UNITED KINGDOM H1 MAR UK PERSPECTIVEpd… · UK and international property markets. *As at end of...

UNITED KINGDOMREAL ESTATE PERSPECTIVE

MARCH 2012REAL ESTATE

FUND MANAGEMENT

Contents

PRUPIM is one of the leading real estate fund managers in the United Kingdom. We form part of the M&G Group of Companies which is the asset management arm of Prudential plc in the UK and europe.

We manage around £15.4 billion* of real estate assets, of which nearly £3 billion* is invested internationally in north America, Continental europe and Asia Pacific. We are invested in over 675 properties with more than 3,900 property occupiers.

We manage real estate investments for a wide variety of clients, offering investors exposure to UK, european and Asian property in both pooled vechicles or segregated mandates.

our major activities are driven by powerful research, managed by the Global Property Research team. our considerable scale and diversified activities allow us to draw on our own multi-dimensional inputs which give us an unrivalled information advantage.

We evaluate the macro-economic environment working as part of the global research capability of Prudential. We receive detailed property related data generated by our on-the-ground surveyors. this is fed into proprietary modelling systems which form the basis of our analysis.

the 12-strong Global Property Research team was formed in 1987 and is comprised of property economists and performance measurement analysts who work together to provide leading property analysis and commentary on the UK and international property markets.

*As at end of 31 December 2011.

ABOUT PRUPIM ExECUTIVE SUMMARy 2PerformanceReviewoutlook

UK PROPERTy REVIEw 3

UK PROPERTy MARKET DyNAMICS 4

RETAIL 5

OFFICES 6

INDUSTRIALS 7

UK PROPERTy OUTLOOK 8

IN FOCUS – DIVIDING ThE MARKET: ANALySING PRIME VERSUS SECONDARy ASSETS 9

INTERNATIONAL PROPERTy MARKETS 11

Global Review north America europe Asia Pacific

GLOBAL ECONOMIC AND MARKET REVIEw 12

DATA AND STATISTICS 13

CONTACTS 14

Unless otherwise specified all data and commentary is as at end of 31 December 2011.

For further information please visit our website: www.prupim.com

Manchester Arndale Manchester

oxford science Park oxford

Cribbs Causeway Bristol

Apex Plaza Reading

1 UK ReAl estAte PeRsPeCtIve • MARCH 2012 REAL ESTATE FUND MANAGEMENT

eXeCUtIve sUMMARY

PeRFoRMAnCe

RevIeW

oUtlooK

Having steadily and continually risen since August 2009, capital values appear to have peaked. Indeed, values have now fallen, albeit only marginally, for the last three months, reflecting a combination of flat or negative rental growth and small increases in yields. As a result, total returns are decelerating sharply and are now largely being driven by the income return.

over the year as a whole, the office sector recorded the strongest performance of the three main sectors, driven by the buoyancy of the london markets. However, in line with more general UK market trends, total returns in the london office segments began to decelerate sharply in the second half of the year. As a result, the industrial sector, boosted by a higher income return, took over as the top-performing sector in the final quarter of 2011.

significant geographic divergence is being felt in the UK property market, with london showing much stronger rental and capital growth than the regions. the rest of the country on the other hand continues to suffer from weak occupier demand as well as high levels of availability. More recently, expectations of flat-lining economic growth have started to impact on the demand for space across all sectors, even in those where occupier demand had previously been showing signs of improvement.

the challenging nature of the occupational environment has also meant that investors continue to show a strong preference for prime and, to a lesser extent, good secondary assets. However, poorer quality secondary and tertiary stock continues to be shunned, particularly as anaemic economic growth will continue to cast a shadow over leasing fundamentals in the short term at least.

the UK economy seems to be on the verge of recession, and most forecasters expect weak growth for the next few years. As such, the outlook for occupier market demand is not particularly rosy, with secondary property likely to see prolonged rental declines, particularly in the regions.

the return of risk aversion has caused a renewed flight to safety. Prime pricing seems set to hold, at least in the short term, but secondary yields look likely to

rise. Furthermore, with vendors unwilling to sell at the prices demanded by risk-averse buyers, transaction volumes over 2012 are likely to be fairly subdued.

In a longer-term sense, secondary markets outside of london appear to offer far better value than the prime london markets, where overseas buyers have inflated a pricing bubble, although, in the short term, secondary yields remain under upwards pressure.

-15

-10

-5

0

5

10

15%

20062005 2007 2008 2009 2010 2011

All Property 3-Month Yield Impact

Source: IPD Quarterly Digest (Q4 2011)

-15

-10

-5

0

5

10

15

Industrial

%

Office Retail20062005 2007 2008 2010 20112009

3-Month Total Return


-3.5-3.0-2.5-2.0-1.5-1.0-0.50.00.51.01.52.0

%

All Property 3-Month Rental Growth


20062005 2007 2008 2009 2010 2011

%

20062005 2007 2008 2010 201120095.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

IPD Equivalent Yield for All Property


REAL ESTATE FUND MANAGEMENT UK ReAl estAte PeRsPeCtIve • MARCH 2012 2

In economic terms, the north/south divide has widened since the onset of the financial crisis in 2007, largely due to london’s and, to a lesser extent, the south east’s relatively robust economic growth. As a result, significant geographic divergence is also being felt in the property market, with london showing much stronger rental and capital growth than the regions. the rest of the country on the other hand continues to suffer from weak occupier demand as well as high levels of availability.

expectations of flat-lining economic growth are inevitably having an effect on the demand for space across all sectors, even in those where occupier demand had previously been showing signs of improvement. In addition, weak prospects for retail sales, coupled with the on-going rise of “e-tailing” will continue to weigh on retailers, therefore leading to the further rationalisation of larger store portfolios. this will drive up vacancy rates and weaken rents further in more secondary/non-performing locations.

on the bright side, Central london has recorded significant rental growth over the past two years, notably in the office and retail markets, reflecting fierce competition amongst occupiers for increasingly limited prime space. In addition, the london retail market has benefited from the capital’s continuing popularity with a growing international middle class as a leisure and shopping destination and so retailers, seeking the best pitches, have pushed rents in prime central locations to record highs.

