Extract from my Q4 2017 CIO letter to Investors

At the end of 2017 the UK real estate market was in good spirits. It appeared that a ‘soft Brexit’ was likely to be agreed and the economy had weathered the vote to leave better than expected. Indeed, the UK real estate listed sector reached a high point on the last trading day of the year and volumes recovered to hit some ￡65bn.

So far in 2018, the mood has been more circumspect. Rising bond yields and the prospect of QE tapering have driven stock market volatility and this has also started to introduce some cause for concern over real estate pricing.

FTSE EPRA/NAREIT UK Index 

 Source: Bloomberg 

We were able to take advantage of the buoyant mood at the end of the year by selling assets such as Atlantic Quay 3 (AQ3) in Glasgow and the Shipping Building in Hayes, London, at prices well ahead of our business plans and our asking prices.

Over the year capital values rose overall with the industrial sector performing the best with 15% growth. Retail underperformed with growth of only 2% and offices outside London marginally outperformed offices in London. 

We have been concerned about supply risks in the City and its exposure to Brexit but the high profile purchases of the ‘Walkie Talkie’ and the ‘Cheesegrater’ by Chinese investors at c.3% yields seemed to defy our negative outlook. We will have to wait and see whether they turn out to be good investments but recent Costar analysis of asking rents showed a fall of 6% in the City and the vacancy rate has been moving up...

Far East investors have been driven in part by currency movements and have increased their share of investment volumes to 21%, up from the previous 5 year average of 12%. On the other hand, the USA has reduced its share from 13% to 8%, representing quite a marked shift in investor make-up.

The performance of industrial vs retail can also be seen in the investment volumes, where industrial increased from 10% to 17% and retail reduced from 21% to 13%. The alternative sectors continue to attract interest as they offer a defensive occupational exposure and opportunities for growth given the very substantial supply / demand imbalances. 

The enthusiasm for industrial was essentially a result of the ongoing impact of the internet, the low levels of supply, limited new development, and as a result very strong rent growth in the year. 

The availability rate for distribution warehouses / logistics is c.6% and occupiers have limited options if they are looking for new space.

Investment volumes in 2017 recovered from the 30% fall experienced in 2016 as a result of the Brexit vote. However, investor enthusiasm has been mainly for long leases and trophy / core assets whilst riskier, shorter income, empty buildings and land remain harder to sell and therefore some 10-15% cheaper than in 2015. This is good for the value-add investor with the skill set to reposition assets and create long term leases or secure cash flows.

It is still that case that we are more likely to generate better returns when the markets are weak and volumes low as that will result in less competitive pricing. Our general approach in 2017 has been to take advantage of the investor enthusiasm and to sell whilst at the same time continuing to hunt for opportunities off market where we can add value and where the asset has been mispriced. 

There is a risk that the interpretation of 2017 (and current) real estate investment and occupational performance is misleading. If we looked at the statistics and excluded the outliers (the likes of Asian investment, WeWork take-up, council purchases, Government devolution/outsourcing and logistics) then the underlying fundamentals of the real estate market have arguably been weakening for a while.

The prime residential market in London is perhaps the worst performing sector, now down some 15% on 2014 levels. This is principally because of stamp duty increases and Brexit and the stock of units priced over ￡1,500psf now stands at 3,000 units, which are expected to take over 3 years to sell. These falls are a painful reminder that markets don’t keep going up forever. 

In contrast the residential markets outside London prices have barely recovered since the GFC. 

Affordability metrics are better outside London.

There has been very little residential development outside London and the prospects for rent and price growth are strong.

Underpinning our confidence in the residential sector is the acute shortage in supply that has been driven by a lack of development. The UK used to build over 300,000 homes annually (in the 30 year period between 1950-1980) and that is now also the target that the House of Lords has set; yet we are only delivering around half that level currently.

This is part of the reason why house prices are high, which contributes to affordability issues, and which in turn is the leading driver of the growth in the number of renters from 2m to more than 5m over the last 15 years. Hence our continued interest in Build to Rent (BTR).

The student market is more mature than the BTR sector but still offers opportunity in the right cities where there is also a supply shortage and growth in student numbers. The introduction of tuition fees resulted in student number caps being lifted and the better universities are attracting more students, especially from overseas.

In addition, the supply of private purpose built accommodation is still relatively low, making up only 7% of the market. The large majority of the student stock is old and tired, lacking amenities, and increasingly not fit for purpose.

These statistics explain why we have conviction in our MREFIII and MREFIV investment themes of (i) BTR, (ii) student, and (iii) last mile logistics. We are also looking for (iv) mixed use projects where there is less competition given increasing sector specialisation and (v) infrastructure-led real estate, where we can piggy-back transport upgrades that will dramatically improve a micro-location, and where we can overlay a value-add strategy.

We also of course have conviction about the retirement village opportunity in the UK, which we invest in through Moorfield Audley Real Estate Fund (MAREF). The ageing demographic, the wealth sitting in the housing equity of the retirees, the increasing propensity to downsize and the lack of suitable options for this huge market all support our investment thesis. Audley is creating wonderful homes and country club style facilities for retirees to enjoy and we continue to support their growth by investing in developing new Audley and now Mayfield (the new more affordable offering) villages. We believe that these dynamics would persist even in a negative economic scenario, whether caused by Brexit or other forces.

Sentiment is stronger than might be expected currently, considering many of the uncertainties ahead. We recognise that we are late in the economic and real estate cycle and with MREFIV in mind we are often asked if we risk being priced out of our target themes given the general enthusiasm for BTR, student and logistics. Indeed, these sectors are certainly more competitive now than when we started our focus on them.

We entered the BTR and student markets a long time before many others. We started our student accommodation activities in 1997 and in the BTR sector, we first turned Velocity Village in Sheffield from a for sale project into a rental investment in MREFII in 2012. We opened The Keel in Liverpool in 2015 and this was the first scheme designed for rent in the UK in our generation. We now also have 3 other BTR schemes being developed, adding a further 1,000 units to our portfolio. This experience brings origination and operational advantages and an outlook on the sector that is informed by real knowledge. This can at times also make us more cautious than others, as we know where issues can arise, but also allows us to innovate to keep ahead of the competition.

In order to expand our origination reach and because we perceive an exciting opportunity, we are now also looking to create a limited service and more affordable offering to target those renters who are most price conscious. This will allow us to target more locations with slightly smaller schemes of c.100 units and we will also be looking to convert/refurbish first generation student accommodation into better but discounted accommodation targeted at the domestic market.

To help with our search for opportunities, we anticipate future volatility over the three year investment period for MREFIV. We believe that this will come from political stresses and a rising bond yield environment and we believe that there will be opportunity for us to take advantage of this in our chosen investment themes if we are patient and disciplined over the three year investment period.