Real Estate Insights
UK Real Estate market commentary - Q1 2019
While it is clear that the UK Parliament wishes to avoid a no-deal Brexit, there is little consensus about what form a future arrangement with the EU should take.
While it is clear that the UK Parliament wishes to avoid a no-deal Brexit, there is little consensus about what form a future arrangement with the EU should take. If there is a deal and then a transition period, Schroders forecasts that the UK economy will grow by 1.25-1.5% p.a. through 2019-2020. Rising real wages should lift consumer spending and the government can afford to increase spending following the turnaround in its finances. In this scenario, inflation is forecast to be around 2% p.a., while the Bank of England is likely to raise its base rate to 1.5% by the end of next year. However, if there were no deal then the economy could stall, as real wages were squeezed by a drop in sterling and faster inflation and as trade and investment were disrupted. The next move in base rate would probably be down, not up.
Uncertainty over Brexit held back occupier demand in the first quarter of 2019. According to CBRE, total office take-up in central London was below one million sq ft in the first two months of the year, the quietest start to a year since 2013. Likewise, industrial demand was subdued and while manufacturers and retailers built stocks ahead of Brexit, they typically crammed more goods into their existing warehouses, rather than committing to additional space.
Regardless of Brexit, we expect that the most resilient sectors will be multi-let industrial estates and offices in dynamic, ‘Winning Cities’ such as Brighton, Bristol, Cambridge, Leeds, Manchester, Milton Keynes, Oxford and Reading. These sectors have seen low levels of new building in recent years and have lost space to redevelopment, with the result that there is little risk of oversupply and rents should be stable. Over 35 million sq ft of office space has been converted to residential since 2013, particularly in southern England where house prices are relatively high (source: ONS, Schroders). Multi-let industrials are also gaining from the growth in online retail sales and last mile logistics. Parcel volumes grew by 6% p.a. in 2018 according to the Royal Mail.
Certain niche sectors should be more defensive, particularly where demand is less tied to the economy and where there is a shortage of modern, good quality accommodation. Demographic trends are increasing the demand for doctors’ surgeries, retirement villages and social supported housing. These sectors improve people’s quality of life and, from the government’s perspective, they are more cost-effective than hospital care. These sectors also satisfy increasing demand for real estate types and strategies delivering positive social impact as well as attractive risk-adjusted total returns.
By contrast, retail rents are likely to fall significantly, as online sales grow at the expense of stores. While there have been fewer retailer insolvencies in recent months, a number of multiples are likely to enter into company voluntary arrangements (CVA) later this year. Moreover, many successful retailers are planning to close stores and Next plc revealed that it had secured an average rent cut of 29% when it decided to keep a store open, rather than close at lease expiry. The most defensive sub-sectors are likely to be convenience stores and retail warehouses with affordable rents and a low exposure to fashion. A no-deal Brexit could help tourist destinations if sterling depreciated.
We are also cautious of central London offices, at least in the short-term. On the plus side, life science and tech companies seem relatively unaffected by Brexit and employment in those sectors should continue to grow. On the downside, there is a risk that London-based financial services will lose access to the EU single market and we are nervous about the rapid growth of serviced offices, which accounted for 15-20% of central London take up in 2018. In addition, the upturn in development in the City is likely to lead to an increase in empty second-hand space, as occupiers move from old to new offices. We expect central London office rents to fall by 5-10% over the next two years, led by the City, before starting to recover in 2021 or 2022.
The slowdown in the investment market which began in late 2018 has continued into this year. The total value of transactions in the first quarter of 2019 was around one-third lower than in the first quarter of last year. To a large extent this can be explained by investors taking a wait-and-see approach to Brexit and by the structural challenges facing the retail sector. Local authorities treasury departments have also bought less, following criticism about their borrowings from the Public Works Loan Board. We expect to see some distressed sales of shopping centres.
We forecast all property total returns will be slightly negative in 2019, but the average will mask a huge variation across different types of real estate. For example, secondary shopping centre values could fall by 15% or more this year, whereas industrial and regional office capital values should hold steady, assuming an orderly Brexit process. Our main focus for diversified portfolios is on industrial / logistics serving large population centres and offices in Winning Cities. We are also investing in certain niche types and strategies (e.g. real estate debt, residential land), which ought to be less correlated with the main commercial markets. We are exploring new opportunities in retirement living and social supported housing.
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