However, concerns have been raised over whether this buoyant rental growth can be sustained, particularly in the Central london office market. the health of the financial sector, key to both the capital’s economy and occupational demand for its office markets, remains under threat from the sovereign debt crises in europe and the more general lack of debt finance. As such, it is likely that more companies could be forced to further postpone any significant occupational decisions in the short term.

the challenging nature of the occupational environment has also meant that investors continue to show a strong preference for assets which are perceived to be more “prime” or lower risk, as distinguished by being better quality, well-located and having more favourable lease structures. the high price of the “primer” assets has forced some investors to look for better value elsewhere, therefore selectively increasing their exposure to good secondary assets. However, poorer quality secondary and tertiary stock continues to be shunned, particularly as anaemic economic growth will continue to cast a shadow over leasing fundamentals in the short term at least. In addition, when combined with weak occupational demand, the continued lack of debt finance also means that it is likely that the pricing gap between prime and weaker secondary property will widen going forward.

Adding weight to this argument, although prime yields have largely remained stable in recent months, the IPD Monthly index, which includes assets from across the yield spectrum, has now recorded three consecutive months of falls in capital values. this potentially also signals an end to the market’s two-year recovery and, with values likely to slip further in the near term, it looks as if commercial property faces a tough year ahead.

“…significant geographic divergence is also being felt in the property market, with London showing much stronger rental and capital growth than the regions.”

The UK economy caught a chill over the final quarter of 2011, with GDP shrinking by 0.2% over the last three months of the year. As a result, concerns are growing that the UK could potentially fall back into recession this year. Moreover, the unemployment rate has risen to 8.4%, its highest level since 1995 and inflation remains painfully high. Current forecasts suggest that economic growth will remain particularly weak this year.

Quarter-on-Quarter UK GDP Growth

Source: Office of National Statistics (January 2012)

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Q4

2011

Q3

2011

Q2

2011

Q1

2011

Q4

2010

Q3

2010

Q2

2010

Q1

2010

Q4

2009

Q3

2009

Q2

2009

Q1

2009

Q4

2008

Q3

2008

Q2

2008

Q1

2008

Q4

2007

Q3

2007

Q2

2007

Q1

2007

Q4

2006

Q3

2006

Q2

2006

Q1

2006

Q4

2005

Q3

2005

Q2

2005

Q1

2005

Q4

2004

%

Yiel

d Im

pact

ove

r H1

and

H2

2011

Yield Impact by Segment: H1 vs. H2 2011

Source: IPD Quarterly Digest (December 2011)

-3

-2

-1

0

1

2

3

4O

ffic

es: R

est o

f UK

Indu

stria

ls: R

est o

f UK

Off

ices

: Res

t of S

E

Shop

ping

Cen

tres

Stan

dard

Ret

ails

: Re

st o

f UK

Off

ices

: Wes

t End

Reta

il W

areh

ouse

s

Off

ices

: City

Stan

dard

Ret

ails

: SE

Off

ices

: Mid

Tow

n

Indu

stria

ls: S

E

%

H1 2011 H2 2011

UK PRoPeRtY RevIeW


UK InvestMent MARKet DYnAMICs

Concerns over weakening prospective rental growth seem, in aggregate at least, to have now offset the sought-after characteristics attributed to commercial property as a stable, high income return asset which is more rewarding than bonds but less volatile than equities. this said, beneath the aggregate level, the dynamics of the constituent markets vary greatly and the level of transacting remains reasonably healthy.

the market remains polarised, with risk-averse investors once again greatly preferring prime over secondary, south over north, offices over retail, long leases over short, and income today over growth tomorrow. this means that, while upward pricing pressure remains, to an extent, on the prime london office markets, a widening range of off-prime, secondary and tertiary markets (even in Central london) is being shunned by investors. to illustrate this, lambert smith Hampton recorded investment activity levels in london at four times that of the most active regional market in 2011, while GvA recently noted that the yield gap between the lowest and highest of IPD’s yield quartiles has more than doubled since september 2007 to 430 basis points, and for provincial offices now stands at 630 basis points.

Given that uncertainties in the real and money economies continue, the general feeling is that this polarisation will persist. As sentiment towards property investment cools generally and expectations grow that banks will continue to release weaker quality assets onto the market, commentators expect pricing in prime markets to broadly hold steady, whilst slipping further in secondary markets in 2012.

the theme of polarisation is further supported by the availability of debt remaining tightly constrained for some time to come, especially so for investments other than absolute prime. However, there may be some new sources of capital coming to market. CBRe recently noted that the constitution of property lending providers is changing, with an increased market share being taken by insurance companies. Accounting for one-seventh of the market in 2011, insurance companies are noted as having a willingness to lend on larger lot sizes and at reasonably generous loan-to-value levels.

overall transaction levels held up well in 2011, with the UK materially more active than other european markets. Albeit having been relatively quiet in the second and third quarters, total UK transactions were boosted by an active fourth quarter, ending up at £31.6 billion, only slightly down on 2010.

there is an increasing feeling that UK investors are leaving the Central london “trophy” office market to non-domestic sources of capital and are focusing on smaller markets which they view as better value and where they have a greater feeling of comfort and relative knowledge. In this regard, UK institutions have been net sellers of Central london offices for most of the last five years, whilst international investors have been consistent net investors for 10 years, and particularly so more recently.

the sources of international investment interest in london are varied but most commentators note that substantial interest is coming from Asian and Middle eastern investors. there is an expectation that this appetite will remain for some time yet and there is some evidence that earlier cohorts of international investors are now beginning to take profits by selling on to new market entrants.

The steam seems finally to have run out of the UK commercial property investment market in terms of pricing, with a reversal to the long run, if anaemic, run up in values which occurred in the last two months of 2011 and has continued into 2012.

“The market remains polarised, with risk-averse investors once again greatly preferring prime over secondary, South over North, offices over retail, long leases over short, and income today over growth tomorrow.”

