yield we transacted at and the yield that will be applied once the property is completed and income producing.

Leveraging our track record

The team were also extremely pleased that despite a considerable weight on money coming into the UK property market and fierce competition for assets, we were still able to complete a number of “off market” transactions. These are opportunities which are not fully exposed to the market. The advantages of these types of deals are that we can be a lot more focused on the transaction and the success rate for buying is much higher than when are competing with other buyers. We are approached for such deals due to our reputation for being quick decision makers, having a streamlined approval process and very importantly because we “deliver” on transactions. These attributes are valued by sellers who may not want to fully market assets for a number of reasons.

Summary

The over-riding consideration for our purchase strategy in 2015, as it has been over the past few years, was to buy quality assets in good locations. Whilst this may sound relatively straightforward, there are alternative strategies investors can pursue. The most obvious one, prevalent in recent years, has been to buy secondary assets and hold them as yields come in. Whilst this has short term advantages, one must be willing to sell before markets rebound and yields move out, as they inevitably will do for these secondary assets. There are clearly timing and trading cost issues with this strategy.

In summary, 2015 was a very successful year for the RLAM Property team – we identified a number of key themes and trends which shaped both our buying and selling decisions and we executed these strategies during the course of the year. 2016 also promises to be an active year and many of the themes of 2015 will continue into this year.

Kings Wharf, Reading

Cardinal Point, Tamworth


THE BIG PICTURE

As expected, the first quarter of the year has been relatively benign in performance terms. With the Brexit referendum fast approaching, market sentiment is understandably at a crossroads.

As well as London’s dominance, the industrial sector has been the success story of the UK market over the last three years. The IPD Monthly Index recorded total returns of 17.3% in 2015, slowing slightly from the previous year’s figure of 24.4%, but bringing the three year annualised figure up to 18.6%

The outlook for the sector remains positive. JLL have forecast that speculative industrial development could double from that seen in 2015. Recent activity would support this viewpoint. US investor Liberty Property Trust has signed a funding agreement to build out 1m sq ft over the next two years. One of our funds is due to commence work on a development in Hayes, with a planned floor area of 180,000 sq ft, due to complete towards the end of the year.

Schemes of this nature are highly sought after by occupiers. A shortage of good-quality stock remains, with low vacancy rates and the ongoing evolution of ecommerce that should sustain the current high level of occupier demand. We expect to see the rental value growth rate remain at around 4.5% next year. The pace of yield compression inevitably slowed over the course of 2015 and we expect this trend to continue into 2016. We therefore expect capital values to rise further, albeit at a more gradual pace.

A slowdown in manufacturing growth presents a risk to the demand side, particularly in the event of a significant reduction in global trade volumes. Nonetheless, we view the overall investment prospects for the sector to be relatively favourable.

The office sector was the best performing sector in 2015 with the IPD Monthly Index recording a total return of 18.2%. Capital values grew by 12.9% on average, driven by yield compression and an increase in rental values. Distinct geographic divergence remained, with London and the South East outperforming, but most regions saw total returns in excess of 10%, demonstrating the strength of the sector.

Sentiment in the first half of 2015 was buoyant continuing the trends from the previous year. Strong appetite from global capital saw investment volumes peaking, driving prices ever higher. By year end, the average office

equivalent yield was 6.0%, the lowest level since 2006. In Central London, yields are at all-time low, so on this metric alone the sector would appear stretched.

However, on the occupier side, the outlook is more favourable. Limited supply of good quality stock and robust occupier demand meant that at year-end the rate of rental growth was a healthy 8% per annum.

Strong employment growth and an increasingly urbanised population should underpin office markets in 2016. We expect take up to remain strong in London and the South East and regional markets, in particular core cities, to perform well.

Various economic measures would imply that the UK consumer is in a comparatively good position. A combination of low inflation, real wage growth and cheap mortgage rates has seen year-on-year retail sales grow for 32 consecutive months.

