UK Real Estate market commentary - Q4 2018

The UK economy is at a fork in the road.  If the UK agrees a deal with the EU then the economy should grow by 1.25-1.5% through 2019-2020.  This is because a stronger pound should curb inflation and lift consumer spending as well as enable companies to trade under existing rules during the transition period.  Conversely, economic growth could slow sharply if there is no deal as a weaker pound squeezes real wages, trade is disrupted and firms cut investment.  Schroders’ base case is that the EU and UK will agree a deal at the eleventh hour, because it is in both sides’ best interests.  However, to quote Mark Carney, Governor of the Bank of England, "the risk that they fail to agree is uncomfortably high".

The UK real estate market is late cycle and we expect returns to slow following a higher than expected total return in 2018 of approximately 6%.  We expect the market to remain highly polarised with industrial and regional office markets relatively well placed to withstand a period of economic weakness.  In contrast, retail is already under pressure with further economic uncertainty adding to the structural pressures affecting the sector.  

Industrial was the standout performer in 2018 with rental growth of 4-5%.  Rents were supported by the growth of online retailing which has boosted occupational demand by 20-30% and by the loss of multi-let industrial estates to other uses, primarily housing.  Looking ahead, we expect industrial rental growth to slow to 1-2% per annum over the next couple of years, as developers build more big distribution warehouses and as second-hand space from failed retailers comes back to the market.  While a no-deal Brexit might lift demand in the short-term, as suppliers stockpile more goods to cope with customs delays, the danger in the long-term is that it would depress foreign inward investment projects in sectors such as aerospace, cars and pharmaceuticals and hit the components manufacturers who serve them.

Despite the uncertainty over the economy, office demand held up well in 2018 with a number of high profile lettings to tech & media (Channel 4 in Leeds, Facebook in London, Hut Group in Manchester), banks (Barclays in Glasgow) and the government (Glasgow, Manchester).  While some of these lettings were due to expansion, a key priority for many occupiers was to upgrade their office space to attract and retain staff and improve wellbeing and productivity.  We expect office rents in central London to fall by 5-7% per annum through 2019-2020, while rents outside will probably be flat.  The difference will mainly be due to the higher level of building in London, particularly in the City, and the release of second-hand space as occupiers move into new offices.  We also have concerns about the rapid growth of serviced offices in London since 2016 and the durability of some providers.

Last year was an annus horribilis for retail real estate as numerous retailers and restaurant chains ceased trading and others used company voluntary arrangements (CVAs) to negotiate rent reductions of 25%, or more.  Moreover, it was not just secondary retail which suffered.  Prime shopping centres and out-of-town parks were also hit.  We expect that retail rents will continue to fall over the next few years as the internet’s share of total sales climbs from 18% in 2018 towards 25% in 2023 and as traditional retailers either cut their store networks or fail.  Unfortunately, history shows that most retailers who have been through a CVA subsequently go into insolvency.  Convenience stores and retail warehouses with affordable rents and a low exposure to fashion will probably be the most defensive sub-sectors.  A no-deal Brexit might help retail in tourist destinations, if it led to a further drop in sterling.

While data on investment volumes has not yet been published, our impression is that the investment market slowed in the final months of 2018.  To a large extent this can be explained by uncertainty over Brexit and by the structural challenges facing the retail sector.  However, two other factors also had an influence.  First, the further fall in the industrial initial yield to a record low of 4.5% at the end of 2018 means that investor appetite towards the sector has cooled, despite good prospects for rental growth over the medium term.  Second, local authority treasuries appear to have scaled back their purchases, following public criticism about the sharp increase in borrowing from the Public Works Loan Board.

We expect capital values in the main commercial sectors to continue to diverge over the next couple of years.  For example, secondary shopping centre values could fall by more than 20%, whereas industrial and regional office capital values should hold steady, assuming the economy continues to grow.  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.  Certain parts of the London office market benefiting from structural or infrastructural changes remain attractive.  We are also investing opportunistically in certain niche sectors and strategies (e.g. self-storage, real estate debt and residential land) which should be less correlated with the main commercial markets.

The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested


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