As the 18-month decline in capital values draws to a close, there are signs that the recovery in the UK is spreading beyond London. Richard Lowe reports

Commercial property in the UK is showing signs of undergoing a broader recovery, and investors are shifting their focus to opportunities outside London, such as regional offices.

Total returns for the second quarter of 2013 were 1.9%, their highest level since the second quarter of 2011. Capital values increased by 0.4% over the three-month period bringing the 18-month decline to an end.

In July, Greg Mansell, vice-president and head of applied research at IPD, told an audience of more than 100 industry participants in London that the results were “not stellar by any stretch of the imagination, but it’s building on previous momentum”.

On releasing the results of the latest UK Quarterly Property index, IPD stated that the figures would “add to the list of economic indicators showing that the UK’s economy is on the mend”.

Significantly, the IPD data show that the recovery was not only led by the London market, but also driven by growth in selected regional markets. Mansell says “the biggest improvements were in the South East offices and industrials”. Ex-London offices were still in the bottom five worst-performing market segments, but he says “they were moving in the right direction”.

A new transaction-based price index, launched this summer by Real Capital Analytics (RCA) and Property Data, suggested that capital values had risen at a similar level (0.3%). RCA reported that regional office pricing might be “staging a rebound”.

Its report says: “The sentiment for office properties outside of central London also appears to be changing. Prices for office ex-London have increased 19.6% over the past year and recorded strong gains again in Q2.”

The suggested change in fortunes for regional offices is also supported by a Q2 survey of prime rents and yields by CBRE, which shows rental growth and failing yields extended beyond London and the South East for the first time since the downturn.

According to Aleksandra Starczynska, analyst at CBRE Research, The results “show that a more widespread recovery in the UK property markets is starting to become apparent”.

A number of real estate fund managers are considering the potential of dedicated regional office strategies in the UK. Patrizia is managing such a strategy in joint venture with US hedge fund Oaktree Capital.

Alice Breheny, head of global property research at Henderson Global Investors, told the IPD quarterly index briefing that the pricing of regional offices looked attractive. “If we compare them to central London, for example, where yields are well below their long-run averages and somewhere close to the bottom end of their historical range, they are starting to look very expensive, and investors are finding it very hard to find value to make returns stack up,” she says.

“When we look at some of the regional office markets…. we can see that rents are below their long-run average and at the upper end of that range and so offering pretty good value in some cases, given that we expect them to return to positive rental growth and given the constrained supply in some of these markets.”

Breheny says there had been a noticeable shift among investors in favour of strategies that venture “outside that very core, prime area, quite simply because we can’t meet their return requirements in the super-prime trophy buildings”.

She says, up until recently, convincing investors to move up the risk curve had been “like pushing against a brick wall”, albeit understandably given the ongoing market and economic uncertainty and risk aversion of recent years.

Breheny adds: “It’s been very difficult, but all of a sudden we do see that people are asking us questions about non-prime, good secondary, and they are certainly happy to talk to us about it.”

But Richard Tanner, managing director at AEW UK, thinks there are a number of risks associated with the regional office markets. He says he is “bullish on most things in the regions” – citing, for example, positive supply-and-demand dynamics – but he is particularly concerned about the potential for obsolescence in the regional office sector.

“I’m pretty much gung-ho about a lot of regional markets,” Tanner says. “But I think the difficulty you’ve got is that office buildings in the regions became very expensive. That was 2007. We’re in 2013. They’re all six years older now.”

Tanner’s issue with offices per se is “they are unlike many other forms of real estate” in that they suffer “heavy depreciation headwinds” which need to be accounted for when investors look for value.

“I’m a little concerned that some of those regional markets and the stock we see – unless they get very cheap – aren’t necessarily particularly good value,” he says. “They don’t even have necessarily huge upside or alternative use for residential, and so I think there’s still a fair few issues out there.”

AEW UK has been active in the office market in the western corridor of London. “We see enormous value,” Tanner says, “and continue to buy there, and have seen some incredible deals, in my view, where we have strong tenant demand, good restrictions on land supply, and  high alternative use value for residential.”