UK Market Commentary: Q3 2020

The main upside risk is that a vaccine becomes widely available in the first half of 2021, allowing sectors such as hospitality to quickly get back to normal.  There are two downside risks.  First, local restrictions might fail to halt the recent rise in infections and the government then has to impose a second national lockdown.  Second, there could be a hard Brexit if the UK and EU fail to reach a trade deal before the end of this year.  Our base case is that there will be a last minute deal, because it is in the interests of both sides to avoid tariffs.   A hard Brexit would push up inflation and be particularly disruptive for the manufacturing sector and financial services in London.

Covid-19 has intensified the plight of retail real estate by accelerating the growth in online sales, cutting footfall and increasing structural vacancy.  Several retailers which had been slow to develop a multi-channel offer have gone into insolvency, and even profitable retailers (e.g. John Lewis, Zara) are closing stores and investing more in their online presence.  In general, retail warehouses have fared better than shopping centres, because rents and service charges are more affordable and there is sustained demand from food and discount retailers (e.g. Aldi,  B&M, Home Bargains, Lidl).  Moreover, social distancing is easier on retail parks and this year has seen a revival in DIY and furniture sales, as consumers have spent some of the money intended for holidays.  We expect retail warehouse rents will fall on average by a further 10-15% over the next 18 months and then stabilise in 2022.  By comparison, shopping centres rents are likely to fall by a further 25-30% and may not hit bottom until 2024, or 2025.  The exceptions are convenience stores and supermarkets where rents should be stable over the next few years.  The future of out-of-town hypermarkets is less certain, although they may benefit from big grocery chains using servicing online food orders.

The jump in online sales has boosted demand for warehouses.  In addition, the disruption of supply chains caused by Covid-19, combined with the growth in protectionism means businesses are holding more stock of key items and reassessing the trade-off between “just in time” and “just in case”.   Despite the strong take up in the second quarter of 2020, industrial rental growth has slowed to around 1% p.a.  This reflects the bargaining power of big occupiers such as Amazon, together with an increase in vacant second hand space, as occupiers transfer into new buildings and as warehouses operated by failed retailers become available.   We suspect that the next 18 months will see more tenant failures not just in retailing, but also among manufacturers and logistics firms and that industrial rental growth will pause, before resuming in 2022.

There is currently considerable debate about the future of the office and whether the increase in home working means companies will require less space once Covid-19 is brought under control.  On the one hand, staff like the flexibility of choosing where to work and companies can save money by cutting space.  On the other hand, existing lease agreements mean that the immediate savings will be  modest unless space can be sub-let (the average unexpired lease term is 9 years) and employers will need to keep a large amount of space if most staff choose to be in the office three or four days a week.  There are also concerns that remote working could damage productivity by reducing informal training and the exchange of new ideas.  We expect that office rents will fall by 5% over the next 18 months as a minority of occupiers try to sublet space and as developers complete speculative schemes started before Covid-19.  However, while we cannot be certain, we think this is likely to be a cyclical phenomenon and that demand for good quality offices in big city centres and university towns will recover in the long-term, driven by the growth in tech, life sciences and professional services.

The last few months post lockdown have seen a partial recovery in investment transactions, as investors have once again been able to visit buildings.  This has allowed valuers to remove material uncertainty clauses and most open-ended funds lifted deferrals on redemptions at the end of September.  The two speed nature of the investment market reflects conflicting pressures.   On one side, the all property initial yield at 4.8% looks attractive relative to bonds and compared with real estate in Asia and Europe, where yields are lower.  The swift recovery in equity markets also means that, unlike in the GFC, there is little pressure on investors to cut their real estate allocations (the so-called denominator effect).  However, on the other side, both investors and lenders are nervous of assets where tenants have recently withheld rent and there is a risk of insolvency.  The prospect of a hard Brexit and sterling depreciation is also deterring many international investors.  The end of this year, or next year could see a big increase in inward investment.  Accordingly, the most liquid parts of the market at present are prime industrials, prime offices and supermarkets.  Conversely, most non-food retail schemes are illiquid and yields will probably continue to rise until there are distressed sales, which help establish prices.

Given the uncertainty over Covid-19 and Brexit, it is difficult to know how far capital values will fall, but our working assumption is that, on average, they will decline by around 10% this year and by between 2-4% in 2021.  Most of the decline in capital values will be in the retail and leisure sectors.  Capital values in the industrial market and certain niche sectors such as social supported housing and retirement villages will probably be stable.