Given this backdrop, one might expect the retail sector to be in a bull market. However, in performance terms, the sector lagged behind, returning 8.9% in 2015. Retail never stops changing and that has been particularly true in recent years. Technology will continue to create new sales channels and influence retailer business models. Shoppers have become far more discerning and prefer destinations that provide leisure as well as retail. At the same time, luxury retailers and global brands compete for the prime sites. Demand for physical space is amplified in core locations, but we’ve seen demand stagnate and

structural oversupply in many high streets.

There are other headwinds on the horizon: business rates revaluation is due to occur in 2017. There will be winners and losers. It will have an effect on profit margins and likely lead to store closures in marginal locations. The national living wage could impact on the profitability of low cost operators. Nonetheless, our outlook on the sector remains one of cautious optimism. The changing dynamic will present challenges but also provide opportunities particularly given the polarised state of the market. Assuming the UK economy remains on track, we expect high quality schemes, retail parks in good locations and prime shopping centres to perform well. The high street will become more fragmented, so stock selection here will be critical.

OFFICES

RETAIL

INDUSTRIAL

James OrrHead of Industrial

Keith MillerHead of Offices

Drew watkinsHead of Retail


1

3

2

Source: RLAM as at 31 March 2015

LEASE RE-GEAR 68-72 MARKET STREET MANCHESTER

RLAM have recently completed a lease re-gear across 41,000 sq ft of prime retail space in Manchester. The collapse of Phones 4 U Limited left a vacant unit at 72 Market Street which comprised 5,200 sq ft across basement, ground and three upper floors. The space was widely marketed and several competitive offers were received for the unit in isolation. However the funds adjoining ownership unlocked an opportunity to create additional value. The adjoining unit was occupied by an international fashion retailer known to trade successfully from this location. RLAM identified that maximum value would be extracted by merging the two units and incorporating the vacant space within a wider re-gear. This resulted in a new lease being secured with the existing occupier across the whole of 68-72 Market Street. The improvement in covenant, increased income and lease term generated a significant p o s i t i v e m o v e m e n t in value.

1

LETTINGCOMPASS BUSINESS PARK, CHESSINGTON

Royal London Property Fund (RLPF) successfully concludes the last letting at Compass Business Park, Chessington. Following the purchase of this new high quality development in Q3 2014, RLPF has now secured the final letting of 31,000 sq ft to Selco Trade Centres on a new 15 year lease at an annual rent of £377,000 pa. Selco now sits alongside the previous lettings to Hermes Parcelnet and Ilecsys Ltd, provide a total rent for the property of £650,831.

The strength in the tenant line up demonstrates the demand for excellent quality industrial accommodation in the south east, with good transport links, which is offered by the Chessington site. The quality of the property will also provide for future rental growth prospects from the current rental level. As a direct result of the final letting, the property has delivered a capital increase of over 34% to £12.1m

3

DEvELOPMENT CARDINAL POINT, TAMwORTH

Over several years RLAM has managed to undertake the comprehensive development of a large site close to Ventura Park, Tamworth. Following a prolonged planning application and appeal process a retail consent was finally achieved, and an 80,000 sq ft retail park constructed. Elsewhere on the site, a car showroom was developed for the Volkswagen Audi Group, and the final stages of the development are now about to be completed with the construction of two car showrooms for the Sytner Group, for BMW and Mini. These showrooms extend to 57,000 sq ft and 15,000 sq ft respectively, and are the latest design and fit out to showcase the range of cars. With competition from retailers to gain representation on the retail park, and ‘state of the art’ car showrooms occupied by high

quality motor traders, the development has been a great success both financially, and in serving the needs of the local customer base.

