Commercial Property News and Comment
Uk investment commentary
Growth boom 2004 with growth forecast to continue into 2005
2004 proved to be a boom year for the global economy with growth of 4.7% driven principally by the US and China. 2005 is set to herald a slowdown in the world economy although above trend growth is forecast to continue in the UK. The success of the global economy is reflected in the revenues of British companies overseas income which totalled 23 billion in 2004, although as growth rates slow there is likely to be a downturn in UK companies overseas income. Sterling remains strong although this has not impacted significantly upon the balance of payments.
Following the four separate rises in interest rates and the cooling of the housing market in 2004, household spending is unlikely to be the driving force behind the economy as it has proved to be in recent years. The UK remains one of the leading European economies with annual growth of 3.25% in 2004.
Economic performance across Europe was mixed in 2004 with France continuing to struggle following a slowdown in consumer activity recording 2.5% growth for the year and Germany recording marginal growth of 1.4%. Ireland continues to enjoy one of the strongest rates of growth within the Eurozone with GDP of 5.0% for 2004.
The UK manufacturing sector demonstrated considerable resilience and registered growth in Q4 2004, although with MG Rover going into receivership prospects for Q1 2005 appear less positive. However, the construction and finance and services sectors continue to boost output figures. Interest rate sentiment has changed considerably in the opening months of 2005 although whether or not rates have peaked in their current cycle remains debatable. The Chancellors Budget in March proved rather more prudent but no less populist than expected. Taking into account the General Election scheduled for the 5th May there were dividends for pensioners combined with a slight tightening of fiscal policy.
Inflation UK inflationary environment remains benign
The UK inflationary environment remains benign although fears persist that further rises may be in the pipeline. The latest UK consumer price figures confirmed that underlying pressures in the high street remain subdued. The CPI has stood at 1.6% for three consecutive months and remains comfortably below the Governments target level of 2.0% despite fears in the market of increases in the future. Both the RPI and RPIX remained unchanged at 2.1% and 3.2% respectively. The majority of upward pressure has been derived from the transport sector, broadly reflecting higher oil prices with the counter balance from a fall in the costs of core goods such as furniture and household goods. The figures suggest that high street retailers are continuing to absorb the rise in producer output price inflation due to concerns over fierce price competition on the high street.
The labour market remains relatively tight with wage costs rising close to 4.5% and producer prices increasing at their fastest rate in eight years. With a forecast slowdown in China, combined with confirmed higher OPEC quotas, oil prices should ease in 2005. This would have a considerable effect on reducing inflationary pressures on producers in the UK and help maintain the CPI below its target level over the next two years.
Unemployment remains low although inflationary wage pressures ease
The unemployment rate in February 2005 remained static at 4.7% for a second consecutive quarter, having last fallen by 0.1% in July 2004. The claimant count unemployment fell by just 700 in February 2005 while the wider ILO measure registered an increase of 22,000 in the three months to January 2005.
Despite the conflicting figures unemployment remains at historically low levels and this was consolidated further with an increase of 127,000 to the workforce.
The headline growth of average earnings for January 2005 totalled 4.4%, although most of this increase was due to the end of year bonus effect. Stripping out the bonus effect the annual growth rate dropped from 4.5% to 4.2%, its weakest since July 2004, reducing fears of mounting inflationary wage pressures.
Overall employment growth remains strong and the bonus effect aside, wage growth levels appear to be easing, reducing the pressure on the MPC to increase interest rates due to inflationary wage pressure.
The service sector continues to experience considerable growth with strong performances from the financial services and ICT sectors. This trend is projected to continue throughout 2005.
The service sector growth for Q4 2004 rose 0.9% compared to Q3 2004 demonstrating continued strength in this increasingly important element of the economy. Finance and Business services remain one of the strongest performing sub-sectors with growth of 4.6%.
Februarys CIPS report on services confirmed that the sector continues to grow relatively strongly. The business activity index remained above Decembers level and suggests quarterly service output growth in Q1 2005 of approximately 0.8%, only marginally below the 0.9% recorded in Q4 2004. There was a slight fall in the new business index which was more than compensated for by a rise in outstanding business.
