Perspective

Why we think UK real estate can flourish after the Brexit deal


The past five years have proven a bumpy ride for most markets, but the UK real estate market has endured a particularly difficult time since 2016. Following Britain’s vote to leave the EU, investment shrank materially, with international capital focusing instead on destinations like Germany and France.

However, the Brexit trade deal last December may prove a turning point. It has clarified the future relationship between the UK and EU and removed a lot of the uncertainty around sterling. At the same time, the rapid roll out of Covid-19 vaccines in the UK means there is real hope for a strong economic recovery in the second half of 2021.

Here we discuss why we are optimistic on UK real estate, why we expect it to attract capital, and which specific sectors we favour.

What is behind our optimism? Two key drivers.

  1. UK economic recovery as Covid-19 worries fade

The UK is forecast to be one of the fastest growing economies in Europe over the next five years. The recovery looks likely to be led by a strong consumer and a recovery in investment, as we gradually start to put the pandemic behind us.

The UK has been quicker than other European countries to roll out vaccinations. The government plans to vaccinate all adults over 50 years old, health workers and vulnerable people by the end of June 2021. If the government hits its target, and the vaccines remain effective against new variants, the current national lockdown will probably be lifted in March /April.

Other restrictions on visiting non-essential shops, pubs and restaurants are likely to be relaxed over the summer. It is estimated that UK consumers - stuck at home during lockdown - have accumulated an extra £100 billion in savings and the second half of this year should see a sharp increase in spending. The Bank of England, meanwhile, is likely to leave interest rates on hold at 0.1% until at least the end of 2022. 

Forecast economic growth and vaccine roll-outs

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Source:Schroders, Our World in Data, Oxford Economics, February 2021. All forecasts should be illustrative of trends. Actual figures may differ.

  1. Brexit trade deal reduces currency risk

The Brexit trade deal with the EU has reduced currency risk for international investors. As a result, we expect increased capital flows into the UK. This in turn should support a recovery in manufacturing investment, given greater certainty over future trade.

For example, soon after the trade deal Nissan announced that it would switch all production of batteries for its European vehicles to the UK. Likewise, we expect that a more stable currency will reignite the interest of international investors in UK real estate.  

The narrow focus of the initial Brexit deal means the impact on services is less clear. Sectors like university education, tech and media - where the UK is strong - should be largely unaffected. This should have a positive impact on clusters in cities like Manchester and London.

EU regulations mean that London has lost some financial transactions to the continent. However, in the long-term, London should recoup these losses by winning new business outside Europe, particularly in Asia.

The UK economy is also set to benefit from an increase in government investment, after a decade of austerity. One of the government’s main priorities is to kick-start economic growth outside London and south east England. It has announced a number of infrastructure projects to improve transport links between cities in the midlands and northern England. The government is also subsidising investment in renewable energy, particularly off-shore wind turbines, as part of its commitment to cut the UK’s net carbon emission to zero by 2050.  

Not all real estate is created equal

Traditionally, a positive outlook for the economy bodes well for all UK commercial real estate.  Faster economic growth translates into greater demand for space and higher rents. However, as the chart below reveals, it no longer makes sense to think of UK commercial real estate as a single market, with the main sectors following the same cycle.

The total returns from the industrial & logistics and retail sectors moved in opposite directions last year. Indeed, 2020 saw the widest range across the three main sectors since the start of MSCI / IPD records in 1970. 

Retail and industrial returns moved in opposite directions in 2020Chart_3_total_returns.jpg

Source: MSCI/IPD, Schroders. January 2021.

The divergence in performance can largely be explained by the growth in online retail sales. This trend was well established before Covid-19, but the closure of non-essential shops during lockdowns fast-forwarded the shift by approximately five years. Online jumped from 19% of total retail sales in 2019 to around 30% last year. Take-up of big warehouses hit a new record in 2020, as both internet retailers and conventional retailers invested heavily in logistics to fulfil online orders.

Consequently, industrial & logistics was the one sector to see rental growth and a favourable decline in yields last year. By contrast, sales per square foot in shopping centres dropped by around 30% in 2020 and many retailers who had been slow to adapt fell into insolvency. Even prime retail locations saw an increase in empty shops and retail rental values dropped by 10% last year. 

UK online retail and logistics take-up

Online_penetration.jpg

Source: Gerald Eve, ONS, Schroders. January 2021. All forecasts should be illustrative of trends. Actual figures may differ. 

 

Taking the three main commercial sectors in turn:

Industrial

Industrial is likely to continue to deliver attractive returns over the next three years. Take-up might fall a little in 2021, as companies digest the space they committed to last year. Overall though, demand is likely to remain strong, driven by further growth in online retail and by occupiers holding higher stocks of key products. The disruption of supply chains in 2020 by Covid-19 has prompted retailers and manufacturers to slightly re-think the balance between “just-in-time” inventories and “just-in-case”. 

We have two minor reservations about the sector. First, there is a risk that the inflow of capital into the sector will trigger a boom in speculative development of big logistics warehouses. That has not happened since the Global Financial Crisis (GFC), but it is possible, and it is why we generally prefer multi-let industrial estates in urban areas where land is more constrained. Second, prime industrial yields at 3.7-4.0% (and 2.5-3.0% in exceptional circumstances) are at historical lows, so there is little room for error if rental growth disappoints.

