Quarterly Investor Report 31 December 2016

We have pleasure in providing our latest quarterly report where we explore the challenges facing the economy and the property market as the global political landscape changes.

Economy & Outlook

There is no doubt that 2017 presented investors with a number of challenges although unusually, these came from changes in the political landscape rather than markets uncoupling.  Very broadly, we think this increased populism will continue throughout 2017 and coming at a time when Europe is expecting a number of key elections, the effect could be marked.  Under threat is the European Union itself and by implication, the Euro.  The Austrian elections narrowly missed a swing to the political right, but since then, we have seen terrorist activity first in Berlin and then at the turn of the year in Istanbul.  It is plausible that electorates demand a more authoritarian regime in the Netherlands, France and later in the year Germany.  With European banks requiring further bailouts in Greece and Italy, the laissez faire mood music is unlikely to cut with the electorate demanding safe streets to walk down.  We feel something has to give.

Since we last reported, the USA has a new president elect, one unburdened by years of political correctness.  Trump has assembled what appears to be a serious team and will be inaugurated on 20 January.  Already, various corporates are reacting to the expected change, with Ford announcing that it will no longer be building a new $1.6 billion plant in Mexico and BP saying that it will not be pursuing its ambitions in Iran.  Ford is apparently going to expand its existing Michigan plant, though quite who will be working there is anybody’s guess with US unemployment at record lows.  Expect more announcements.

In the UK, the May Government is getting ready to announce broad tactics for Brexit, but we expect that some primary legislation will be required when the Supreme Court announces its verdict on the process later in January.  This legislation is expected to be obtained but not without some dancing around handbags at Westminster.

While the UK economy has performed rather well this year amongst its G7 peers, boosted by the fall in the pound which is making exports competitive, business decisions are hampered by a lack of clarity on the Brexit terms.  We will not concern ourselves here with the various permutations, but as we have noted above, the European political landscape is changing rapidly and all bets are off.


The main change has been the lifting of the US 10 year bond yield from c1.8% prior to the US election to c2.4% today.  Fiscal stimulus is expected to return to the armoury to get the US economy motoring and with it, inflationary pressures.  Hence The Fed’s decision to raise interest rates to 0.75%.  Whilst the market believes US rate will be 1.5% in 18 months, we are less convinced and think the increasing level of indebtedness will form a natural break to growth.  There may well be a Trump boost to the economy, but without a slow down in increasing debt levels and then their subsequent reduction, the USA economy is again living on borrowed time.

In the UK, as well as dealing with the expected changes in the US economy, we have our own issues. Even 7 months after the Brexit vote, the language being used in Government does not seem to be unequivocal and so a gentler Brexit is mooted.  We would respectfully point out that it is the other 27 members that count, not us and we think it is best just to get on with it and face up to any consequences as well as embracing any potential opportunities.

Stock markets around the world have rallied post Brexit and post Trump, with even emerging markets showing a turn for the better.  We have commented before on the level of US stock market indices and again note that on some measures, US stock markets would seem to be expensive. The UK is less so and working through an export boost.

Bond markets remain expensive and we think Trump represents a turning point for bond investors globally.  Avoid if you can.

Where does that leave UK real estate? We continue to recommend that property is held by longer term investors who understand the illiquidity and valuation characteristics.  Nonetheless, the latest MSCI Monthly Index shows that a balanced portfolio of assets produces an income return of c4.2%.  In fact, this is not the full picture as rents have in fact been growing over that last year at a rate of c1.5%.

The Investment Property Forum produces a Consensus Forecast for rental and capital growth and total returns, and Keills contributes to this.  The table below compares our own forecast to that of the consensus.

  Rental Growth Capital Growth Total Returns
  2016 2017 2018 2016/20 2016 2017 2018 2016/20 2016 2017 2018 2016/20
Consensus 1.4 -0.5 -0.1 0.7 -4.1 -3.6 -0.2 -0.8 0.6 1.3 5.1 4.2
Keills 3.0 1.8 1.8 1.9 -2.0 0.0 0.0 0.4 3.0 4.0 5.0 4.6

There are a number of external factors which may upset property markets and affect both the Consensus and Keills Forecasts.

  1. Gearing

Banks seeking secure lending opportunities have in the past lent heavily to the sector. Following the Great Financial Crisis and the re-assessment of risks banks are less keen to lend and some of the slack has been taken up by insurance companies and specialist lenders. We see no immediate return to the tap being turned on and therefore reckless lending.

  1. Debt refinancing

On the back of the reckless levels of gearing leading up to the Great Financial Crisis, there remains a lingering debt overhang which increases the level of risk as debt terms mature.  It can no longer be assumed that banks will simply rollover historic debt finance.  While much of this hit has already been taken, it will take a considerable time for this risk to diminish or be eliminated.

  1. Occupational demand and supply

We subscribe to the belief that in the long term, returns are driven by collecting rents and rental growth generated at rent reviews.  Currently, there is balanced demand and supply in London, modest supply and less demand in provincial markets so we are inclined to expect rental growth will be modest overall, albeit with some pockets of growth and decline.

  1. Development

The time lag for development often results in areas of under supply suddenly experiencing considerable over supply and a resulting impact on rental and capital values.  Other than London, which continues to experience strong development activity, we see no over development.

  1. Property as an investment class

Investors are continually assessing how real estate compares to other investment classes relative to pricing and sentiment.  As we have seen against bonds, UK property would appear to offer a significant yield premium with the potential for additional modest rental growth.  The global investment market continues to shrink in size and UK real estate, because of its relatively long leases and well understood and transparent tenure, is often a first place for overseas investors.  This is especially so of London, but applies also too many larger provincial prime assets.  If bond yields increase, the relative attractiveness of property will reduce.  Given that real estate is delivering a significant yield premium to bonds, we think this effect is unlikely.


For income hungry investors seeking an income in excess of bond yields, UK real estate continues to appear to offer relative value.  In the traffic light analogy, the light is green but there are external factors (Brexit and the US) which are likely to turn the lights amber over the next couple of years.  For longer term investors, the additional yield gained is expected to reward them for the risk taken.

Our long term approach of investing in sustainable locations with good quality tenants and with rents which are contracted to increase fits well with the current uncertainties.  Hence our optimism.