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000£m

20012000 20032002 20052004 20072006 20092008 20112010

Retail WarehouseOffice

Industrial

Unit Shop

Leisure Mixed

Shopping Centre

Source: Property Data (February 2012)

Annual Investment Volumes

-10

-15

0

-5

5

15

10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

£bn

Net Investment by Type of Investor

Source: Property Data (February 2012)

Overseas InvestorsUK Institutions

Private Individuals

Quoted Property Company

Occupiers Others

Private Property Company


RetAIl

PeRFoRMAnCe

oCCUPAtIonAl DYnAMICs

InvestoR sentIMent

the retail sector delivered a total return of 2.7% over the second half of 2011, underperforming the All Property average. over the year as a whole, the sector recorded a total return of 7.1% per annum, again the weakest of the three sectors, reflecting a combination of negative rental growth and a lower income return.

sub-sector total returns varied widely during 2011, with Central london shops outperforming due to positive rental growth and a continuing hardening in yields, fuelled by strong demand from

international investors. out-of-town shopping centres and retail warehouses also performed relatively well, while regional high street shops and in-town shopping centres struggled, witnessing low or negative capital value growth.

Additionally, the prime/secondary divide remained a prominent feature of the market, with higher yielding properties in the high street retail and shopping centre sub-sectors underperforming those in the lowest yield quartile by a significant margin throughout the year.

the underlying fundamentals of the retail occupier market remained weak in 2011 and the outlook appears little brighter. Although retailers fared better than expected over the Christmas period, retail sales volumes remained comparatively lacklustre and this weakness is expected to continue this year, hampered by falling disposable incomes and weak consumer confidence. As such, occupational demand for retail space is likely to remain relatively restrained in the short term.

on a more positive note, completion levels, especially in the retail warehouse sector, remain at record lows, helping to support rents in the prime areas of the retail market. Indeed, completions are expected to remain well below their long-term averages in all three sub-sectors for the next five years. nevertheless, vacancy rates are expected to continue to rise this year as more secondary space is released onto the market and retailers continue to focus on rationalising their store portfolios in the face of weak consumer demand.

Retail yields have remained broadly stable since June 2011, albeit with regional and quality-based differentials. Central london prime shops have seen continued yield compression, largely from overseas investors looking for a safe haven. Meanwhile, shopping centres have continued to struggle as their large lot size and capital-intensive nature makes such assets unattractive or even inaccessible for many buyers.

Demand also remains weak for the regional markets, particularly for more secondary assets as investors still have

limited appetite for risk. As a result, the yield premium attached by buyers to anything other than the best-quality retail assets in the strongest locations has increased.

nevertheless, investment volumes remained relatively healthy in 2011, at similar levels to 2010. Purchases were dominated by overseas investors, who largely focused on buying prime stock in london, whilst UK institutions, net purchasers of retail for much of the year, disinvested from the sector in the final quarter of 2011.

-40

-30

-20

-10

0

10

20

30%

3mth % 12mth %

2007 2008 2009 2010 2011 2012

Retail Sector Total Returns

Source: IPD Monthly Digest (January 2012)

-8

-6

-4

-2

0

2

4%

Retail Sector Rental Growth

2007 2008 2009 2010 2011 2012

3mth % 12mth %


-3.0-2.5-2.0-1.5-1.0-0.50.00.51.01.5

South East Standard Shops Rest of UK Standard ShopsUK Shopping Centres UK Retail Warehouses

%

Retail Sector 3-Month Rental Growth


2007 2008 2009 2010 2011 2012

-20

-15

-10

-5

0

5

10

15

20


%

Retail Sector 3-Month Total Returns


2007 2008 2009 2010 2011 2012

4.5

5.5

6.5

7.5

8.5

9.5

10.5

11.5


%

20082007 2009 2010 2011 2012

Retail Sector Equivalent Yields



oFFICes

PeRFoRMAnCe


InvestoR sentIMent

Although on a 12-month basis, the office sector remained the clear outperformer by a notable margin with a total return of 9.3% per annum versus All Property’s 8.1% per annum, the three-month trend shows that office total returns have slowed significantly and are now much more in line with those of the other sectors.

this principally reflects the on-going deceleration in the pace of capital growth in the Central london market which, in turn, has been caused by a combination of

weaker rental growth and a marked slowdown in the rate of yield compression.

Despite weakening performance in london, negligible rental growth and a continued lack of yield compression in the rest of the country has meant that the london/non-london divide has remained a firm feature of the market – indeed, the capital’s “safe-haven” status is likely to maintain this divide going forward, at least in the near term.

Although down for the country as a whole, take-up in Central london improved over the final quarter of the year, with the West end in particular recording a bounce-back in demand. nevertheless, take-up in 2011 was significantly below levels recorded in 2010, both in london and the UK more generally, reflecting occupier caution over current economic weakness.

With tenants continuing to take advantage of current conditions to upgrade to the best available space, occupier demand

has remained firmly focused on Grade A assets. even so it has become increasingly difficult to achieve higher prime rents. Prime rents in the West end and the City, for example, have now remained stable for the last three and four quarters respectively, despite an on-going lack of development. With tenant demand likely to weaken this year in the face of continued economic headwinds, it is unlikely that prime rents will return to growth in the short term.

the investment market is becoming increasingly polarised, with prime property yields holding firm, whilst secondary yields – even in Central london – are already showing signs of moving out, reflecting investors’ growing concerns over the weak economic outlook. this trend is likely to continue over the short term as investors’ risk aversion continues.

the other main feature of the current investment market is still the north/south divide. Central london remains the focus of the majority of investor demand –

according to PropertyData, london made up 73% of all office sector transactions (by volume) last year.

It is, however, important to note that the bulk of demand has been from overseas investors, who accounted for a record 62% of Central london offices transactions (by volume) in 2011. As such, domestic investors have been increasingly shifting their focus to prime markets in the south east and, to a lesser extent, the regions.

