Real Estate Research
UK Real Estate market commentary – September 2017
Economic growth slowed to 0.3% in the second quarter of 2017, as rising inflation cut households’ real incomes and business investment stagnated. Despite the slowdown it seems likely that the Bank of England will raise base rate to 0.5% in order to support sterling and restrain import prices. We think that this will be a one-off increase and that the Bank will then leave interest rates on hold due to Brexit-related uncertainty and the absence of a wage-price spiral.
Falling consumer spending may impact retail real estate rents, already under pressure from rising on-line sales and the squeeze on retailers’ margins due to the fall in sterling and the increase in the national living wage. Furthermore, certain sectors such as pound shops, restaurant chains and luxury retailers, which had been expanding, have reached saturation and are now starting to retrench. Despite these challenges new fashion brands continue to take space in large regional shopping centres and there is good demand for shops in tourist destinations (e.g. Bath, Chester, York) and affluent London suburbs. Our retail strategy is to focus on convenience retail and bulky goods retail parks which are relatively immune to the internet and where current yields at 6-7% are above the all property average.
In the office market, vacancy rose in the City of London and Docklands in the first half of 2017, but was stable, or fell slightly in the West End of London and major regional cities. The difference was mainly due to speculative development in the City and the release of second-hand space, as occupiers moved to new offices. In general, office take-up held up in the first half of 2017, reflecting good demand from professional service, tech and media firms and HMRC, which is consolidating into fewer, larger hubs. Paradoxically, one concern is the large amount of space which has recently been taken by serviced office providers, particularly in the City fringe and South Bank. While a growing number of companies will pay a premium rent for the flexibility of a daily, or weekly contract, there is real mismatch between those agreements and the long leases signed by serviced office providers themselves, which could leave some operators vulnerable in the event of a downturn.
The industrial market is the one sector which continues to see steady rental growth, running at 3-5% p.a. There is strong demand for industrial space from both traditional retailers, who are re-engineering their supply chains to service on-line orders, as well as internet retailers and, associated with these requirements, from parcel companies. In addition, industrial rents are being supported by limited levels of new building and by the loss of space to housing and other uses. The total amount of industrial space in London has fallen by 14% over the last decade and both the West Midlands and the North West have seen declines of 8-10% (source ONS).
In the investment market, the all property initial yield has been flat at 5.1% since July 2016 (source CBRE). In part this stability reflects strong demand from Chinese and German investors for trophy offices in London, attracted by the fall in UK prices in foreign currency terms. It also reflects good demand from a range of investors for regional offices and industrials. Conversely, yields on secondary retail assets have risen. However, the inertia of the all property initial yield also reflects two bigger market forces. First, the low level of bond yields means that real estate looks attractive and 10 year gilt yields would probably have to rise to 2-2.5% before investors started to lose appetite. Second, the more cautious approach of banks to property lending since the financial crisis means that there are currently few forced sellers in the market.
Despite the current resilience of the UK real estate market we continue to adopt a defensive stance. 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. Whilst we are cautious about parts of the Central London office market due to falling rents, those sub-markets undergoing structural change such as improving infrastructure around Tottenham Court Road remain attractive. We are also investing opportunistically in certain niche sectors and strategies (e.g. self-storage, residential land, real estate debt) which should be less correlated with the main commercial markets.
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