UK Market Commentary – Q4 2020

Industrial was the star performer in 2020.  Covid-19 has not only fast forwarded the growth in on-line retail, but it has also prompted manufacturers and retailers to review their supply chains and hold extras stocks of key items.  Take-up of big distribution warehouses hit a new record last year and industrial rental values rose by 2%.   While 2020 also saw an increase in new development, including several speculative schemes, it is unlikely to result in a widespread over-supply of space and rental growth is likely to continue at between 1-2% p.a. through 2021-22.  One of the main challenges now facing the logistics sector is how to cut air pollution by streamlining deliveries and switching to electric, or gas powered vehicles.

The retail sector is full of extremes.  In the food segment, the big grocery chains continue to open convenience stores and use their big stores to fulfil on-line orders.  Supermarket open market rents are broadly flat.  At the other extreme, the insolvency of Arcadia and Debenhams means that many shopping centres have lost some of their biggest occupiers and the second quarter could see further failures, if the government suddenly halts the furlough scheme and other measures (e.g. business rates holiday) at the end of March.  While the shift to turnover rents will help some retailers, it is only a partial solution and the large amount of empty space means that shopping centre rental values are likely fall by a further 20-25% over the next three years.  Retail warehouses sit somewhere in the middle.   Although  some out-of-town retailers have gone bust (e.g. DW Sports, Harveys), there is steady demand from discounters (e.g. Aldi, B&M, Home Bargains, Lidl) and that has helped limit the increase in vacancy.  We expect rental values on bulky goods parks to fall by 5-8% in 2021, but to then stabilise in 2022.

In the short-term Covid-19 has depressed office demand.   Take up in 2020 was half that of 2019 and vacancy rates rose by 2-3%, as occupiers attempted to sub-let surplus space.  The long lag between companies deciding to look for new office space and signing leases suggests that demand will remain weak in 2021 and office rental values are likely to fall by 5-7%.  The low level of office building should prevent a steeper decline.  What is unclear is how much of the recent drop in demand is cyclical, as companies go into survival mode and preserve cash during a recession and how much is structural, as companies rely more on staff working from home.  We believe that it is largely cyclical and that office demand will recover from 2022, as employment in tech, life sciences and professional services grows.  However, demand is likely to be more focussed than in the past.  Offices in city centres and close to major universities, which have high quality air conditioning, good connectivity and plenty of informal working areas will attract occupiers.   Older space in satellite towns and office parks is likely to struggle.

In total the value of investment transactions in 2020 was around 20% lower than in 2019.  While part of the decline was due to the interruption of deals by the first national lockdown, the fall also reflects the fact that investors have become more selective and focused on security of income.   Accordingly, the most liquid parts of the market at present are industrials, prime offices, supermarkets and residential.  Industrial yields fell by 0.25% in the final quarter of last year and strong investor demand means that the sector is likely to see further yield compression in 2021.  This year could also see a fall in London office yields, as international investors re-enter the market, now that Brexit is completed and there is less risk of a sudden depreciation in sterling.  Conversely, most shopping centre and leisure schemes are illiquid and yields will probably continue to rise until there are distressed sales which help establish prices.

The divergence in rental values and yields means that the wide range in returns seen in 2020 across different sectors is likely to be repeated in 2021.  We expect that industrial will again be the strongest of the three main sectors over the next 12 months and that certain niche types such as GPs surgeries, social supported housing and retirement villages will also see capital growth.  By contrast, shopping centre and leisure capital values are likely to fall by 10%, or more in 2021.  Office capital values will probably also fall in the short-term, but the decline should be more limited and next year is likely to see a recovery, as rental values bottom out and international investors bid down yields.

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