-30

-20

-10

0

10

20

30%

Office Sector Total Returns

3mth % 12mth %

2007 2008 2009 2010 2011 2012


-20

-15

-10

-5

0

5

10%

Office Sector Rental Growth

3mth % 12mth %

2007 2008 2009 2010 2011 2012


City OfficeMid-Town & West End

Rest of South EastRest of UK

-20

-15

-10

-5

0

5

10

15%

Office Sector 3-Month Total Returns


2007 2008 2009 2010 2011 2012

-12-10

-8-6-4-20246

%

Office Sector 3-Month Rental Growth

City OfficeMid-Town & West End

Rest of South EastRest of UK


2007 2008 2009 2010 2011 2012

Mid-Town & West End

Rest of South East

Rest of UK

City Office

%

4.5

5.5

6.5

7.5

8.5

9.5

10.5

11.5

Office Sector Equivalent Yields


20082007 2009 2010 2011 2012


InDUstRIAls

PeRFoRMAnCe


InvestoR sentIMent

the industrial sector delivered steady performance over the second half of 2011, recording a total return of 3.7%, which was slightly higher than the All Property average of 3.2%. Although the sector recorded mildly positive capital growth over the period, despite rental growth remaining in negative territory (having fallen by 0.4% over the final six months of the year), the bulk of performance came from the sector’s higher income return.

the north/south regional divide also persists within the investment market, with the south east having witnessed on-going yield compression, whilst yields in the rest of the UK have now started to soften again. Although over the six-month period, standard industrials have seen much greater yield compression than distribution warehouses, the latter’s stronger rental growth and higher income return has compensated for this. As such, the two sub-sectors have performed very much in line with each other over the period.

Industrial sector take-up slightly increased in the second half of 2011 compared with the first six months of the year. However, take-up for the year as a whole was notably lower than in 2010, when it reached an historical high.

With “e-tailing” becoming an increasingly important driver of occupational demand, the importance of retail sales to the industrial sector cannot be understated. the uncertainty surrounding the current economic environment means that retailers have already become less active

in the occupational market. this trend is likely to continue into 2012, with retailers’ demand for space remaining subdued and a growing proportion of overall demand coming from third party logistic providers and manufacturers.

Pre-lets have dominated development activity for the past three years. speculative completions are likely to remain muted in the near term until a tangible recovery in occupier fundamentals reduces risk aversion surrounding this type of development.

Industrial transaction volumes were boosted by the sale of three large portfolios in the final quarter of 2011, with investors attracted to the sector by its relatively higher yields. Although short-term prospects for further yield compression are limited, prime logistics properties with good quality covenants and a secure income stream will continue to appeal to investors. this type of property is particularly attractive to overseas investors, whilst multi-let industrials remain the domain of the UK investor.

At the same time, the slowdown in GDP growth and continued uncertainty over the short-term outlook for the UK economy are maintaining the polarisation in demand for prime versus secondary property. In the short term, secondary and tertiary industrial assets are unlikely to witness any further yield compression, and indeed may see a renewed softening in yields as their long rent-free periods and high void rates make them a risky proposition for many investors.

-25-20-15-10

-505

10152025

%

Industrial Sector Total Returns

3mth % 12mth %

2007 2008 2009 2010 2011 2012


-6

-5

-4

-3

-2

-1

0

12

%

Industrial Sector Rental Growth

3mth % 12mth %

2007 2008 2009 2010 2011 2012


-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0%

Industrial Sector 3-Month Rental Growth

South East Rest of UK

2007 2008 2009 2010 2011 2012


%

-15

-10

-5

0

5

10

Industrial Sector 3-Month Total Return

South East Rest of UK

2007 2008 2009 2010 2011 2012


5

6

7

8

9

10

11

London South East Rest of UK

%

Retail Sector Equivalent Yields


20082007 2009 2010 2011 2012


UK PRoPeRtY oUtlooK

However, it is not just the immediate short term that is set to be weak; most forecasters expect economic growth to be below-trend for three years at least – by which time the UK economy will have suffered from more than seven years of weakness since the credit crunch began. With this in mind, comparisons with Japan’s lost decade do not seem too far out, even without the obvious downside risks that could materialise through contagion from a possible escalation of the eurozone crisis.

With the economic backdrop in mind, the outlook for the demand side of property occupier markets is not particularly rosy. even london’s rental growth appears to be moderating as companies have been less willing to compete to take space, reflecting continued uncertainty. Indeed, it seems plausible that london could see some rental falls start to come through, particularly if more job cuts occur in the financial sector, although tourism continues to support the capital’s retail sector – which will be boosted further by the olympics this summer.

For markets outside of london, particularly those in the regions which are highly dependent on the public sector for both output and employment, occupier demand is likely to remain weak. However, a lack of construction in recent years (and a very limited development pipeline going forward) means that rents will be supported, at least at the prime end, through a lack of supply. secondary properties in these markets are likely to see further declines though, with the viability of some secondary retail pitches being tested.

on the investment side, the return of risk aversion has caused a renewed flight to safety. Prime pricing seems set to hold, at least in the short term. In addition, london’s buoyancy is driven by overseas investors, many of whom are treating it as a safe haven amidst the wider financial market turmoil and macro-economic risks. such investors, by and large, are not interested in the rest of the UK. At the secondary end, outside of london, it seems likely that yields will rise. Furthermore, with vendors

unwilling to sell at the prices demanded by risk-averse buyers, transaction volumes over 2012 are likely to be fairly subdued.

But in a longer-term sense, secondary markets outside of london appear to offer far better value than the prime london markets, where yields are close to their pre-credit crunch lows. Indeed, while secondary office yields have recently moved beyond the highs reached in 2009, prime Bond street shops yields are currently the lowest they have ever been. even if the prime london pricing bubble does not burst, there are much more attractive opportunities on offer elsewhere for investors seeking high risk-adjusted returns.

with the final quarter of 2011 recording a contraction in GDP of 0.2%, the UK economy seems to be on the verge of recession, and, indeed, may fall into technical recession this year. The UK has been affected by ongoing concerns over the Eurozone crisis, and confidence remains subdued. In addition, spending cuts introduced by the coalition government are restricting growth further, and the rate of unemployment is set to continue rising. Furthermore, while inflation has eased recently, it remains above target and above household income growth rates, meaning that declines in real incomes are set to continue, restraining the consumer spending outlook.

The Property Yield Spectrum%

0

2

4

6

8

10

12

Source: CBRE (February 2012)

Seco

ndar

y In

dust

rial E

stat

es

Seco

ndar

yO

ffice

s

Seco

ndar

ySh

ops

Seco

ndar

ySh

oppi

ng C

entre

sPr

ime

ex-L

ondo

n

Ind.

Est

ates

Prim

eM

25/S

E O

ffice

s

Prim

e Lo

ndon

Ind.

