UK Real Estate market commentary – December 2017

Schroders expects the UK economy to see moderate economic growth of 1.5% p.a. during 2018-19.  On a positive note, exporters such as car manufacturers are benefiting from sterling’s depreciation in 2016 and unemployment should remain low at 4.5%.  However, uncertainty over Brexit is likely to weigh on business investment and inflation at 2.5% will constrain real incomes and consumer spending.  Despite inflation exceeding its target, Schroders expects the Bank of England to leave base rate on hold this year and to tighten only gradually through 2019-2020. 

In the retail market December saw an outbreak of proposed mergers among shopping centre REITs.  This in turn reflects the polarisation of the non-food retail market as clothing and other retailers shift towards a smaller number of larger stores in big malls.  Whereas ten years ago many non-food retailers would have between 200-300 outlets, they can now cover the country with half the stores and service any gaps via the internet.   As a result, whereas big shopping centres have an average vacancy rate of 8%, in many smaller centres vacancy exceeds 20%.  By contrast, the switch from the big weekly supermarket shop to high frequency small basket shopping means that food retailers are expanding their network of smaller stores, either through openings (e.g. Aldi, Lidl, M&S), or acquisitions (e.g. Coop, Tesco).  It is now common for two-thirds of Britons to pop into a supermarket, or convenience store more than once a day (source:  Waitrose). 

In most cities office take-up in 2017 was close to its long-term average, reflecting good demand from professional services, tech and media occupiers.  However, 2017 data were also flattered by some big one-off lettings to HMRC and by the rapid growth of serviced offices which in London accounted for an unprecedented 14% of take-up.  While some occupiers are willing to pay a premium rent for flexibility, the recent rate of serviced office openings is unsustainable and there is a serious mis-match between the short licences offered to customers and the long leases which serviced office operators sign with landlords.   In general, we anticipate that office rents in the regions are expected to be flat but this will be polarised between winning cities, where there is economic growth, and the rest.  Office rents in the capital are likely to fall, primarily due to an increase in new building in the City and Brexit-related uncertainty. 

Despite the slowdown in the economy, the industrial sector will probably continue to see modest rental growth of 1-2% p.a. through 2018-2019 thanks to the growth in online retail.  E-commerce is boosting warehouse demand for new space by approximately 20-30% per annum.  In addition, industrial rents will be supported by a shortage of supply, particularly of multi-let estates.  This is because smaller industrial tenants will generally not enter into pre-lets which restricts the availability of development finance.  Furthermore, a combination of lower industrial rents in the Midlands and North and rising construction costs means refurbishing existing stock is more viable.   

Although total UK investment transactions were around £60 billion in 2017, in line with the average for 2014-2016, liquidity is uneven in two respects.  First, while there is good investor demand for office and industrial assets, there is only limited interest in most retail assets.  Ignoring the proposed REIT mergers, retail transactions in 2017 were almost back to the trough of 2008-2009.  Second, the London office investment market has recently been driven by private investors from Asia who accounted for over half of deals by value last year.  While there are no immediate signs that their appetite is waning, it is possible that the government’s proposal to impose capital gains tax on foreign owned commercial real estate from April 2019 (though certain non-UK investors will still be exempt) may reduce demand. 

After good performance in 2017 with all property total returns of around 10%, we expect all total returns in 2018 to be lower with capital value falls in parts of the market including retail and City offices which together account for almost half the index by value.  Our main focus is on industrial / logistics serving large population centres and offices in winning cities such as Bristol, Leeds and Manchester which have good demand and supply dynamics.  Certain parts of the London office market benefiting from structural change (e.g. Crossrail stations, Shoreditch) remain attractive. We are also investing opportunistically in certain niche sectors and strategies (e.g. self-storage and real estate debt) which should be less correlated with the main commercial markets. 


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