UK Market Commentary: Q1 2022

The war in Ukraine has added to the inflation caused by the combination of pent up demand and supply disruptions due to Covid-19. While the drop in real incomes means that consumer spending will be weak in 2022, we expect that the UK economy will avoid a recession thanks to higher government spending and an increase in investment, as businesses take advantage of temporary capital allowances. Schroders forecasts that GDP will grow by 4% in 2022 and 2% in 2023. Next year should see a recovery in consumption as inflation slows to 3% from 8% this year. That assumes that oil and gas prices stabilise at current high levels and that wage increases do not accelerate, generating second round inflation. In this scenario we expect the Bank of England to raise base rate to 1.5% by the end of 2022. A wage-price spiral would force the Bank to tighten more aggressively.

The outlook for town centre retail remains difficult. On a positive note the vacancy rate in shops and shopping centres fell marginally in the second half of 2021 to 14.4% and 19.1% respectively (source LDC), as more empty units were converted to other uses. Moreover, high streets are becoming more varied as local independents take some of the units vacated by multiples. However, on the downside, independent retailers often fail after a few years and demand from banks, bookmakers and major fashion brands continues to shrink as they close stores and shift more of their business on-line. As a result, we expect that high street shop and shopping centre rents will fall by a further 5-10% through 2022-2023. By contrast, supermarket and bulky goods retail park rents will probably increase by 1-2% p.a. Both types are relatively insulated from on-line competition and rents and service charges are lower than in shopping centres. The big grocery chains have ambitious plans to open more small supermarkets and there is steady demand for retail park units from discount retailers and gyms.

Although the office market is still adapting to hybrid working, some patterns are emerging. First, there are few signs of companies dispersing to the suburbs because of Covid-19. Occupiers continue to be drawn to city centres. Second, whereas some companies are cutting their office space, occupiers in professional services, tech and media where employment is growing are either maintaining, or adding to their footprint. Vacancy rates in central London and major regional cities have stabilised at 10% and 8%, respectively. Third, occupiers have a strong preference for high quality offices with good broadband, energy efficiency and ventilation and which provide plenty of collaboration space. In contrast, demand for secondary offices is weak. While this flight to quality could be temporary, we think it will persist, as companies look to cut carbon emissions and attract staff back to the office to foster a shared culture. Given the polarisation in demand and limited new development, we expect prime office rents in London, Cambridge and major regional cities to continue to rise through 2022-23. Rents on secondary offices are likely to decline, or at best be flat.

Industrial rents have risen by 5% p.a. over the last five years, fuelled by the growth in on-line retail. Amazon alone has accounted for 25% of take-up in distribution warehouses since 2016 and the virtual doubling in parcel deliveries and returns has boosted demand for smaller warehouses from couriers. In addition, the disruption of supply chains during the pandemic has prompted manufacturers and retailers to dial down on just-in-time deliveries and hold more stock. Looking ahead over the next 2-3 years, industrial rental growth is likely to slow to 3-4% p.a., partly as the growth in on-line sales moderates and partly because of a big increase in construction of distribution warehouses. Two-thirds of this new space is pre-let, but it could lead to an increase in vacancy as occupiers leave older units. The revaluation of business rates in 2023, which will shift more of the burden on to warehouses and add to tenants’ costs, could also have a restraining effect on rents.

There are no immediate signs that the uncertainty created by the war in Ukraine and the further rise in interest rates and bond yields have negatively impacted investor appetite for UK real estate. The value of investment transactions in the first three months of 2022 was close to the average for first quarters before the pandemic, and there was strong demand from both domestic and international investors, with the latter helped by the removal of travel restrictions.

We expect all property total returns to average 5-7% p.a. over the three years to end-2024. If we view the market in terms of sectors, then we expect the range in returns to narrow because most of the favourable decline in industrial yields and unfavourable rise in town centre retail yields has now happened. Industrial is still likely to be one of the strongest parts of the market, but largely because of superior rental growth. Retail parks and prime offices should also out-perform.

However, while the sector range in returns is likely to narrow, the gap between buildings with strong and weak sustainability features is likely to widen. Occupiers and investors are increasingly prepared to pay more for “green” buildings and we expect this premium to grow following the spike in energy prices and as the government raises carbon taxes and bans the occupation of units with poor energy ratings. The recent increase in construction costs means that some buildings with poor energy efficiency could become stranded assets, because it is no longer viable to upgrade them.

The downside risk is that higher inflation becomes entrenched and the Bank of England is forced into a sharper rise in base rate than markets are anticipating. That would hurt economic growth and although rental growth might be faster in nominal terms, it is likely that the impact on capital values and total returns would be more than out-weighed by an increase in real estate yields. We estimate that UK real estate would look expensive if 10 year bond yields rose to 2.5%, or higher.

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