Real Estate Insights
UK Real Estate market commentary - Q1 2020
The UK economy is now in recession, following the lockdown imposed by the Government to slow the spread of the Coronavirus. Consumer spending and investment will fall sharply in the second quarter of 2020, as people stay at home and businesses conserve cash. The Bank of England has cut base rate to 0.1% and the Government has announced a huge package of state-guaranteed loans, grants, tax holidays, wage supplements and other measures designed to support peoples’ incomes and allow companies to hibernate until the virus has passed.
Schroders’ central scenario assumes that the lockdown is phased out over the summer and that the economy re-bounds quickly in the second half of 2020, regaining its pre-virus peak by mid-2021. This scenario also assumes that either the UK and EU agree a trade deal by the end of this year, or the transition period is extended until the end of 2021. However, there is a clear downside risk that the recession is longer and deeper - potentially because the coronavirus re-surfaces and the lockdown has to be re-introduced, or because a lot of businesses do not survive and unemployment is permanently higher.
The Government has closed all stores, bars and restaurants except supermarkets, pharmacies, banks and DIY shops. Some non-food retailers have deferred paying rent1 and service charges, while others have requested a move from quarterly to monthly payments. Schroders is dealing with these requests on a case-by-case basis.
However, despite the flexibility of many landlords and the Government’s support, we expect that a number of mid-market retailers and restaurant chains who were already under financial pressure will fail over the next few months. Consequently, it seems probable that the Coronavirus will accelerate the increase in structural vacancy and decline in retail open market rents. We expect that supermarkets, convenience stores and bulky goods retail parks will be more defensive than shopping centres and department stores.
While the Coronavirus could increase the demand for warehouses to fulfil online orders, the impact is likely to be modest. The vast majority of warehouses are occupied by manufacturers, non-food retailers, third party logistics operators and local small businesses (e.g. kitchen fitters, garages) and much of their activity has halted or been disrupted by the virus. Moreover, some retailers, such as Next, have temporarily suspended online sales and closed their warehouses in order to protect staff. As a result, we expect overall demand for industrial space to fall in 2020, with a limited rise in vacancy and fall in rents, before recovering in 2021.
Another consequence of the virus is that UK retailers and manufacturers may try to build more diversified supply chains and reduce their reliance on Asia. In the long-term, some production could be re-shored, although any new factories are likely to be highly automated and will not necessarily generate many jobs.
In the short term, the office sector has probably been least affected by the Coronavirus. Although most offices are deserted, a lot of occupiers have been able to carry on business almost as usual by staff working from home. The obvious exception is serviced offices and some providers will fail. Some smaller occupiers such as recruitment consultants also look vulnerable. We expect that office demand will recover quickly after the virus, driven by the growing tech sector, lawyers, and by the public sector as the Government recruits more staff.
The big question is whether the current mass evacuation to home-working will prompt companies to re-think their long-term space requirements. The amount of office space per person has been falling slowly since the mid-1990s and this trend could now accelerate as more people work remotely. However, it is also possible that people who have been isolated at home gain a greater appreciation of the benefits of being in the office – particularly shared space facilitating communicating with colleagues, meeting clients and communal values.
The impact of the Coronavirus on niche sectors has been mixed. At one extreme, the crisis has increased demand for laboratories and data centres. Demand for social supported housing has also increased as the NHS and social services have tried to free up capacity in hospitals and care homes. At the other extreme, hotel occupancy has collapsed as business travel and tourism has ceased and demand for student accommodation could also fall sharply if the start of the next academic year in September is delayed, or if international students cannot travel. The government freeze on house sales has also temporarily halted the development of retirement villages, as purchasers typically need to sell their current home before buying an apartment.
Investment transaction volumes have declined as deals have stalled and few new transactions are being initiated given the practical impediments to completing the requisite due diligence, such as site visits. The lack of transactions coupled with some tenants, particularly retailers, deciding to defer rent means that valuers have decided to apply material uncertainty clauses, which in turn has forced many open-ended funds to suspend dealing of primary shares.
We expect that real estate yields will now rise despite the low level of bond yields, as investors price-in potential falls in rental income - albeit these should be short-lived in the office and industrial sectors. Given the uncertainty over the economy it is difficult to know how far capital values will fall, but our working assumption is that, on average, they will decline by 10-15% in the first half of the year, before partially recovering in the second half of 2020. Retail real estate and secondary assets are likely to be hit harder than office, industrial and prime assets.
Although there may be some distressed sales, we do not anticipate a repeat of the vicious circle of falling prices and forced sales which occurred between 2007-2009. In general, investors have borrowed less in recent years than in the run up to the global financial crisis and banks will probably tolerate temporary breaches of loan terms, provided there is a good prospect that rent and interest payments will resume once the virus has passed.
- The Government has temporarily banned the eviction of commercial tenants for non payment of rent due to the coronavirus, initially until 30th June.
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