Est

ates

Prim

ePr

ovin

cial O

ffice

sPr

ime

City

Offi

ces

Prim

e Sh

ops

(ex-

Lond

on)

Prim

eW

est E

nd O

ffice

sPr

ime

Bond

Stre

et S

hops

2006/07 Minimum Yield 2009 Maximum Yield Yield as at February 2012

2012 2013 2014 2012-2016

Feb (12) Nov (11) Feb (12) Nov (11) Feb (12) Nov (11) Feb (12) Nov (11)

standard shops 0.2 3.6 6.2 6.6 7.4 n/a 5.7 n/a

shopping centres 0.3 3.1 6.5 7.1 8.4 n/a 6.4 n/a

Retail warehouses 1.5 4.2 6.9 7.4 8.0 n/a 6.5 n/a

offices 3.0 6.1 6.5 8.4 7.5 n/a 6.5 n/a

West end offices 4.0 7.3 6.3 8.8 7.0 n/a 6.4 n/a

City offices 2.9 7.0 6.3 8.5 7.5 n/a 6.0 n/a

Industrial 2.5 4.5 7.0 8.0 8.3 n/a 6.9 n/a

All property 1.6 4.5 6.4 7.7 7.8 n/a 6.4 n/a

source: IPF Consensus (november 2011 and February 2012)

IPF Consensus Forecasts for Total Returns November 2011 vs. February 2012 % p.a., 2012 – 2016

“...a lack of construction in recent years (and a very limited development pipeline going forward) means that rents will be supported, at least at the prime end, through a lack of supply.”


DIVIDING ThE MARKET: ANALySING PRIME VERSUS SECONDARy ASSETSWeijia WangIn-FoCUs

Defining Quality: the IssuesIn other asset classes, such as bonds, tens of thousands of people are dedicated to assessing credit ratings, tagging and categorising issues into different baskets according to their individual credit worthiness. In contrast, direct real estate, characterised by heterogeneity and data collection issues, is generally only divided into three vague and subjective classifications of quality: prime, secondary and tertiary.

the majority of analysis and research focuses on sector-based and geographic breakdowns of the market as it is here that there is greater availability of market information. nevertheless, there is an increasing desire for a better and more quantitative-based understanding of how prime and secondary property have performed relative to each other over the course of previous property cycles.

However, defining assets as prime or secondary by taking account of factors such as location, building specification, covenant strength, lease structure and sustainability would be both highly subjective and time-consuming. this is further complicated by the fact that the very definition of prime and secondary can vary over the course of the property cycle, influenced, for example, by investors’ attitude towards risk and the tendency for individual property markets to move in and out of favour as prime locations over time. nevertheless, even without strictly defining prime, secondary and tertiary, some data does exist that could allow us to get a flavour of how different quality assets have performed in aggregate.

Data and AnalysisUsing an asset’s equivalent yield as a very rough guide of its “prime-” or “secondary-ness” relative to its peers, IPD’s quartile analysis can help us to compare the performance, albeit at a simplistic level, of lower yielding properties (a rough proxy for prime) with mid-yielding (representing secondary) and high-yielding (tertiary) properties1. In addition, although not strictly comparable for a variety of reasons, prime (in this case, CBRe) and “average” (IPD Monthly) data can also be analysed to provide a rough guide to how asset quality impacts on performance. Both of these times series have been available since 1987 and, therefore, can provide a longer-run view of relative performance. CBRe’s monthly prime and secondary yield series, available since 1999, have also been analysed to provide, arguably, a more accurate view of the transactions market.

Rental Growth Cycle Both the IPD quartile analysis and the IPD Monthly/CBRe prime analysis suggest that rental growth on prime properties tends to lead that of the rest of the market during the recovery phase of the rental cycle. However, there is little evidence to suggest that any such leading/lagging effect occurs between prime and secondary during an occupational market downturn.

In addition, eRv growth appears to have been stronger for secondary properties at certain times in the cycle, specifically after prime rental growth has peaked. this, of course, may partly reflect the fact that there is valuation lag inherent in IPD data, but also that there is an element of “catch-up” for secondary properties once prime becomes too expensive or occupier demand for space exceeds readily available supply. However, intuitively, such relative outperformance of secondary/tertiary assets is unlikely to be sustained over the longer term and this belief is also borne out by the analysis.

As an example, comparing CBRe’s prime, headline 12-month rolling rental growth for the City office market with IPD’s average figures, it is clear that rental growth for “average” City offices outperformed once rental growth in the prime market had peaked, and indeed continued to outperform in most cases until the market re-entered a recovery phase. During market downturns in particular, “average” rental growth proved to be more resilient than prime, with rents for the latter falling faster and further than in the remainder of the market.

Source: IPD Monthly Digest, CBRE Prime Rent and Yields Monitor (December 2011)

ERV

Gro

wth

-40

-30

-20

-10

0

10

20

30

40

50

City Offices (IPD)

Rolling 12 month ERV Growth for prime CBRE and IPD average (%)% p.a.

Dec

-87

Dec

-88

Dec

-89

Dec

-90

Dec

-91

Dec

-92

Dec

-93

Dec

-94

Dec

-95

Dec

-96

Dec

-97

Dec

-98

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

-07

Dec

-08

Dec

-09

Dec

-10

Dec

-11

City Offices (CBRE)

“During market downturns in particular, “average” City office rental growth proved to be more resilient than prime, with rents for the latter falling faster and further than in the remainder of the market... however, these trends are not universal across the segments.”

1 Although not an ideal indicator for differentiating between prime and secondary property, partly due to the “time-varying” nature of the quality definitions as outlined, quartile analysis does produce some useful results. However, care must be taken with the interpretation of these results, particularly for those segments which can be further split into specialised lower- or higher-yielding sub-groups, such as retail warehouses (e.g. fashion parks versus bulky good parks).


However, these trends are not universal across the segments. Most non-london-focused segments saw prime and secondary rental growth starting to slow simultaneously once the rental market had peaked. In addition, the outperformance of secondary compared to prime at this stage in the cycle does not appear to be seen in all segments, with, for example, prime london industrial rents proving more resilient than secondary/average rents during rental downturns, suggesting that prime/secondary performance differentials may be more market-specific.

