UK Real Estate market commentary - Q4 2019

The election of a Conservative government with a large majority means that the UK will leave the EU at the end of January.  There will then be a transition period which will maintain existing arrangements while a new trade deal is negotiated.  Our central scenario is that there will be a deal, because it is in both sides’ interests.  However, if the UK government insists that the transition period stops at the end of this year, then there may only be time for a deal on agriculture and goods and not services.  Schroders expects that the UK economy will grow by 1% in 2020 and that the Bank of England will leave interest rates on hold until a trade deal is agreed.  Next year could see an acceleration in growth to 2%, assuming there is a trade deal and investment recovers and the government raises spending.  The Bank would probably increase base rate to 1.5% by the end of 2021.

At the national level, office employment increased by 2% p.a. in 2019, driven by growth in tech, media and professional services.  However, the overall picture masks a long-term shift in demand to offices in city centres and away from smaller towns and suburban office parks.  In part this reflects employers gravitating to where there are large pools of skilled staff, but in part it is also due to technology (e.g. chatbots, robotic process automation) cutting mid-skilled jobs in back office administration and call centres.  We expect office rents to be broadly stable in 2020 and to rise from 2021 onwards, as the economy strengthens.  The West End will probably lead the upswing in London, followed by Bloomsbury, Farringdon and Whitechapel which should benefit from Crossrail when it finally opens.  Outside London we expect that the strongest office rental growth will be in cities with strong universities and critical mass in tech, media and professional services (e.g. Bristol, Leeds, Manchester).  These cities should also gain over the long-term from the devolution of public services and higher spending on infrastructure.

We expect industrial rents to follow a similar trajectory, pausing in 2020, before rising in 2021.  While there is an underlying shortage of industrial estates, we expect that manufacturers who account for a third of the space on estates will hesitate to sign leases until there is a trade deal with the EU.  Demand should pick up in 2021 assuming a deal is agreed and rental growth should resume.  By contrast, rents on big distribution warehouses are more likely to be held back in the short-term by supply than demand.  Although they will continue to benefit from the growth in on-line retail (manufacturers account for less than a fifth of space), the last two years have seen an upturn in speculative development of big warehouses, particularly in the Midlands.  As a result vacancy has risen and this, coupled with the downward pressure on logistics firms’ profit margins, means that distribution warehouses rents will be static through 2020-2021.

The retail sector is tough.  The first quarter of this year is likely to see more retailer insolvencies and it is now routine for retailers to ask for cuts in rent, either at lease expiry, or in exchange for lease extensions.  We expect that on average retail rents will fall by a further 12-15% over the next three years, as on-line penetration increases and as discount retailers take market share from mid-market brands.  The most defensive types, in relative terms, are likely to be convenience supermarkets by transport hubs and bulky goods retail parks.  Rents on bulky goods retail parks are generally affordable at 6-8% of sales and there is still demand from retailers who need showrooms to display goods and give expert advice, discounters and gyms.  Bulky goods parks and convenience supermarkets also suit click and collect sales.

The total value of investment transactions fell by a quarter between 2019 and 2018.  Investors adopted a wait and see approach to the general election and Brexit and liquidity in the retail sector dropped sharply, as the insecurity of income made it difficult to agree prices.  The open-ended M&G Property Portfolio was suspended in December, although so far it has been an isolated event.  We expect the all property initial yield to rise from 4.7% to 4.8% by the end of 2020, but the increase will largely be driven by retail.  By contrast, yields on London offices are likely to fall this year despite the uncertainty over a trade deal, because after three years on hold, they are now unusually high compared with office yields in Berlin, Paris, Hong Kong and Tokyo.  Regional office and industrial yields will probably be flat in 2020.  

We forecast that all property total returns will be around 2% in 2020, before improving to 5-6% p.a. in 2021-2022, as the economy accelerates and rental growth resumes in the office and industrial sectors.  Our main focus for diversified portfolios is on offices in certain London sub-markets and winning cities such as Bristol, Leeds and Manchester and on standard industrials outside London.  We also favour some niche types (e.g. hotels with management agreements, retirement villages, social supported housing) which are benefitting from long-term structural forces and offer attractive returns.  We are cautious of retail, but may invest opportunistically in bulky goods retail parks where rents have re-based to sustainable levels, or where there is the potential for higher value alternative uses. 

 

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