THE UK investment market is easily Europe's most efficient property market. It may not currently match the staggering returns witnessed recently in the Irish market but with long-term lease contracts of 15 years and over including five-yearly upwards-only rent reviews, full repairing and insuring terms and strong covenants, it represents a safe haven for the cross-border investor.
Total returns on UK property, as with many European property markets through the 1980s and early 1990s reflected the historically cyclical nature of property performance.
The tail end of the 1980's represented the peak of the commercial property cycle (15 to 30 per cent p.a.) with the early 1990s very much the trough (negative returns of 2 to 8.5 per cent). Returns picked up through 1993 and 1994 but dipped again in 1995. Currently, the UK is experiencing for the first time a stable property market averaging 12 per cent per annum total returns for the last three years and predicted to deliver 12 to 14 per cent per annum total returns for the next five years.
This stability is very much a reflection of positive economic growth and low inflation, with Bank of England's responsive monetary policy a key factor in removing the boom bust shape of the traditional property cycle.
Rental growth is a factor of demand and supply for space with capital growth derived from yields and interest rates.
The demand for space on the back of the positive economic outlook for the next five years looks promising. GDP growth is expected to show trend performance at 2.5 to 3 per cent per annum, unemployment is falling and the rolling inflation target of 2.5 per cent is a rate set to stimulate but not overcook markets. These factors combined with the responsive monetary policy and the emerging confidence of the personal and business sectors in the UK, should ensure continued demand from occupiers for property.
On the supply side, across the sectors, the scene has changed dramatically from the massive over supply of the early 1990s. Now, limited availability of space across the sectors is being matched by a limited development pipeline caused by restrictive planning policies and less speculative funding by banks.
Rental growth forecasts for the next five years range between 3 and 8.5 per cent per annum depending on location and sector, with the greatest expectation for growth attaching to London's West End offices.
Capital value growth should be driven by greater expectations of rental growth and a shift in yields on the back of anticipated lower interest rates for the UK. Interest rate convergence across Europe would suggest that Euro rates and UK rates will meet somewhere between their current respective levels and the historically wide gap, currently at 2.5 per cent, between average property yields and UK long term gilts, will be narrowed in property's favour.
Interest rate increases in the UK, particularly in the cost of three to five-year money, are proving expensive for the traditional debt driven private property investor.
However, the very economic growth that is happening and forecast for the next five years and is itself the driver of demand for property, is fuelling the increases in interest rates. In other words, the news is good for property performance.
Generally speaking, house prices are increasing and consumer expenditure, which accounts for 40 per cent of UK GDP, is strengthening. Manufacturing and export businesses particularly, which have been dragging the strong performance of the services sector, are becoming accustomed to working in the environment of strong sterling.
Notwithstanding the higher interest rates, the property market continues to strengthen with institutional investors particularly, who are less sensitive to interest rates, driving demand. We are increasingly finding that with greater expectations for rental growth, institutions and private investors using longer term money (seven to 10 years), are continuing to buy. Their demand is augmented by demand from overseas investors attracted by the strong fundamentals of the UK property market.
Although the euro, and by implication the Irish pound, are anticipated over the next couple of years to appreciate against sterling, the weight of money for investment into the UK by euro denominated investors suggest that property performance is expected to far outweigh potential losses from the depreciation of sterling.
The exchange rate risk is also considerably less for the geared investor whose equity is the only part of the purchase price exposed to exchange rate movement. To protect this element of the investment, many Irish investors are arranging 100 per cent finance in sterling with the top slice of about 25 per cent supported by a back-to-back deposit in Irish pounds.
The Irish investor into the UK is less initial yield driven and more long-term growth driven i.e. they are prepared to buy at prime yields.
Conclusions
Stable economy with growth trending upwards
Short term rising interest rates, longer term falls
Downward yield shift in progress
Investment demand strong from domestic and overseas buyers
Real rental growth forecast
Attractive low risk real returns
Liam Lenehan is International Investment Director of Hamilton Osborne King
