Quarterly Investor Report

Economy & Strategy

Keills Property Trust | 31 December 2014

 It is fair to say that markets in 2014 did not behave as expected.  The principal asset class which refused to comply with the stated wisdom was fixed income, in particular Treasuries, Gilts, and Bunds.

10 year gov bonds

Source: FT

Many commentators were pointing to the end of QE, particularly in the US, as being the trigger for yields to rise.  Throughout the year, there was indeed much guidance from the US Treasury on how it would tip-toe forward and the term “taper tantrums” was coined.  Yields were volatile, but fears over growth outside of the US, in particular the Eurozone, have convinced investors that deflation may win the first round of the inflation/deflation conundrum.

Inflation in Germany for example, is at a 5 year low at 0.6%, compared with 1.0% in the UK. The more recent fall in the oil price means that deflationary pressures will increase further in 2015.  We wonder whether the benefits of lower oil prices to consumers and oil importers have yet to be fully priced?  The effect is much like a huge global tax cut and consumers will benefit from more cash in their pockets.

Inflation deflation

Globally, economic growth picked up in 2014, with China leading (some argue that it is now the world’s biggest economy) followed by the US and some way behind, little old UK.  The Eurozone weakened while in Japan, major efforts to boost that economy by Prime Minister Abe, continued.  Japan remains the world’s biggest debtor nation and that, together with its ageing population, means that digging the hole deeper in the hope that a sustained recovery will emerge, is risky.  We are of the view that this debt problem won’t be sorted out with more debt.  Japan is set for a (very) long period of poor growth and investors should be cautious.  These thoughts underlay our view on Europe where, again, the QE experiment is yet to be effected in full.  Greece for example cannot cope with its existing debt level, so increasing debt further doesn’t make much sense.

China’s managed growth also suffers from too much property related debt and pessimists would argue for a sharp property correction, which could have immediate implications for Chinese banks.  Any risk that US Treasuries (held widely as China’s foreign exchange reserves) could be sold to support more domestic concerns, may have widespread global repercussions, at a time when QE may finally end.

In conclusion, there are a number of serious issues on the world economic stage and it is far from clear how things will turn out.  We remain of the view that this period will become known as the “Great Muddle Through” and that it will last for longer than many expect.

The UK economy

The first half of 2015 is likely to be dominated by the General Election set for 7th May.  2015 has seen all political parties respond to the firing of the election starting pistol.  At this stage it is not obvious which, if any, party will gain a majority.  The outcome is so uncertain that some commentators are even suggesting that we may ‘enjoy’ two general elections this year!  What will not change is the level of debt in the economy and the need to work at getting this down.  There is little scope therefore for politicians, of any colour, to adopt anything other than a “steady as she goes” policy.  Yes, there may be tinkering at the edges but we don’t expect much else.

As we know, yields on other asset classes, especially bonds, have fallen significantly since the Global Financial Crisis.  We are now considering whether property yields will continue to fall if yields on other assets fall too?  We have said before, that the current global economic picture, is very different to the experiences gained by investment managers throughout their working lives.  The problem with debt crisis is that typically, they only arise every couple of generations or so and therefore, investors must learn again.  Happily, the printed word has been around long enough that several good books, which set out the history of the last serious credit dislocation in the 1920’s, allow us to learn from that era.

The biggest surprise learned, is the length of time taken for “normality” to return.  Simply, it took much longer than everyone thought and our feeling about the current position is, that it could possibly be even longer this time.  While debt levels are still rising, if interest rates are also to rise, then the threat of some kind of major dislocation remains very real.  As a result, we don’t think interest rates will rise for many years to come and certainly not before debt levels start to fall.

With this outlook for interest rates, investors seeking income (and more will as pension funds mature) are forced to look out further along the yield curve, resulting in long dated yields also remaining low.  Note that deflationary pressures in Europe, in spite of the stopping of QE in the UK at £375billion, have already caused bond yields to reduce.  Will we see yet another dose of QE?

