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UK commercial property not yet past its prime

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Stephen Rees, Head of Real Estate at Coutts, comments on the prospects for UK commercial property…

In a world of rock bottom interest rates, the high yields of UK commercial property have captured the attention of income-starved investors. But with initial yields (annualised rents expressed as a percentage of property value) now below 5.5% and possibly falling further, has the asset class had its day in the sun? We remain positive on UK commercial property – though it might be more realistic to expect rental growth to play a bigger part then initial yields in determining total returns. And asset selection will be even more important in 2015.

History suggests that we’re not far off the bottom of the yield cycle for commercial property. Yet in an unprecedented era of prolonged low interest rates – with the UK base rate unlikely to rise until 2016, at the earliest, in our view – the paucity of alternatives mean investors in search of yield are likely to consider commercial real estate assets. Against such a backdrop, who can say that initial yields won’t slide lower still?

But while yields may play less of a role in determining total returns, we believe rental growth will take up the slack (as we highlight in the latest Real Estate Perspective). As economic growth in the UK spreads – underpinned by rising wage growth – we expect to see prime office rents rise across regional city centres this year. Overall, prime headline rents in Manchester are expected to reach record highs of GBP34 per square foot by the end of 2015 – a 10% increase over the year.  Meanwhile, analysts predict office rental prices will inflate by more than 5% in Bristol in 2015, getting closer to a GBP30 per square foot threshold, with prices driven up by limited supply.

Indeed, in our view, a lack of supply at the prime end of the market will add further upward pressure on rental growth. And unlike residential property leases, commercial property has traditionally contained clauses dictating that rent reviews are ‘upward only’ or at least linked to an inflation index.

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