A focus on income
Recent performance from UK property compares favourably against other asset classes, largely owing to its steady income return. The UK real estate market has continued to deliver positive annual returns since the final quarter of 2009, although returns were more muted over the year to March amid the wider economic slowdown. The income return from property has remained consistent, and we expect it to dominate future returns.
Brexit's effect on the UK property market is a complex issue. Investment volumes held up through 2017 and 2018, although they are 40% below the long-term average so far this year, owing to the extension of the deadline for the Brexit withdrawal agreement and ongoing political uncertainty.
However, we believe that to some extent the Brexit effect on occupational demand has been overplayed. Retail, for example, is facing bigger structural issues than Brexit with the growth of e-commerce. Although a minority of retailers have seen profit margins impacted by rising import costs linked to currency movements, overall consumer spending is (perhaps surprisingly) healthy, and retail sales are overall positive.
The impact of Brexit on the offices sector is nuanced, with Brexit considerations playing out in different ways. Central London's strength has surprised to the upside, with city offices outperforming in 2018. Although rental growth is currently subdued, take-up reached 25% above the long-term average over 2018, while void rates remain well below 10-year averages. Across the house, leasing activity at our London office assets has remained strong.
Retail – stock selection is key
The past 18 months have seen a raft of retailers hitting the headlines, with administrations, profit warnings, store closures and CVAs dominating the sector's outlook. The impact is being felt most in shopping centres and department stores, although high streets and retail warehouses are not immune.
Retail sales are positive but the historic relationship between retail sales and retail rental growth has faltered. Online penetration, particularly for non-food items, as well as rising business rates and labour costs, are all factors.
The key to preserving value within retail is stock selection and asset management. We have no exposure to shopping centres or department stores, which are witnessing a severe fall in value. While across the house we have exposure to the high street, these assets are in centres with strong underlying fundamentals, which could help provide an effect defence to the growing presence of online shopping.
We also hold a limited number of retail warehouses, which have historically outperformed town centres, although more recently the sub-sector has also suffered from the structural issues facing retailers. The sub-sector continues to face challenges, including tenants' increasing preference for smaller store sizes, rendering many older large-format stores obsolete. However, retail warehousing can play a role in the multi-channel offer, offering locations for click and collect and showrooms, or their use can be expanded to include food and beverage, health and leisure facilities to widen the pool of potential occupiers.
Industrials – growth but not all va-va-voom
The industrial sector has been the star performer of UK property, owing to strong capital growth off the back of yield compression and positive rental growth. As a house, we hold a relatively high average weighting to industrials and logistics, and while the market has been buoyant, we have successfully captured rental growth and increased the values of these assets. We believe there are still strong prospects for rental growth in industrial assets, particularly for urban logistics in areas where the land supply is constrained.
However, it is important to exercise caution on overexuberance – current yields are not cheap and occupier demand for very large big-box units is thin, particularly in more bespoke locations. The UK car industry is facing continued issues as production fell for the tenth straight money in March following declines in both domestic and international demand, which could have a knock-on effect on localised occupier demand for industrial units. On the other hand, the growth of online commerce, a key driver in logistics take-up in recent years, looks set to continue, supporting sustained occupier demand in this sector.
The future of offices
In addition to Central London, regional offices also performed well last year. Town and city centres saw rental growth due to low levels of supply and increased take-up not only from the new government hubs but also form the banking sector. This picture looks set to continue as levels of office development remains low across the regions, keeping supply constrained.
The key theme running through the sector is what the future will look like. Occupiers increasingly seek accommodation offering high-quality amenities and flexibility that suits the needs of their business. The growth of serviced offices is partly in response to this changing demand; Central London serviced office stock has increased 2.7x since 2007, and WeWork is now London's largest private occupier. Serviced offices are not suitable for all occupiers, but the ease of occupation is appealing to smaller businesses. For larger companies, serviced offices offer a solution to requirements for flexi space.
As owners of more traditional office space, we are adapting to respond to changing occupier needs by offering fitted “plug and play” space with an emphasis on design and amenity, and delivering and expanded service culture.
Location will also become key to future success in the office sector, both in London and the regions. The more traditional office locations of the City and West End have been replaced by a widening of the London market, fuelled by transport improvements and the growing important of connectivity. In the regions, hubs are emerging around universities and technology research centres creating new office districts, such as the Oxford-Cambridge-Milton Keynes corridor, where growing occupier demand supports infrastructure development and future rental growth.
- Income dominates future positive returns
- Brexit has dampened the cycle – headwinds continue
- Retail is severely challenged – stock selection is key
- Industrial is the star performer but caution on overexuberance
- Offices – landlords must not offer flexibility and increased amenities
The value of investments can go down as well as up and investors may not get back the original amount invested.
At BMO, our aim is to help our clients overcome the challenges they face and deliver the investment outcomes they seek. We've been helping clients with their financial needs for over 200 years.
A lot has happened since 1817, including the launch of the world's oldest collective investment fund vehicle - F&C Investment Trust over 150 years ago. This fund made investing more accessible to individual investors and we are proud to still manage it today.
We currently manage 10 Investment Trusts, providing a range of investment opportunities including access to equities, bonds, property and private equity. Each trust has different aims and objectives with the option of capital growth, income or a combination of the two and with a specific regional focus or with a global remit.