Given the above, investors seeking income need to look elsewhere.  The UK dividend yield is circa 2.8% and with gilts currently showing 1.6%, UK property at c5.4% remains an important supplier of yield to investors.  Total return for property for 2014 was c20% and this will have done nothing to diminish property’s attractiveness.  Some investors may decide to take some capital ‘off the table’ but, on balance, we forecast that the sector will attract further investment, driving yields lower.  Both main political parties are committed to reducing the deficit, so we cannot see any reason for policy relaxation.

UK Property

Continued economic growth (expect 3% for 2014) resulted in modest tenant demand and rents rose overall by circa 2.5% according to the Monthly Index of the Investment Property Databank.

retail value index


London dominated activity in terms of rental growth, with City and West End growth being particularly strong, driven by demand and reducing supply, as some offices are converted into residential, and this is expected to continue.

west end city
Source: Colliers

* It is believed a rental deal of circa £83 per square foot (psf) has been achieved on a high floor of “The Cheesegrater” in the City of London

Outside London and the South East, tenant demand is weak and business confidence is not sufficient to justify major property commitments.  Companies are using up spare capacity and we believe it will be sometime yet, before companies invest for growth.  We expect that the pressures on rents to grow will abate and investors will focus on the sustainable income returns from property.  Thus, 2.5% may be the peak rental growth rate for this cycle.

The other component of total return is the income return or yield.  A table setting out yields is set out below:

income yield
Source:IPD Monthly Index November 2014

We have examined the data from an historic perspective and determined that, according to IPD, yields now are the lowest they have been on record.  Yields vary for a number of reasons.  The comparison with other asset yields, interest rates, the cost of debt and the prospects for both capital and rental growth in the property market itself.  The point we would make is that this time is different.

One of the best ways to examine how the property market reacts to change, is to look at the very prime end of the market.  In particular, new properties requiring funding.  Developers are naturally, wishing to offload their property risk as soon as possible after agreeing a deal with a land owner, tenant or contractor.  They achieve this by inviting investors to bid for the property in question.  To achieve the best price, they try and deliver to an investor exactly what they want in terms of the quality of the property, the quality of the covenant, the lease length and the rent review terms.  Today, the best prices are being achieved for long leases (in excess of 15 years), with good quality tenants and rent reviews geared to the RPI or CPI indices.

Specifically, we have witnessed new supermarkets being offered at yields of say 5% for 15 years of income, with the rents geared to the lower of RPI or market rents.  The emergence of such clauses is indicative of poor negotiation and understanding by landlords and proof of what a landlord must concede to agree this type of deal.  Either way, the clauses do not give us much confidence in rents outperforming.  If true, such “lower of” clauses effectively set a ceiling for rents throughout the lease.


The Christmas quarter is critical for retailers and as usual there are winners and losers.

retail winners
Source: Keills

The mainstream supermarkets chains dominate the Losers, with the discounters in the Winners column and continuing to gain market share.  We haven’t seen many new entrants into the sector, probably as a result of the fierce competition.  It certainly doesn’t feel the best environment to launch a new retail concept.

Our expectation is that the retail market will continue to evolve and successful retailers will adapt to the new world order.  This is already happening and there will be plenty of opportunities for consolidation and start-ups along the way.  Meantime, the focus on offering value for money to the consumer is unlikely to put any pressure on rents to grow.





The shed market continues to evolve, in this the highest yielding sector of the market.  We expect yields to be bid down further, but we are most concerned about the ability to find “natural home” investments.  We think that property depreciation is least obvious in the industrial sector, but it still exists.  Some of the largest users of industrial property are retailers who, as mentioned earlier, are having their own problems.  The prices we have witnessed being paid for sheds seem, to us to be aggressive when these additional factors are considered.



2015 will be a year of a return to property fundamentals, firstly looking at property against other assets and then between each sector.  With income returns at 5.4%, we expect further capital appreciation compared with other assets.  At the same time, rental growth may have peaked at 2.5%.  Buy well let property with a “natural home” where the rent is contracted to increase.