The employment index fell for the third consecutive month and figures suggest that while the labour force continues to expand, rising costs are leading firms to become increasingly wary when replacing staff.
Overall information from the latest surveys on the service sector for 2005 suggest that growth remains robust. The sustained growth in the service sector continues to impact positively upon the UK office market as demonstrated by improved total returns and recovering rental growth figures. The improvement in the office market is illustrated by the M25 vacancy rate which has continued to fall for the fourth consecutive quarter in Q4 2004 and stands at its lowest level since December 2002.
Regional office markets continue to enjoy positive market conditions in line with the improving economic sentiment in the UK. Key regional centres have experienced stable volumes of demand within the office market helping maintain vacancy rates in single figures while letting activity remains resilient. Moving forward in line with improving sentiment rental growth is set to return to the majority of office markets in 2006.
Investment performance continues to remain extremely strong bolstered further by increasing demand for product, particularly in London and the South East. Office total returns over the 12 months to February 2005 were up to 14.1%, their highest level in 4 years; however, returns are still being hampered by negative rental growth. The improved prospects for rental growth will continue to attract investors to the sector.
Yield compression has continued for both prime and secondary opportunities in the M25 investment market. Investors from all sectors remain active including UK and overseas institutions, private individuals and property development companies. Prime office yields for well let opportunities are now in the order of 5.75% - 6.0%.
The strong demand and relatively tight supply of opportunities is resulting in an increasing number of direct approaches to freeholders, particularly where buildings have recently witnessed leasing activity.
Increasingly, land development opportunities are attracting interest, driven by an improving occupational market sentiment and an increasing weight of money being targeted towards the sector.
Latest figures suggest the slowdown in the underlying rate of retail sales experienced at the end of 2004 has continued into 2005. The volume of sales for the three months up to February 2005 was 0.6% lower than in the previous three months, the lowest level since March 2003. Over the three month period the only sector to enjoy sales growth was food while all other sectors experienced a decrease of 1.7%, the lowest for non-food stores since 1992.
The British Retail Consortiums Sales Monitor figures for February re-iterate that consumer spending growth remains in decline following a disappointing performance in December 2004. These statistics will be noted by the MPC who voiced concerns in the February Inflation Report over a sharp slow down in the housing market and consumer spending as a reason for not raising interest rates. Latest data would suggest that consumer spending has weakened to a certain extent although the housing market remains stable. As the rate of growth of consumer spending falls this will become an increasingly important factor for the MPC when considering a possible interest rate change.
The underlying rate of retail sales continues to decline in 2005 and the retail property market may have also peaked. All retail returns appear to have peaked at 21.6% in January 2005, and despite having fallen to 21.5% over the 12 months to February 2005 continue to significantly outperform total returns for all other sectors over 1, 3, 6, 12 months, 3 and 5 years. Retail returns remain high largely due to sustained rental growth.
Manufacturing output increased by 0.6% in Q4 2004 reflecting an unexpected upturn in the sector, although with the MG Rover plant going into receivership prospects for Q1 2005 appear less positive.
In contrast to consumer spending, Q4 2004 figures mark a marginal increase in the rate of growth contrary to many market expectations. The latest CBI industrial trends survey suggests that the recent upturn in the official manufacturing data may not be sustained and that external demand may not be able to fully compensate for the slowdown in household spending growth. The UK export market remains hampered by the high price of sterling, however, the value is forecast to fall later in the year which should aid international competitiveness.
Transport storage and communication was one of the high growth areas in the economy during Q4 2004 and this may to help to explain to a certain extent the sustained growth in demand for distribution and warehousing space, as retail led requirements form a substantial proportion of all demand for industrial property.
Against this background industrial property returns continue to increase. In April 2002, annualised industrial returns were 8.0%, since then returns have steadily improved and over the 12 months to February 2005 stood at 17.8%, the highest level since June 2000. Greater returns have been largely due to the relatively high income return that the sector offers. Income return stands at 7.5% which bodes well for the sector given that the income return which the sector offers is set to play an increasingly dominant role in total returns as the role of yield shifts continues to decline. Notably the industrial sector offers the highest income returns over 3, 6, 12 months and 3, 5, and 10 years.
Source: Knight Frank - Spring 2005