Quarterly Investor Report
Economy & Strategy
Keills Property Trust | 30 September 2015
From our office in Glasgow, the third quarter of 2014 was dominated, in the UK at least, by the Scottish Referendum. The result is now known, giving a degree of certainty. Initially the markets were slow to show any interest and it was not until a Sunday Times poll on 7 September, that the Westminster parties decided that maybe there was a chance of a Yes vote. A flurry of activity ended with the former Prime Minister, Gordon Brown, putting forward a ‘devo max’ type proposal and associated timetable, signed by all the main parties, and days later, Better Together won by 10 clear points.
As investment managers we seldom comment about politics but here we are compelled to say that this time was different. With a record 85% turnout for a UK plebiscite, the people had spoken and clearly there was an expectation of change. Ten year gilt yields reacted by falling to less than 2.3% shortly thereafter as opposed to over 2.5% in the run up to the vote.
In truth, the UK should have other things to worry about. Debt levels are continuing to rise and the first expected fall is not until 2018 or 2019. This makes the UK the second most heavily indebted nation on the planet (behind Japan). Our other mantras of the forthcoming pension crisis and escalating healthcare costs, do not look like going away at all and, there is an increased risk that economic growth in Europe, will act as a drag (or should that be a Draghi?) on the UK. Deflationary pressures in Europe certainly mount. Markets are increasingly concerned that we could be in for a post 1990 style Japanese economy of low growth, with dips in and out of deflation.
Domestically, economic growth has been revised upwards, reflecting continued strength in particular from the services sector. Retail is again suffering. People do not have extra cash to encourage spending and it looks like the supermarkets, led by Tesco, are heading for a full-on price war, to retake sales back from the ever more popular discounters, like Aldi and Lidl. The market expectation is that Tesco will have a significant rights issue, although one has to ask, what will it use the cash for? If it is simply being used to enable cheaper prices while the dividend is suspended, then investors aren’t going to buy that. It would appear that Tesco needs major surgery and it will not be alone. We feel that generally, the retail sector is currently un-investable until there is more clarity. While businesses come and go, there are still more leaving than new arrivals and this quarter alone saw the demise of Phones 4 U, Athena, Internationale and La Senza. The internet remains a very powerful force and combined with over supply of supermarkets, would suggest that only the brave or those with excellent management such as Next, will deliver. Whether this means that landlords will benefit is a moot point. We think not.
The office sector remains patchy outside the London and South East. There, supply constraints are forcing up rents, with strong growth in the West End and City markets. Best prime City rents exceed £70 per square foot, a level not seen since 1988. West End rents are around £120 per square foot for the best space, which is roughly in line with its more recent all-time record. New companies, especially in the Technology, Media and Telecommunications (TMT) sector, find working together in a village atmosphere is appealing and conducive to output. It is for this reason that former fringe areas like Old Street, Clerkenwell and Farringdon have seen the biggest percentage increase in rents. One concern that we (and others) have, is the difficulty of recruiting staff, combined with the quality of housing that these people must suffer. In the regions, the picture is quite different. Although many do feel more optimistic, positive decisions about business expansion remain rare and in property terms, there is very little new development. We have recorded before that Aberdeen is an anomaly and the boom continues with Aberdeen office rents now the most expensive in the UK, outside Greater London. Anecdotally, this takes us back 30 years. At that time, the pattern of rental levels was the same in the UK with Aberdeen again sticking out as an expensive outlier. When the oil prices collapsed to $4.50 per barrel in the late-mid 1980’s, Aberdeen’s property market acted like a rabbit caught in the headlights for 18 months, then the reality kicked in with a sudden price adjustment, downwards.
London boomed when Chancellor Lawson introduced the end to double tax relief on mortgages in August 1988 (MIRAS). At the same time, the Sunday Times had a double page aerial photograph of Lee Crescent North – part of a new housing estate in Aberdeen, where owners were handing back the keys to their lender, as the value of their house plummeted below the level of their mortgage. Negative equity was born.
Cash pressures on business continue apace and property is always a focal point for any savings because of the high capital intensity. Operational property, such as factories and warehousing, is a perfect example of this and the property market calls this industrial property. Manufacturing is returning to the UK, but not in a big way and is currently being hampered by the strength of Sterling. In terms of ‘value add’, the UK still seems to excel at the early design stage of business innovation, the intellectual bit, rather than churning out physical things. But, we still need to transport and store goods around the country and the warehousing sector, combined with much better use of technology, has transformed this sector over the last 15 years or so. Generally, the trend has been to flexible, large, well located units which as far as the supermarkets are concerned, are 24 hour operations. Better home food delivery may reduce demand from the very large supermarkets for retail stores and perhaps some of these will be converted into so called ‘dark stores’, running 24/7 with an army of vans delivering locally. Building a state of the art warehouse is not cheap, but much of the investment comes in the fit-out and over time, rents have been fairly flat. We see much the same moving forward, with the main driver of demand being larger unit consolidation, with new technology often being the driver.