The Interaction between Prime and Secondary yields and the Implication for Total Returns the first seven years of the “noughties” saw relative stability and robust economic growth in the UK, leading to overly-optimistic expectations regarding future performance across virtually all of the asset classes. the property market was no exception and, with prime yields having been forced down to record lows and debt finance easily available, investors increasingly began to buy into secondary property.

the chart below compares CBRe’s prime and secondary yield series for high street retail. As in virtually all of the other markets for which data is available, the yield premium between prime and secondary property narrowed significantly between 2000 and 2006, indicating the possibility that secondary assets could have outperformed during that period.

Analysis of the existing data suggests that, during the first 12 months of the property market downturn (early-2007 to early-2008), the yield gap between prime and secondary shops widened from 100 basis points to just over 150 basis points. However, once the full extent of the financial crisis became clear, the spread more than doubled to 400 basis points within the next 18 months. since then, investors’ risk aversion towards more secondary assets has persisted, with the gap having remained around the 400 basis points level. More recently, however, the premium has actually increased further due to renewed investor anxiety amidst

concerns over the outlook for the UK economy, and thus the property occupational market, and it now stands well above its historic average. this dramatic increase in the yield gap over a comparatively short period of time has meant that secondary property will have significantly underperformed prime during the downturn.

However, it is difficult to know how this yield premium will change in the short to medium term. Although secondary properties are likely to continue be negatively affected by much weaker occupational fundamentals in the short term, prime properties are also exposed to risk in the form of potentially being seen as over-priced, particularly in those segments where yields are already approaching pre-credit crunch lows. this may not be an issue in the immediate term as interest rates are not expected to increase any time soon. However, when monetary policy does start to be tightened, the yield premium between prime property and government bonds will start to look uncomfortably small. In contrast, although the current level of pricing for secondary property incorporates a significant level of risk, once the economic outlook has improved the unusually large yield premium between prime and secondary property will start to appear relatively attractive. this could, therefore, indicate that huge potential for outperformance exists for secondary property compared to prime over the more medium term.

In 2011, olivier Blanchard, chief economist of the IMF, stated that “the world economy is pregnant with multiple equilibra”2. this is also true of the UK property market and it is becoming increasingly difficult to determine how the interaction between prime and secondary assets will play out, and thus which type (or, rather, quality) of asset will prove to be the best performer over the medium term.

The Prime-Secondary Yield Differential (Non-London High Street Retail)

Source: CBRE Monthly Investment Yields (February 2012)

Mar

-01

Mar

-00

Mar

-99

Mar

-04

Mar

-03

Mar

-02

Mar

-07

Mar

-08

Mar

-06

Mar

-10

Mar

-11

Mar

-09

Mar

-05

SecondaryPrime

0

1

2

3

4

5

6

7

8

9

10

CBR

E Yi

eld

Yield Gap

% %

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Yiel

d G

ap (S

econ

dary

- Pr

ime)

“...properties will continue be negatively impacted by much weaker occupational fundamentals... prime properties are also exposed to risk in the form of potentially being seen as over-priced, particularly in those segments where yields are already approaching pre-credit crunch lows.”

2 “2011 In Review: Four Hard truths”, December 2011.


InteRnAtIonAl PRoPeRtY MARKets

GloBAl vIeW

Prospects for global economic growth have continued to deteriorate and this has inevitably started to affect property markets across the world. Whilst just six months ago occupier demand was strengthening, continued uncertainty over the economic outlook is affecting rental growth prospects and prime rents have now started to stabilise, even in the previously-buoyant Asian markets.

Although there had been signs that investors were become slightly less risk averse, the weakening economic outlook and continued concerns over the future of the eurozone mean that this burgeoning trend is already starting to reverse. As such, the pricing on prime property has remained stable or even sharpened, whilst yields are again softening on secondary property.

noRtH AMeRICA

the Us recorded relatively subdued GDP growth of 1.7% in 2011, although growth accelerated in the final quarter. Meanwhile the unemployment rate fell to 8.3% in January, suggesting that some recovery momentum was maintained into 2012. In contrast, according to nCReIF, property market total returns decelerated from 7.4% in the first six months of the year to 6.4% in the second half of 2011.

Meanwhile, the economic recovery in Canada is on shakier ground, with the unemployment rate jumping from 7.1% in september to 7.6% by January 2012. nevertheless, IPD office total returns continued to accelerate in the last quarter of 2011, sharply reducing the gap between this sector and retail, the current top performer.

eURoPe

the on-going sovereign debt crisis in the eurozone continues to weigh on the region’s prospects for economic growth. the currency union is now expected to fall back into recession this year, reflecting increased concerns that Greece in particular may default and/or leave the eurozone. this much weaker outlook is inevitably affecting prospects for the occupier markets and rental

growth forecasts have been downgraded throughout the region.

Investors remain highly risk averse and continue to focus on prime property in the core countries. Although prime yields have now largely stabilised, some further expansion is being registered in the peripheral countries as investors continue their “flight to safety”.

% p.a.

Asia PacificNorth AmericaEurozoneUK

2012 (f) 2013 (f)2011

GDP Outlook

Source: Consensus Economics (February 2012)

-1

0

1

2

3

4

5

6

AsIA PACIFIC

the outlook for growth in the Asia Pacific region continues to moderate as the fragile Us recovery and on-going sovereign debt crisis in europe weighs on regional export growth and domestic activity. smaller, export-dependent economies like singapore, Hong Kong and taiwan are particularly vulnerable to a slowdown in external demand.

Demand for commercial real estate space continues to soften. office rents in Hong Kong, singapore and seoul are all under downwards pressure. Meanwhile, rental growth in the retail and logistic sectors remains subdued, although no significant rental correction is expected. As a result, investors remain cautious regarding acquisitions and are likely to stay focused on prime assets in the near term.

2007 2008 2009 2010 2011

%

Total Return

US All Property Total Return (% per qtr)

Source: NCREIF (January 2012)

-10

-8

-6

-4

-2

0

2

4

6

Q4Q3Q2Q1Q4Q3Q2Q1Q4Q3Q2Q1Q4Q3Q2Q1Q4Q3Q2

% p.a.

