Real Estate Research
UK Real Estate market commentary - March 2018
Schroders forecast that the UK economy will grow by 1.5-1.7% p.a. through 2018-19. Exporters are benefiting from the acceleration in world trade and the drop in sterling following the EU referendum and the conditional agreement on a post-Brexit transition period should help business confidence and investment. In addition, the squeeze on real incomes and consumer spending should ease, as inflation slows to 2.2% by the end of 2018. The low rate of unemployment (4.3%) and the possibility of higher wage awards mean that the Bank of England is likely to raise base rate to 0.75% later this year. Thereafter, Schroders expects the Bank to gradually raise the base rate until it reaches 2% in 2020.
In the retail market, profits are being squeezed by a combination of higher import prices, the increase in the national minimum wage and intense competition from online retailers such as Amazon and Asos. Several retailers fell into administration in the first quarter of 2018 and others deliberately entered into CVAs in order to cut their rents. Furthermore, a number of restaurant chains announced closures, reversing the rapid expansion of the previous five years. In general demand for retail space is weak and many town centres are suffering from rising vacancy rates, higher business rates and falling rents. The exceptions are certain dominant shopping centres which offer a mix of retail and leisure experiences and convenience stores, as the big four grocery chains, Aldi and Lidl open more smaller format supermarkets.
The City of London has seen a bigger fall in prime office rents over the last two years (-7%) than the West End (-4%), according to PMA. Prime office rents in King’s Cross, Shoreditch and the South Bank have been flat. Looking ahead, we expect that the City will continue to be the weakest sub-market over the next couple of years, partly because of the large amount of vacant space which will come back on to the market as occupiers move into new offices and partly because of its high exposure to financial services (50% by floorspace), the known supply pipeline and uncertainty around Brexit. The West End should be more resilient thanks to a wider range of occupiers and limited new building, while areas like Farringdon, Stratford and Whitechapel will gain from the start of Crossrail services in December 2018. Outside London, we expect that office rents will generally be stable through 2018-2020, reflecting the bigger role played by government and local occupiers and lower reliance on international finance, modest levels of new building and the recent conversion of older offices to residential, particularly in southern England.
In the industrial sector, take-up of big logistics warehouses was lower in 2017 than 2016 (source: Gerald Eve), mainly because Amazon had a quiet year by its standards. The most active occupiers were manufacturing companies and discount supermarkets Aldi and Lidl, who took additional space to support their store expansion. While developers have begun to build more, vacancy is low at 6% and the high cost of bank debt for speculative development means that 75% of schemes are pre-let before construction begins. To put that in context, only 40% of logistics schemes were pre-let in 2007. As a result, while rental growth in the industrial sector will probably slow through 2018-2019, it is likely to remain positive at 1-3%, given the growth in online shopping and assuming developers continue to take a measured approach.
Based on our forecast for base rates, Schroders expects the yield on 10 year gilts to rise from 1.4% at the end of March 2018 to 3% by mid- 2020. While the all property initial yield is also likely to rise over the same period, we expect the increase to be much smaller – from 4.7% to 5.1% – for three reasons. First, the current gap between the all property initial yield and 10 year gilts is well above its long-term average of 2%. Second, real estate is not a fixed income asset and yields are also influenced by investors’ rental growth expectations. While we expect retail rents and office rents in central London to fall over the next couple of years, we expect office rents across the rest of the country and industrial rents to be stable, or even rise slightly. Third, there is a large amount of international capital which is targeting UK and European real estate.
After good absolute performance in 2017 with all property total returns of 10%, we expect total returns in 2018 to be lower with capital value falls in parts of the market including retail and City offices which together account for almost half the IPD All Property Index by value. For diversified portfolios our main focus is on industrial / logistics serving large population centres and offices in winning cities such as Bristol, Leeds and Manchester which have good demand and supply dynamics. Certain parts of the London office market benefiting from structural change (e.g. Crossrail stations, Shoreditch) remain attractive. We are also investing opportunistically in certain niche, alternative sectors and strategies (e.g. self-storage and real estate debt) which should be less correlated with the main commercial markets.
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