UK Real Estate Market Commentary – September 2015
After a strong 18 months, Schroders expects the UK economy to experience a mid-cycle slowdown with GDP growth of around 2.25% in 2016. Activity will be affected by cuts in public spending which will reduce growth by around 0.5% in 2016, although this will now be smoothed over four years rather than three (source: Schroders). We expect consumer price inflation to accelerate towards 2% by the end of next year, as the fall in oil prices drops out of the equation and that accordingly the Bank of England will gradually raise base rate from its current level of 0.5%. While the South East continues to see the strongest economic growth, many regions are also seeing reasonable growth.
In the office sector the main change so far this year has been the upturn in office rents in the regions. Although this could be portrayed as a ripple effect from London, the reality is more complex and while certain cities (e.g. Bristol, Manchester) are seeing rental growth of 5% per annum, office rents in other cities (e.g. Leicester, Sheffield) have barely moved. In general, we favour offices in Brighton, Cambridge, Cardiff, Guildford, Leeds, Manchester, Oxford, Reading and Solihull. These towns and cities have a strong base of technology and professional occupiers which should more than offset the impact of falling demand from public sector agencies. There are also signs in the north of England that the big city amenities of Leeds and Manchester are drawing occupiers away from smaller neighbouring cities (e.g. Liverpool, Sheffield).
By contrast with offices, retail rents outside London remain in the doldrums. While store sales have begun to recover, on-line sales are growing much faster and there is rarely serious competition between retailers for space (source: ONS). On average 12% of high street units and 15% of shopping centres units are vacant and there has been little improvement over the last couple of years (source: Local Data Company). Retail warehouses have seen a fall in the vacancy rate to 7% from 10% in 2013, but again the omens are mixed. On the one hand, M&S, Next and Poundland are expanding out-of-town while other retailers like PC World are focusing on bigger stores where they can demonstrate products and tempt shoppers to trade up. On the other hand, the big DIY chains and supermarkets have surplus out-of-town space and are seeking to downsize.
Industrial rental growth accelerated to 4% per annum in the second quarter of 2015, its fastest rate since 2000. While in part the recovery is being driven by the general upswing in the economy, the sector is also benefiting from the rapid growth of on-line retailing, which now accounts for roughly 20-25% of demand. In general, we prefer industrial estates to big distribution warehouses, because they attract a wider range of occupiers, yields are higher and because capital values are normally too low to make speculative development viable.
£34 billion of investment transactions were completed in the UK in the first half of 2015, surpassing the previous peak in the first half of 2007 (source: Property Data). The biggest net buyers were foreign investors, in particular US opportunity funds, followed by UK institutions. Chinese and Russian investors accounted for less than £2 billion of purchases. While most of the capital invested is equity, the availability of debt has increased significantly over the last two years, as insurers and debt funds have entered the market.
Strong competition among investors pushed the IPD all property initial yield to 5.1% in August, down from 5.6% 12 months earlier. While certain parts of the market now look expensive – prime City offices, shopping centres, London industrials – we continue to see value in other areas: parts of London which are benefiting from new transport infrastructure and gentrification / regeneration, certain regional office markets (see above), convenience retail and regional industrials. In addition, we see attractive opportunities in some alternative sectors such as car showrooms, data centres and healthcare, 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.
The latest IPF Consensus Forecast is for capital values to increase by 4% in 2016 and then hold steady through 2017-2018. While we agree with the outlook for next year, we expect that there will be a small fall in capital values in either 2017, or 2018. In part this is simply down to experience. In relatively liquid real estate markets like the UK capital values tend to either go up, or down, but not sideways. More fundamentally, it reflects our assumption that 10 year gilt yields will rise to 3-4% by 2017-2018 and that will have a limited knock-on effect on real estate yields. We believe that segments with good rental growth prospects and assets which are reversionary are likely to be relatively defensive.
There are two other “known unknowns”. First, the extent to which the economic slowdown in China will affect capital flows from South East Asia. Second, the EU referendum. We expect the UK will vote to stay, but there could be a hiatus in occupier and investor demand in the run up to the referendum, if polls suggest a close result. Conversely, if the UK leaves, then capital values could fall sharply, particularly in those segments such as central London offices and student accommodation which benefit most from open access to the EU.
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