2


The growth in online retail sales has driven significant new demand for logistics real estate. This demand requires a variety of different types of logistics facilities, including fulfilment centres, sortation centres, cross-dock facilities and processing centres for returned items. Multi-channel retail is evolving into omni-channel retail to provide a fully integrated seamless customer shopping experience. With omni-channel the role of shops and warehouses is becoming blurred.Retailers, parcel operators and logistics companies along with developers and investors need to stay ahead of the curve and be responsive to this change in order to optimise their respective strategies and get best value from their logistics real estate from an operational or financial return perspective.Developers need to focus on acquiring appropriate sites and building up strong relationships with key retailers, logistics companies and parcel operators.Investors in the industrial sector need to understand how online and multi-channel supply chains work in order to understand the function of the warehouses that support these and what this means for specification, location and investment performance prospects.

Parcel hubs: A key driverParcel hubs are typically specialist warehouse facilities designed to facilitate rapid through-flow, as opposed to storage. These networks are organised as hub-and-spoke systems, where the main hub functions as a sortation centre, receiving orders from local spokes, sorting them by end destination and dispatching them to appropriate local spokes for onward delivery. These sortation centres are typically long, thin, low rise warehouses, with docks along two elevations and large external yards, and are often between 10,000 sq m and 20,000 sq m in size. The process of sortation is usually highly automated. The local spokes which act as points for local collection and delivery are similar in specification to the hub sortation centres, although smaller in size, at around 5,000 sq m. From a location perspective, local parcel spokes require good proximity to major population centres for final delivery, and hence are typically found in, and on the edge of, major urban areas. The demand for these facilities, and the large sortation centres, is increasing significantly in line with the growth in parcel volumes, representing an important opportunity for new development as can be seen with occupiers such as Geopost driving the market in this area.

THE CONTRIBUTORS

Insight into...

Impact of internet on industrial markets

Gareth DickinsonHead of Property

Gareth is Head of Property at RLAM. He has overall responsibility for the Department’s funds and processes whilst retaining responsibility for a number of assets in the South East and regional office portfolio.

Drew watkinsHead of Retail and Senior Fund Manager – The Royal London Long Term Property Fund

Drew is the portfolio fund manager for the Royal London Long Term Property Fund and heads up the Retail team with a particular specialism in retail warehousing.

James OrrHead of Industrial and Senior Fund Manager – The Royal London Pension Property Fund

James is the portfolio fund manager for the Royal London Pension Property Fund and heads up the Industrial team.

Keith MillerHead of Offices and Senior Fund Manager – The Royal London CIS Property Fund

Keith is the portfolio fund manager for the Royal London CIS Property Fund and heads up the Office team, with a particular specialism in the Central London office market.

Tim GreenwayProperty Researcher and Financial & Performance Analyst

Rachel HoltSenior Asset Manager

Tim is responsible for providing research and forecasting support to the fund managers. He is also responsible for coordinating fund reporting and performance analysis across the team.

Rachel is a Senior Asset Manager specialising in retail properties across a number of Royal London Funds. Her role is to actively enhance the cash flow profile and value of these assets.


In thepicture...Eden House, London w1Located opposite Spitalfields market, this building was redeveloped by RLAM in 2008. Comprising office space across five floors, the building is fully let.

Issued by Royal London Asset Management March 2016. Information correct at that date unless otherwise stated. This document is for professional customers only. The views expressed are the authors own and do not constitute investment advice. Royal London Asset Management Limited, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, registered in England and Wales number 2372439. RLUM Limited, registered in England and Wales number 2369965. All of these companies are authorised and regulated by the Financial Conduct Authority. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London, EC3V 0RL. The marketing brand also includes Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central

Bank of Ireland, registered in Ireland number 364259. Registered office: 70 Sir John Rogerson’s Quay, Dublin 2, Ireland. Ref: 262-PRO-03/2016-CH

CONTACTFor further information about any of

our products or services, please contact:

Royal London Asset Management 55 Gracechurch Street London EC3V 0RL

Tel020 7506 6754

Fax020 7506 6796

[email protected]

www.rlam.co.uk

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Real Insights Issue 4