-8

-6

-4

-2

0

2

4

6

SwedenGermanyFranceIrelandSpainItalyPortugalGreeceEurozone

GDP Growth Outlook for SelectedCountries in the Eurozone


2012 2013 2011

Real

GD

P G

row

th

Australia

Singapore

Japan

% p.a.

0

1

23

4

5

6

789

2013 (f)2012 (f)

South Korea

Hong Kong

GDP Growth Outlook for Selected Asia Pacific Economies



GloBAl eConoMIC AnD MARKet RevIeW

europe’s government debt crisis remained centre stage throughout the quarter. the continued deterioration was signalled by spiralling borrowing costs in the region’s heavily indebted countries and a freeze in interbank lending. the european Central Bank cut interest rates in two successive months to 1% and, while closer fiscal integration within europe was mooted, the market remained sceptical of a successful resolution to the crisis. Additional resources were proposed by the International Monetary Fund and the european Financial stability Facility, the eurozone’s bailout fund, and the world’s major central banks eventually took coordinated action to supply ultra cheap funding to ease strains in the financial markets and help bolster economic activity.

nonetheless, fears of contagion hurt global economic prospects, with growth estimates for 2012 deteriorating around the world. Asian countries were particularly affected due to an uncertain outlook for the region’s export-orientated manufacturers as forecasts for global demand fluctuated. China, too, showed signs of slowing growth, and the government loosened monetary policy although, with a growth rate of 9.1% year-on-year in the third quarter, the country still outpaced growth in Western countries by a substantial margin. In the UK, the office for Budget Responsibility downgraded the UK’s growth forecasts until 2014 and the government announced guarantees to lending and infrastructure spending to help mitigate the worst impact of the austerity measures. However, in the Us, better economic data hinted at a possible recovery with rising consumer confidence and housing starts, as well as better manufacturing and employment numbers.

Global equities started the fourth quarter at historically low valuation levels, but ended the year on a positive note. shares in energy companies rebounded sharply over the final quarter of the year, while financials were one of the major losers over fears about banks’ exposure to peripheral european sovereign debt. the Ftse World Index was up 7.7% in sterling terms, with Us share prices gaining the most, rising an impressive 12.1% in sterling terms, while the

performance of Asian and emerging market equities varied widely: Chinese stocks were among the weakest while Japan also fell on fears that its exporters could also suffer from softening european demand.

Despite the fragile growth outlook, the Ftse All-share Index climbed 8.4% in the final quarter, supported by compelling equity valuations coupled with healthy corporate earnings. Fears of a possible recession in 2012 and continuing turmoil in europe, the UK’s main export market, meant that investors preferred large multinationals over smaller companies given the former’s greater exposure to faster-growing regions such as Asia and the emerging markets. Meanwhile, european equities managed to shrug off a change in the governments of Greece and Italy and a threatened ratings’ downgrade from standard & Poor’s and Fitch as investors took advantage of very low valuations and focused on companies with growth opportunities in other parts of the world.

In contrast to equities, “safe haven” sovereign bonds were heavily favoured by investors. the benchmark 10-year gilt yield dropped below 2% for the first time in December helped by the stable and low interest rate environment. Investors particularly favoured long-dated issues which recorded an impressive 9.6% return in comparison to returns on shorter dated stocks which registered a more modest performance.

the Us and Germany also enjoyed record low borrowing costs, but yields on highly-indebted sovereigns, such as Italy and spain, climbed sharply over the quarter as investors sought safety in higher-quality government bonds on concerns over the threat of a disintegration of the euro. Italy’s 10-year bond yields surged past 7% in november, the level that prompted Greece, Ireland and Portugal to seek bailouts. Meanwhile, credit tended to underperform government bonds as investors continued to discount a worst-case economic scenario. Bank bonds, in particular, came under pressure due to worries over banks’ exposure to debt issued by the weaker eurozone countries.

Risk appetite ebbed and flowed during the final months of 2011 depending on investors’ confidence levels in policymakers’ resolve in dealing with the Eurozone debt crisis.

UK

US

Germany

Japan

2011

%

J F M A M J J A S O N D0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

10-Year Government Bond Redemption Yields

Source: Thomson Reuters Datastream (December 2011 )

Local

£

2011

FTSE World Index

Source: Thomson Reuters Datastream (December 2011)

J F M A M J J A S O N D80

85

90

95

100

105

110


DAtA AnD stAtIstICs

PRoPeRtY PeRFoRMAnCe MetRICs (%)

source: various (compiled by PRUPIM performance measurement team) *Annualised

Index Frequency Date 1 month 3 months Calendar yTD 1 year 3 years*IPD Monthly Index Monthly Jan-12 0.4 1.4 1.4 7.8 9.2

CBRe Monthly Monthly Jan-12 0.3 1.2 0.3 7.6 10.4

IPD Quarterly Index Quarterly Dec-11 – 1.4 7.8 7.8 8.7

IPD Annual Index Annual Dec-10 – – – 15.1 -2.5

InvestMent YIelDs (%) FoR PRIMe PRoPeRtIes

source: PRUPIM Data refers to PRUPIM’s estimates of prime rents and yields for the best locations in the regions in question. Yields rounded to nearest 25bps *Yields refer to a prime restricted use Retail Park**Please note that due to a sample changes, the previous data for retail warehouses is not available.

