Quarterly Investor Report
Economy & Strategy
Keills Property Trust | 31 March 2015
Writing this today I fear I may be off on a ramble, please bear with me. Investment management is an art as well as a science and as a scientist, it has taken me many years to appreciate this fully.
In attempting to produce real returns for our clients, we always must have an eye on the real economy and right now, the path to follow is not well illuminated. On balance, we think that we can see sufficiently well to continue further along the journey.
We have written before about there being not just one, but three elephants in the room: increasing healthcare costs, high debt levels, and the forthcoming pension crisis. Taken together, these issues persuade us that this time IS different. Everyone needs a little encouragement and we were delighted when the McKinsey Global Institute published their paper Debt and (not much) Deleveraging in February. Similarly, Redington released their The Age of Responsibility which discusses wider issues flowing from the demographic changes upon planet earth.
There is no doubt that the world is getting increasingly connected and so what happens in emerging markets, or Iran, Yemen or Ukraine, can have an immediate impact on capital markets. During the last quarter, we witnessed the widespread phenomenon of negative sovereign interest rates at the 10 year mark, principally due to poor growth prospects in Europe and the expectation of deflation. According to JP Morgan, there is some $2 trillion of outstanding debt trading at negative rates, roughly a quarter of the total. The owners of this debt are principally governments, operating in the make believe land of Quantitative Easing, but the effect is to encourage (we would say force is more like it) genuine investors further up the risk curve, reducing yields for risk assets. In the UK, 30 year government bonds are trading at around 2.25%, with the majority owned by pension funds and other institutions. At these yields, it is unlikely that these institutions will generate sufficient returns for their investors and hence, the attraction of other income producing assets, including alternatives such as property.
The current expectation is that US interest rates will be the first to rise among the large economies and when this happens, frictional funds seeking higher rates will be drawn there, potentially creating a bond market rout. We wonder whether this is correct? It may be, that the time taken to get the global economy back on course will be much longer than markets expect. If the US slows down (perhaps precipitating a Chinese debt crisis) then it is not obvious which way US interests will go. Nearer to home Ben Broadbent, at the Bank of England, suggested the same conundrum here when he stated that UK interest rates could as easily fall as rise.
Europe has just left the starting blocks in terms of QE and we expect much more to come over the years. UK growth has recently been upgraded to 2.8% for 2014, a strong performance. The future is less clear not least because of uncertainty amongst our trading partners and domestic politics.
The Investment Property Databank (IPD) Monthly Index (Feb) states property is currently yielding 5.34%, compared with 10 year gilts of 1.6% (30yr gilts at 2.25%). It is this measure, more than anything, which is fuelling the surge in investment. We expect that if it were not for General Election 2015, property yields would be 50 to 100 bps lower than they currently are, implying a total return for 2015 of c20%, a repeat of 2014. Risks remain, including upheaval in the bond markets, but if that event happens, then we expect all assets other than cash, to be affected. If these lower yields are reached then would property offer value?
Current market activity suggests the following indicators:
The long term driver is of course rents and these are rising, albeit modestly (1-2%pa). What we must remember is that in a lower growth environment, such modest rises are probably acceptable and will outperform government debt over 10 years.
Traditionally, the first quarter of the year can be volatile. Do you pay the Christmas rent in the hope of recovering business in the January sales, or do you call it a day? This year, there were some notable failures around Christmas time. City Link stood out and was the subject of post event enquiries by MP’s into its failure and the administrative process which saw Better Capital publicly slated. Less public, has been the appointment of CVA’s at Country Casuals and Austin Reed. A CVA (Company Voluntary Arrangement) permits companies to continue and play hardball with, for example, landlords. Austin Reed is seeking a 50% rent reduction against 20% for Country Casuals. In the current retail environment, only a brave landlord will not negotiate.
Out of town, B&Q, the DIY retailer, has announced that it will close 60 stores nationally, but that it is expanding its Screwfix offer by a similar number of stores. A B&Q store is many times the size of a Screwfix store, so the net picture will be less retail space. From a property investor’s perspective, many out of town retail parks are anchored by B&Q and this statement of intent does not bode well for rents. We remain particularly concerned out the out of town retail market with the very best parks performing, but those in the middle and lower end of the market, set to seriously struggle.
Supermarkets are also off-loading their poorer stores with Tesco expected to shrink its estate by 40. Expect others to follow.
In London, where most of the action is, activity seems to be slowing a little and agents guide that this may be a pre-election lull. Demand is spilling over from central London to other areas in the South East, but we are not seeing a forest of cranes in the Big 6 provincial cities. Recent announcements regarding the HSBC moving its UK operation to Birmingham in order to comply with regulatory requirements, may encourage others to do the same and if so, profitable development in target cities may ensue. We suspect that access to London will have been a major factor in this decision, no doubt helped by the prospects of 15 minutes off the journey time when HS2 eventually opens.
According to Ryden, the Aberdeen market has already been affected by the fall in the oil price. While rents have not yet fallen (we think they will) confidence has evaporated and few new leases are being signed.
The often quoted defensive nature of the market was brought into question with the recent sale of a new warehouse let to John Lewis at a record yield of 4.25%. The tenant was good and investors (a large fund) had JL on a new 25 year lease. In ‘old money’ this yield would have been associated with the retail sector, how markets change. The fund in question paid c£80m for the shed and standing back, you could imagine the rent increasing over 25 years. Whether it will double is less certain than the yield doubling in 25 years’ time. So, relative to a 25 year gilt, you are getting a 2% premium, a good deal of illiquidity and quite a lot of investment risk.
We are now into the final few weeks before the General Election, the first one to be held under the new fixed parliament regime. You wouldn’t know it. Anyone landing in the UK over the last six months, particularly the last two, has been inundated by the posturing of the two main parties and this time, by a number of smaller parties. Polls suggest that GE 2015 will be the closest run election for generations.
The latest leaders’ debate on ITV, has done little to remove the uncertainty surrounding the outcome. As mentioned above, when the election is over we think property yields will be forced down further by the global hunt for income.