Real Estate Research
UK Real Estate Market Commentary - September 2016
While third quarter data for GDP has not yet been published, retail sales and other indicators suggest that the economy has continued to grow since the EU referendum. In addition, the Bank of England has cut interest rates and restarted quantitative easing and the new Chancellor has promised to raise spending on infrastructure. However, despite these signs, Schroders expects economic growth to slow in the coming year, with GDP forecast to be 0.5% for 2017.
Despite fears expressed in the immediate aftermath of the EU referendum, occupier demand for commercial real estate has remained firm since June. While tenants are now putting more emphasis on flexibility and break clauses, office and industrial rents have remained solid, reflecting low vacancy and the limited level of new building in recent years. Furthermore, developers have put a number of office schemes on hold since 24 June, putting a further constraint on medium term supply. The exception is the retail sector which, outside central London, continues to struggle with online competition and chronically high vacancy rates. Although the market has benefited from the growth of pound shops and casual dining, we think that there are now too many discount stores and restaurants in the wrong places.
Uncertainty around the impact of trade agreements negotiated with the EU and other countries will inevitably persist until 2019 and beyond. The City of London and Docklands office markets appear most vulnerable, given their high exposure to international financial services and the fact that no country outside the EU/EEA has passporting rights. Demand for office and industrial space outside London should be more stable, because businesses there tend to be more focused on the domestic economy. However, those towns and cities which are a base for multi-national manufacturers exporting to the EU (e.g. Sunderland and Swindon) are likely to be adversely affected as new investment is redirected to factories inside the single market. Our approach is to invest predominantly in winning centres such as Brighton, Bristol, Cambridge, Leeds, Manchester, Milton Keynes and Reading which should be relatively resilient.
The vote to leave the EU had a short term impact on the investment market, although in most sectors there has been sufficient market evidence to enable valuation surveyors to remove uncertainty clauses at September 2016. Overall, year-to-date commercial real estate transaction levels are comparable with those seen in 2013, according to propertydata.com, although anecdotally smaller lot sizes under £20 million have remained more liquid than larger assets. This reflects continuing demand from owner-occupiers and from foreign private buyers who have come into the market following the sharp fall in sterling. Conversely, the majority of domestic and foreign institutions and REITs appear to be waiting on the sidelines until there is greater clarity about the outlook for the economy.
In the two months after the Brexit vote, the MSCI/IPD all property initial yield rose by 0.25% to 5.2% in August and capital values fell by 4%. While we expect that yields on secondary assets with short unexpired terms or weak covenants will continue to rise, we think that yields on prime assets and assets with index-linked rents will level off or even fall, given the near record yield gap (+4.5%) over 10 year gilt yields. In addition, there are relatively few distressed sellers, partly because banks have been quite cautious over the last few years and partly because the wave of redemptions which hit daily dealing funds for retail investors in June and July have abated.
Uncertainty around the impact of the Brexit negotiations will affect market sentiment in the coming part of the cycle. There are as many reasons to be positive on the market outlook as there are reasons to be fearful. The short term view suggests that the optimists are in the ascendancy.
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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