Shops Offices Business Parks Retail warehouses* Industrials

Region Dec–11 Change over

quarter (%)

Dec–11 Change over

quarter (%)


quarter (%)


quarter (%)**


quarter (%)

Central london 3.75 – 3.75 0.00 – – – – – –

sub london 4.75 0.15 6.25 0.00 – – – – – –

london – – – – – – 5.00 – 5.75 –

south east 4.75 0.00 6.25 0.00 6.50 0.00 5.00 – 6.75 0.00

south West 4.75 0.00 6.25 0.00 7.25 0.00 5.25 – 6.75 0.00

eastern 4.75 0.00 6.00 0.00 7.00 0.00 5.00 – 6.50 –

east Midlands 5.00 0.00 7.50 – – – 5.25 – 6.50 0.00

West Midlands 5.00 –0.25 6.25 0.00 7.75 0.00 5.25 – 6.75 0.00

Wales 5.25 0.00 6.75 0.00 7.50 0.00 5.50 – – –

north West 4.75 0.00 6.25 0.00 7.75 0.00 5.25 – 6.75 –

Yorks & Humbs 5.00 0.00 6.50 0.00 8.00 0.00 5.25 – 7.25 0.00

north east 5.00 0.00 6.75 0.00 7.75 0.00 5.25 – – –

scotland 5.00 0.25 6.00 0.00 7.75 0.00 5.25 – 7.50 0.25

northern Ireland 5.75 0.00 8.00 0.00 – – – – – –

PRIMe HeADlIne Rents – £ PeR sQUARe Foot PeR YeAR

source: PRUPIM Data refers to PRUPIM’s estimates of prime rents and yields for the best locations in the regions in question *Rents refer to a prime restricted use Retail Park **Please note that due to a sample changes, the previous data for retail warehouses is not available.

Shops Offices Business Parks Retail warehouses* Industrials

Region Dec–11 % change

over quarter

Dec–11 % change

over quarter

Dec–11 % change

over quarter

Dec–11 %change

over quarter**

Dec–11 % change

over quarter

Central london 900 – 95.0 0.0 – – – – – –

sub london 330 0.0 41.5 7.8 – – – – – –

london – – – – – – 50.0 – 12.0 –

south east 320 – 30.0 0.0 27.5 0.0 40.0 – 7.5 0.0

south West 240 0.0 27.0 –1.8 19.5 0.0 60.0 – 5.3 0.0

eastern 180 0.0 30.0 0.0 26.5 0.0 50.0 – 7.5 –

east Midlands 200 –9.1 19.5 – – – 105.0 – 5.5 –

West Midlands 220 0.0 28.5 0.0 19.8 3.9 50.0 – 5.5 10.0

Wales 280 0.0 21.0 0.0 15.5 3.3 32.0 – – –

north West 270 0.0 28.5 1.8 17.0 3.0 42.5 – 4.0 0.0

Yorks & Humbs 220 0.0 – – – – 60.0 – 5.3 –

north east 225 0.0 – – – – 50.0 – – –

scotland 255 0.0 30.0 0.0 16.5 –2.9 35.0 – 5.5 0.0

northern Ireland 180 0.0 – – – – – – – –


ContACts

CONTACTS

ABOUT ThE GLOBAL PROPERTy RESEARCh TEAM

KEy PEOPLE

DISCLAIMER

BIOGRAPhIES

REGULATORy INFORMATION

PRUPIM’s well known and widely respected Global Property Research team, based in london and singapore, comprises of 12 staff including eight property economists and three performance measurement analysts. the team engages in three main types of work namely; assessing the attractiveness of UK and international property markets, providing strategic recommendations and risk control measures for clients’ funds, and conducting ad-hoc property related analyses on key issues as they emerge. the research team also assists in buy, sell and hold decisions by working closely with colleagues across PRUPIM to create a holistic approach to asset management.

Paul McNamara, Director, head of Research BSc (hons) PhD ASIP FRSA OBEPaul is responsible for the overall direction of property research within PRUPIM. He is also a member of the PRUPIM Board. Paul joined Prudential in 1987. He is a visiting Professor with the Centre for estate Management at oxford Brookes University. Paul was appointed Chairman of the Investment Property Forum (2005-6). He has been Honorary President and Chairman of the society of Property Researchers and is a non-executive director of IPD Holdings limited. In June 2003, Paul was awarded an oBe in the Queen’s Birthday Honours list for services to the property industry.

Richard Gwilliam, Deputy head of Property Research, BSc (hons.)Richard is the Deputy Head of Property Research at PRUPIM. His responsibilities include analysis of the UK and global property markets, the formation of in-house views, and determination of strategy for PRUPIM’s funds. Richard has more than eight years of analysis and research experience within property investment; prior to joining PRUPIM in 2006, he spent three years at Investment Property Databank (IPD). Richard has a Bsc (Hons.) in economics from the University of nottingham, and also holds the Investment Management Certificate. He is a member of the committee of the society of Property Researchers.

PRUPIM forms part of the M&G Group of companies. PRUPIM is an indirect subsidiary of Prudential plc, a company incorporated and with its corporate head office in the United Kingdom. Prudential plc and its affiliated companies constitute one of the world’s leading financial services groups and is not affiliated in any manner with Prudential Financial, Inc, a company whose principal place of business is in the United states of America.

For Investment Professionals only. No other persons should rely on any information contained in this document.

Past performance is not a guide to future performance and the value of investments can fall as well as rise. Property is valued by an independent valuer. However, valuations are subjective

and may vary between valuers. Commercial Property is a specialised sector and has different characteristics to investments in equities, bonds or residential property.

100% of the inks used are vegetable oil based, 95% of press chemicals are recycled for further use and, on average 99% of any waste associated with this production will be recycled.

this document is printed on Revive 50:50 White silk, a paper containing 50% recycled fibre (25% post consumer waste and 25% pre consumer waste) and 50% virgin fibre sourced from well managed, sustainable, FsC certified forests. the pulp used in this product is bleached using an elemental chlorine free (tCF) process.

PRUPIMCity Place House55 Basinghall stlondon eC2v 5DU

Governor’s House (Registered office)laurence Pountney Hilllondon eC4R 0HH

Tel 020 7548 6600Fax 020 7548 6999web www.prupim.comLisa white 020 7548 6861(team secretary)

Paul McNamara, Director, Head of Research, Bsc (Hons.) PhD AsIP FRsA oBeScott Girard, Chief executive officer, PRUPIM singapore, B.Comm MAFRichard Gwilliam, Deputy Head of Property Research, Bsc (Hons.)Cuong Nguyen, senior Analyst (singapore), Bsc (Hons.) Msc PhDEmma harding, senior Analyst, Bsc (Hons.)weijia wang, Analyst, Bsc (econ.) MscCheng Ma, Analyst, Bsc Msc MscKostis Papadopoulos, Analyst, Bsc MscNick Blakemore, Director, Performance MeasurementTracy wang, Performance Analyst, Bsc MscAndrew Pain, Performance Analyst, Bsc (econ.) MscLisa white, team secretary


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