UK Real Estate Market Commentary – June 2015
Schroders expects economic growth to slow from around 3% in 2014 to 2-2.5% through 2015-2016. Part of this will be because the one-off boost to household incomes from last year’s drop in oil prices will soon start to fade, and in part due to cuts in government spending. We also think that the recent sharp acceleration in wage increases and signs of skill shortages in sectors such as construction and IT will prompt the Bank of England to raise interest rates to prevent a wage-price spiral.
In London a combination of modest new supply and strong demand from media, technology, professional services and serviced office providers has pushed office vacancy rates down to historically low levels in core and fringe locations. Consequently, we expect London office rents to increase by around 10% in 2015. Looking ahead, there are two clouds on the horizon. First, the prospect of an EU referendum could inhibit demand in 2016, particularly from banks and the law firms who work for them, although a rally would probably follow if the UK votes to stay in the EU. Second, the upswing in office rents finally appears to have triggered an upturn in new development in the City of London. If all the new schemes which have recently been announced go ahead, then office rents in the City are likely to peak in around 2017.
Despite strong consumer spending, rental growth is scarce in the retail sector. The main hotspot is London’s West End which is benefiting from both tourist spending and demand from retailers for flagship stores and certain London suburbs which are undergoing gentrification. The real challenge comes from online sales, which are forecast to rise from 13% of total sales in 2014 to 17% in 2019 according to Conlumino. There is therefore little depth to retailer demand in many locations and openings of convenience stores, cinemas, discount stores and restaurant chains are balanced by closures of banks, electrical and fashion outlets.
While industrial rents have traditionally been relatively stable, the last 18 months has seen a definite upturn with most of the UK seeing rental growth of 2-3%. Indeed, in parts of the Midlands and northern England, industrials are seeing faster rental growth than both office and retail property. The upswing is being driven partly by a cyclical recovery in small and medium sized businesses and partly by the rapid growth in express parcels (approximately 5% pa) fuelled by online retailing. In addition, the amount of space in standard industrial units has fallen over the last decade, as estates have been redeveloped for housing and business parks.
£18 billion of investment transactions were completed in the first quarter of 2015, the busiest start to the year since 2006 (source: Property Data). The biggest net buyers were foreign investors, while UK institutions were slightly less active than in previous quarters. At present there are no figures for the second quarter of 2015, but our impression is that the investment market only paused briefly in the run up to the general election before picking up again in June.
As a result of strong competition in the investment market, the IPD all property initial yield fell to 5.2% at the end of May 2015, its lowest level since early 2008. While that looks reasonable in the context of very low interest rates, and prospects for steady rental growth over the next few years, it becomes harder to rationalise if 10 year gilt yields are assumed to rise from the current 2.0% (at end June 2015) to 3-4% by 2017-2018. Nevertheless, we see value in parts of the market, including those areas of London which are benefiting from new transport infrastructure and gentrification / regeneration and smaller regional office and industrial assets, where competition among investors is less intense. In addition, we see attractive opportunities in some alternative sectors such as data centres and care homes which are benefiting from technological or demographic changes and where yields are relatively high.
We expect UK commercial real estate to have another strong year in 2015 with capital growth close to 10% and total returns of around 15%. The main driver will be a decline in yields, although rental growth of 3% should also make a useful contribution.
Looking ahead over the next couple of years we expect capital growth to slow as the decline in yields slows, and it is possible that capital values may fall modestly in 2-3 years’ time. Although in the short-term there is no correlation between property yields and long-term gilt yields, the latter are clearly an important reference point and we believe that those assets and parts of the market where there is little prospect of any income growth will be most vulnerable when bond yields rise. The other “known unknown” is the EU referendum. Our assumption is that the UK will vote to stay in the EU, but if it decides to leave then those areas of the market which are most exposed to the international economy – London offices, student accommodation, industrial units in towns dominated by major manufacturers – could suffer most.
The views and opinions contained herein are those of Schroder Real Estate Investment Management Limited and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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