2017 Predictions: surprise of 2017 could be the bounce-back of UK real estate

What is even more surprising is that the markets liked these outcomes: the FTSE 100 and S&P 500 closed on 30 December at near all-time highs, even with the Italians voting ‘no’ to constitutional reform.

Unfortunately, the same cannot be said of the UK quoted real estate sector, which significantly underperformed relative to the FTSE 350 Index.

Indeed, 2016 was the worst year since 2007 and the third worst for 20 years. Conversely, global real estate performed well, delivering a total return of 8.1% compared with global equities at 9.9% and global bonds at 2.9%.

But as Amos Tversky, the renowned cognitive and mathematical psychologist, said: “He who sees the past as surprise-free is bound to have a future full of surprises.” So could the UK-quoted real estate sector surprise the markets with a bounce-back in 2017?

Outlook doesn’t look great for US real estate

According to EPRA, North American real estate delivered a total return of 11.4%, Asia 9.3% and Europe (excluding the UK) 5.1%. In stark contrast, the UK delivered a total return of -8.5% in spite of its economy performing well last year. Clearly Brexit meant Brexit for UK real estate.

Moreover, according to the new narrative of rising US bond yields, higher inflation and higher interest rates, particularly in the US, the outlook doesn’t look great for real estate without higher growth in the economy - or mixed at best.

Specialists on top

For the past three years, I have highlighted the performance of UK-quoted real estate companies with predominantly UK-focused portfolios and a market capitalisation in excess of £100m. With the exception of Secure Income REIT, whose total shareholder return (TSR) performance was outstanding at 30%, the TSR for the companies highlighted in the table ranged from 15% to -36%.

Only 14 companies delivered a positive capital return, although taking into account dividends declared, 21 companies did so. Even then, only one company actually beat the FTSE All-Share Index.

Once again, it is companies that are either specialists and/or income-focused that occupy the top positions in the league table.

Companies that are more London-focused and/or development-focused and have benefited from significant development profits in recent years have been hit hard by equity investors.

But are the markets overstating the case for higher bond yields and interest rates? Research from the Bank of England shows that interest rates have been declining for 35 years. The main reason is the supply of savings far exceeding demand for investment, thus lowering interest rates as well as the cost of capital.

An ageing and more slowly growing population, income inequality and lower productivity are the main drivers for the savings glut and lower investment demand. These demographic trends are very likely to continue supporting lower demand for capital and thus lower interest rates for longer.

Attractive and secure return

Our basket of listed real estate companies currently returns a dividend yield of circa 3.6%, so in a world of excess capital I believe a sustainable income underpinned by recurring cash revenue streams from a diversified occupier base provides an attractive and secure return.

That leaves Brexit. Given the fall in the value of sterling, the effective price for UK real estate for international buyers is very attractive and perhaps this will support values, particularly for the London market. In addition, it is highly unlikely that the terms of the EU divorce will be apparent until well into 2018.

Many of the quoted real estate firms are well placed to face the challenges and likely volatility of 2017 given their high-quality management teams and conservative balance sheets, so perhaps the surprise of 2017 will be the outperformance of the UK-quoted real estate sector against the wider equity markets.

Allan Lockhart is property director at NewRiver REIT