Real Estate Insights

UK Real Estate market commentary - Q2 2019

The UK economy is currently mired in Brexit related uncertainty. While employers have continued to recruit and real wages are increasing, exports were flat in the first quarter of 2019 and business investment was weak.

07/07/2019

The UK economy is currently mired in Brexit related uncertainty.  While employers have continued to recruit and real wages are increasing, exports were flat in the first quarter of 2019 and business investment was weak.  This suggests that many new jobs are low skilled.  Our central forecast still assumes Parliament approves a version of the EU withdrawal bill later this year with a transition period until the end of 2020.  In this scenario, Schroders expects that the UK economy will grow by 1.5% p.a. through 2019-2020, inflation will run around 2% and the Bank of England will raise base rate to 1.5% by the end of next year.  However, neither candidate for the leadership of the Conservative party is willing to rule out a no-deal Brexit.  In this scenario weaker sterling would  squeeze real wages  and disrupt trade and investment.  Were this to occur the next move in base rate would probably be down, not up.

While Brexit has caused some hesitancy among occupiers, its impact on office and industrial demand has, so far, been limited.  Although investment banks have been relatively quiet this year, tech and media companies have continued to take office space in both London (e,g. Facebook, Sony Music) and in regional cities (e.g. Amazon in Edinburgh, Moneysupermarket in Manchester).  Professional services firms and government agencies have also remained active and the serviced office sector continues to grow, particularly in central London where it accounted for 20% of take up in the first half of 2019.  In the industrial sector Amazon has committed to a further 1.5 million square feet of space this year as it expands its range into fashion, food and homewares.  Amazon and the third party sellers using its platform now account for 5% of total UK retail sales, against 2% in 2013 (source: Global Data).

Niche sectors are also benefiting from structural changes that are independent of the economy.  We estimate potential demand for around 150,000 units in private retirement communities in the UK, three times the existing stock.  This reflects an ageing population, the high net wealth of many over-65s and the need to reduce loneliness among older people.  We also favour specialist parts of the residential care market and expect demand for social supported housing (SSH) to grow as the government enables more people with learning disabilities and autism to live in the community.  Adults who move into SSH generally enjoy a better quality of life and it is more cost effective for the government than support in either a registered care home or long stay hospital.       

Demand for retail space remains weak in town centres and out-of-town.  For example, almost half of BHS stores remain empty three years after the retailer failed and 14% of shopping centre units are vacant, up from 12% in 2017.  However, vacancy only tells part of the story.  Another less visible sign of weakness is the growing number of retailers who have secured rent cuts, either at lease renewal, or as part of an administration process called a company voluntary arrangement (CVA).  Whilst some CVAs have involved rent cuts of 50% this this may not be enough to restore the profitability of certain retailers, given that rents usually only account for 15% of their costs.  CVAs may therefore only provide a short reprieve.  We think the most defensive types will be those which are relatively internet immune, such as convenience stores and retail warehouses with affordable rents.

The investment market has lost momentum this year as investors hesitated ahead of Brexit and as structural headwinds facing the retail sector intensified.  Furthermore, banks are reluctant to lend against retail real estate and serviced offices, restricting the ability of debt-backed investors to make purchases. The total value of transactions in the first half of 2019 was approximately one-third lower than in the first half of last year.  Consequently, yields in the retail sector rose by 0.2% in the first five months of 2019 and yields on secondary assets in more favoured sectors such as industrial and regional offices have also edged up. 

We forecast negative all property total returns 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 20% or more this year, whereas industrial and regional office capital values should remain relatively stable, assuming the economy avoids a recession.  Our main focus for diversified portfolios is on industrial / logistics serving large population centres and offices in winning cities such as Bristol, Leeds and Manchester.  We are also investing in certain niche types (e.g. hotels with management agreements, retirement villages, social supported housing) and real estate debt that should offer more attractive and less correlated returns.

 

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