UK Market Commentary: Q3 2021

Schroders forecasts that the UK economy will grow by 6-7% per annum (p.a.) through 2021-2022 and return to its pre-virus level in the first half of next year. The main drivers will be consumer spending and investment, as businesses take advantage of the temporary increase in capital allowances.  There are two clear downside risks. First, a resurgence in Covid-19 infections over the winter, although the rollout of booster jabs for people over 50 should prevent a big increase in hospital admissions. Second, there is a chance that labour, fuel and materials shortages becomes a permanent feature of the economy and that inflation settles at 4-5% p.a. That would force the Bank of England to hike interest rates, which would depress consumer spending and house prices. While possible, we think it more likely that inflation will slow to 2.5% in 2022 as labour shortages ease and supply chains normalise and that the Bank will gradually raise base rate to 0.5% by the end of next year.

Despite the re-opening of non-essential shops, footfall in town centres is still 20-25% below pre-Covid levels. While this to some extent reflects the limited return of office workers and foreign tourists, the major factor is the jump in on-line retail sales from 19% of total sales in 2019, to 27% post lockdown. The average vacancy rate in shops and shopping centres has risen to 15% and 19%, respectively and vacancy is likely to increase further as banks, bookmakers, fashion retailers and travel agents move more of their business on line. Consequently, we expect shop and shopping centre rental values to fall by 8-10% between end-2021 and end-2023, bringing the cumulative decline since 2017 to 35%. Although lower rents will help retailers’ profitability, it will not solve the problem of structural vacancy and ultimately, between 25[(-33) was not found] of town centre retail space will need to be converted to residential, or other uses, or demolished.   

By comparison, food stores and bulky goods parks are more immune to on-line competition and have been fairly resilient through the pandemic. We expect supermarket rents to be flat over the three years to end-2023 and rents on bulky goods parks to fall by 2-3% this year, but then stabilise.

Industrial demand is likely to hit a new record in 2021. After a quiet start to the year Amazon has taken a large amount of space in both big distribution warehouses and smaller “last-mile” units and the need to match Amazon’s delivery times has put pressure on rival retailers to upgrade their warehouses. This year has also seen a revival in demand from manufacturers and wholesalers, echoing the broader economy. As a result, industrial rental growth has accelerated to 5% p.a., its fastest rate since 2017. Looking ahead, we anticipate that rental growth will ease to 3% p.a., partly because of slower growth in on-line sales and partly because of an increase in development.  In addition, it is possible that industrial rents in London are becoming unaffordable for some occupiers, following a cumulative 30% increase over the last five years. London is one of the few regions which has seen a rise in warehouse vacancy during Covid-19, albeit the vacancy rate is still low at 6%.

The office market is harder to diagnose. On the one hand, office take-up in the first half of 2021 was 45% below the average between 2015-2019 and demand is likely to remain tepid until occupiers gain a better understanding of how hybrid working will work in practice. On the other hand, vacancy in central London has levelled off at 10%, below its peak in the GFC (12%) and this year has seen an increase in prime office rents in Leeds, Manchester and the West End. We think this odd mix of symptoms reflects a polarisation in demand and that while demand for secondary offices is in decline, demand for high quality offices in city centres and close to leading universities, which enable companies to attract highly qualified staff and cut carbon emissions, is growing. The structural increase in demand for Grade A offices highlights a key difference between office and retail. Whereas the internet allows retailers to both cut costs and find new customers, remote working only cuts costs and potentially might jeopardise top line growth, if it results in less innovation, or poorer client service.

We forecast all property total returns of 13-15% in 2021 and an average of 6-7% p.a. over the next three years to end-2024. The lower level of future returns is mainly due to the industrial sector, after an exceptional performance this year. That in turn reflects our view that with prime industrial yields at 3.25% -3.75% most of the good news on rental growth is in the price and that the favourable fall in industrial yields has run its course. Conversely, we expect returns on Grade A office to improve in 2022, assuming that the recent isolated increases in prime rents gathers pace and that prime office yields fall by 0.25%. Accordingly, while industrial will continue to be one of the best performing parts of the market, the gap in returns between it and prime offices and bulky goods retail parks is likely to narrow significantly. We also think that certain niche types, including self-storage, social supported housing and retirement villages are likely to out-perform the all property average. By contrast, shops, shopping centres and secondary offices are likely to under-perform.

Our forecast assumes that inflation moderates to below 2% in 2022. But what if inflation becomes entrenched at 4-5% p.a.? Faster inflation and higher corporate profits should feed through to stronger rental growth, assuming no change in economic growth, or the volume of new building. The pick-up would happen immediately on index linked leases, or with a lag on a portfolio of conventional leases due to rent review cycles. 

However, the sting in the tail is what happens to bond and real estate yields? If a rise in 10 year bond yields were limited to under 2.5% then the impact might be minimal. This is because real estate yields are only loosely correlated with bond yields in the short-term and the bigger influence is investors’ rental growth expectations. However, if 10 year bond yields rose above 2.5% then there probably would be a knock-on effect on real estate yields and average capital values could fall.  In these circumstances, history suggests it would take a few years for real estate yields to find a new higher equilibrium. Once this adjustment was complete, capital values would stabilise and UK long run real estate total returns would be higher in nominal terms.

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