Retail

At the other extreme, we believe that retail will continue to struggle over the next few years. Non-essential shops, bars and restaurants will hopefully re-open in the spring. Even so, sales are unlikely to fully recover to pre-virus levels, assuming that some of the gains made by e-commerce during lockdown will be permanent. Moreover, a number of fashion retailers and banks have announced plans to cut their branch networks, leading to more vacant units in shops and shopping centres and a further drop in rents. At present it is difficult to see where shopping centre rents will find a new equilibrium. The big challenge and opportunity in most towns centres is to replace obsolete retail schemes with other uses such as doctors' surgeries, apartments, and retirement housing.

Online market penetration by product in 2020

Chart_8_online_vac_rate.jpg

Source: Schroders November 2020

It should be noted that some retail types are more resilient than others. The obvious exceptions are food supermarkets and convenience stores. These have continued to trade strongly and remained open through the pandemic. The catch is that prime supermarkets - let to big grocery retailers such as Tesco - are not cheap. Prime yields on these properties have fallen to 4%. 

Less obviously, retail warehouses (also known as big boxes) have been relatively defensive. These are the units that sell bulky goods such as furniture, DIY and homewares.

Shoppers still generally prefer to buy these goods in person rather than online. Although some retailers have failed, vacancy rates are significantly lower than in town centres because rents are affordable. There is good demand from discount food retailers (e.g. Aldi, Lidl) and variety stores. In addition, because retail warehouses are in the open air and have ample car parking, footfall has held up much better through the pandemic than in shops and shopping centres.

We believe that bulky goods retail warehouse rents will stabilise in the next 12-24 months and that their current rating with prime yields (cap rates) at 7%, on a par with shopping centres, is unwarranted. This mispricing is creating selective investment opportunities in markets with strong local catchments and where the rents remain affordable.

Office space

The office sector is perhaps most challenging to call over the near term. Lockdown measures in the UK (and elsewhere in Europe) have resulted in most office staff working from home. On the one hand, some staff like working from home and companies can save money by cutting office space.  On the other hand, existing lease agreements mean that the immediate savings are often quite modest unless space can be sub-let (the average unexpired lease term is nine years). There are also concerns that remote working will damage staff productivity, by reducing informal training and the exchange of new ideas.

In the short-term we expect that office rents will fall by 5-7% as some occupiers attempt to sub-let space in order to cut costs. The low level of new office building in the UK should prevent a repeat of the GFC when office rents fell by 17%.

However, we see this as largely a cyclical rather than a structural phenomenon. We expect that office demand and rents will recover from 2022 onwards, as the novelty of working from home wears off and as employment in IT, life sciences, media and professional services grows.

The main difference with the market pre Covid-19 is that demand is likely to be more polarised. We expect demand to focus on modern offices in city centres and close to universities, which have high quality air conditioning, good connectivity and plenty of informal working areas.  Older space in satellite towns and office parks is likely to struggle. 

Prime yields by city and sector

Chart_8_Yield_city_sector.jpg

Source: CBRE, Schroders, December 2020

Another reason the office sector looks attractive over the medium term is that UK office yields (cap rates) look good value compared to the rest of western Europe. Prime office yields in the West End of London are normally within 0.5% of those in Paris QCA (Quartier central des affaires), reflecting the fact that they are Europe’s most liquid markets.

London office deals averaged £15 billion per annum between 2017-2019. Even last year when asset inspections were interrupted by lockdowns, there was over £8 billion in investment transactions.  However, at present prime office yields in London (3.75%) are one percent higher than in Paris (2.75%), because a lot of international investors were hesitant to invest in the UK due to the perceived currency risk surrounding Brexit.

Now that Brexit is over, we expect that international investors will pivot back to the UK and that London office yields will start to fall later this year, lifting capital values and total returns. We do not expect the yield gap with Paris to close completely, given the 0.6% gap in 10-year bond yields, but we question whether the 1.0% gap is justified. The decline in London office yields is then likely to ripple out to other UK cities in 2022, where yields also look high compared with other regional cities in Europe.

Total and forecast returns by sector 

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Source: MSCI/IPD, Schroders. January 2021. All forecasts should be illustrative of trends. Actual figures may differ. Please see important information regarding forecasts.

Emerging alternatives to see yield compression

Although we’ve focused on the three main sectors, we also see good prospects in certain niche types of UK real estate. In particular we like self-storage and social supported housing. Neither type has been significantly disrupted by Covid-19. Despite good prospects for income growth, yields (cap rates) are relatively high at around 5.5%, because they are not yet understood by most investors. As a result, they can be harder to aggregate into meaningful portfolios. We also expect to see some distressed sales in the UK hotel market later this year and that could create some interesting opportunities to acquire good quality assets at discount prices.

Sustainability

Finally, investors need to embrace sustainability, both because it is the right thing to do and in order to comply with increasingly demanding regulatory requirements. Part of this is about making buildings more energy efficient through, for example:

  • Improving insulation
  • Upgrading heating and ventilating equipment
  • Incorporating lights with motion sensors, smart energy metes and installing solar panels

However, that is not the whole story.  It is also important to think about the carbon embodied in existing building materials and their reuse, water conservation (climate change means there is an increasing risk of drought, particularly in England) and encouraging cycling rather than driving to work by providing cycle stores and showers. None of these features are free, but we believe that occupiers will increasingly regard them as essential and that the capital expenditure will enhance returns, rather than dilute them.

A turning point?

We believe the UK real estate backdrop has all the positive attributes that suggest an imminent recovery. This is especially true in sectors which look to offer good value compared with certain comparable international markets, which lack the liquidity, transparency, legal confidence and ease of doing business of the UK market. It’s hard to tell whether we are before, at, or just after the ‘bottom’ of the market, but we encourage investors to take a closer look.