1 July 2013

Target rental growth in commercial property to beat inflation

One of the biggest challenges facing investors in the current economic climate is inflation. The real value of money held on deposit is falling and the returns offered by low-risk investment strategies struggle to keep pace with inflation. In the 12 months to March 2013, the Office for National Statistics (ONS) recorded the Consumer Prices Index (CPI) at 2.8% and the Retail Prices Index (RPI) at 3.3%.

Rental growth – useful protection against inflation

Commercial property has long been held up as a good hedge against inflation, which in the right circumstances it has proved to be. Whilst, in an inflationary environment, investors are attracted to real assets and commodities as a wealth protection strategy, protecting the real value of income streams remains a challenge.

Rent, in common with all income streams, will see its purchasing power eroded by inflation. However, in the UK, upward-only rent reviews and the increasing use of index-linked rent reviews is providing some very useful protection against the ravages of inflation and, indeed, the expectation of future inflation in the wake of widespread quantitative easing. In short, rental growth is the essential component of total return from commercial property that delivers some long-term shelter from the erosive effect of inflation.

Positive signs on the horizon

The good news is that for the first time in five quarters, the Investment Property Forum has forecast positive rental growth for 2013 and beyond. The consensus forecast suggests a five-year average rental growth of 1.7% per annum, albeit rental growth is forecast to be muted through 2013.

This forecast is in line with current market research from CBRE. In the first quarter of 2013, the worlds’ leading commercial property and real estate services adviser, CBRE, showed in its Prime Rents Index that all UK property rents grew by 0.5% over the quarter and by 1% year-on-year.

The Custodian Capital view

How does this index and the Investment Property Forum (IPF) Consensus Forecast accord with our experience of commercial property?

Custodian Capital manages a nationwide commercial property portfolio of in excess of 80 properties, with an aggregate value of approximately £140 million. This geographically diversified portfolio has many high-profile tenants, including Tesco, Bentley, Superdrug, Royal Mail, Regus, RBS and Currys.
While there are pockets of the market where rental values are still falling, perhaps most obviously on regional high streets, in recent rent reviews Custodian Capital has secured improved income returns of between 10% and 20% in a number of locations:

• In Redhill, an open market review secured a rental increase of nearly 20% at Honda Motor Europe Limited’s car showroom
• In Bedford, a consumer price index (CPI) linked increase delivered a rental increase of 17% at Emerson’s industrial unit
• In Aberdeen, an open market review secured a rental increase of 15% at the DHL Express depot
• In Oldbury, a consumer price index (CPI) linked increase delivered a rental increase of 13% at Sytner BMW’s body shop

These rental increases will do much to protect the real value of investors’ returns while simultaneously bolstering capital values.

Further rental increases across the portfolio

With a positive forecast for rental growth, the prospect of securing open market rental increases across the portfolio at the next round of rent reviews has the potential to strike another meaningful blow against the negative impact of inflation.

The two most recent properties acquired by Custodian Capital for its clients have leases with inherent inflation protection, both benefiting from indexed-linked rent reviews:

These long-term income streams, secured against excellent tenants should provide real income protection to investors for the 20-year term of the leases. This is perhaps where commercial property can add a useful dynamic to a balanced investment strategy; a high-income return, with the potential for some protection against inflation.

Richard Shepherd-Cross