Real Estate Research
UK real estate market commentary - March 2017
The vote to leave the EU has generated different responses from UK business and consumers. Despite the Bank of England’s cut in interest rates and other measures, business investment fell in 2016 and companies have become more cautious about recruitment. Conversely, the immediate reaction of consumers has been to borrow and spend more and this helped the economy to maintain momentum through the second half of 2016. The sharp upturn in inflation caused by sterling’s depreciation will curb real incomes and consumer spending in 2017 and is unlikely to be fully offset by an improvement in exports. Schroders expects quarterly GDP growth to slow from 0.7% in the final quarter of 2016 before seeing a modest pick up in growth next year, assuming that sterling stabilises and inflation then decelerates.
Historically, strong consumer spending would boost retailers’ profits, which in turn would feed through to retail rents. However, online sales have put retailers’ profits under serious pressure, despite the growth in volumes. Retailers’ profits margins are being squeezed by a number of factors including investment in websites, online delivery, the increase in the national living wage and the ending of foreign exchange hedges, which initially protected them from the jump in the sterling price of imports. The increase in business rates will also hit stores in London and the South East, although the impact on national retailers is likely to be broadly neutral, as rates decline in other regions. Our retail strategy is to focus on convenience retail and out-of-town retail, where rents are relatively affordable. We also favour schemes which can be converted to accommodate hotels, restaurants and other leisure operators.
The greater caution of corporates is most visible in the central London office market. Gross take-up fell by 20% last year and indications for the first quarter of 2017 suggest that demand has remained relatively weak. Given the uncertainty over passporting rights for financial services, the recognition of professional qualifications and the free movement of labour, we assume that employment in central London will fall over the next couple of years leading to declining office rents. We think that the City office market is most vulnerable, given its high exposure to financial services and the volume of new space under construction.
Outside of London, we expect that office rents will be stable through 2017-2018. Occupiers are generally less reliant on international business while the government’s plan to consolidate the civil service outside London into 13 hubs will provide further support to office markets in cities such as Birmingham, Bristol, Leeds and Manchester. Furthermore, new building has remained muted and the introduction of permitted development rights legislation in 2013 has meant that a lot of obsolete offices have been converted into apartments, especially in southern England. We also continue to see good demand for distribution warehouse space, reflecting the growth in online retail and expansion by discount retailers.
While domestic and foreign institutions have been relatively quiet since the EU referendum, the sharp fall in sterling has encouraged private buyers from Asia and the Middle East back into the market. Chinese investors have also been concerned that the authorities there will tighten capital controls. The other active buyers have been UK local authority treasury departments who have become particularly competitive given their very low cost of borrowing, and have been acquiring income producing assets outside London which will help to fund local services. As a result, liquidity has been surprisingly strong, particularly at the prime end of the market, and investment volumes appear to have stabilised.
The CBRE all property initial yield has held steady at 5.1% since last July. Looking forward, with 10 year gilt yields at around 1.25%, the current yield gap is so large that we doubt whether an increase in long dated gilt yields even to 2.0% would have an impact on real estate yields. However, investors will also be influenced by the Brexit negotiations and there is an obvious risk that sentiment could weaken, and yields rise, if the talks between London and Brussels get off to a difficult start. If this were the case, secondary assets would be more likely to be adversely affected.
Our strategy will be to continue to focus on owning assets offering good real estate fundamentals in towns and cities with diverse economies, good infrastructure and other differentiating factors such as good universities. We prefer office and industrial assets in Brighton, Bristol, Cambridge, Leeds Manchester, Oxford, Milton Keynes and Reading. We expect these towns and cities will outperform over the next few years, particularly in a period when there is relatively little new development. We also favour certain alternative property types, with above average yields and index-linked rents.
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