2017 real estate market outlook uk july - m&g … estate market outlook uk july 2017 for...
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Part of the M&G Group
Real Estate Market Outlook UK
July
201
7
For investment professionals only
Front cover photo: Hardman Square, Manchester.
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Furthermore, business investment since the start of
this year has seen strong growth, with sentiment
remaining positive.
The UK has entered the uncertainty of Brexit negotiations
on a relatively positive economic footing. The latest
consensus forecasts see the UK economy growing by
1.6%3 this year, on a par with Germany and ahead
of France. While a further softening is expected, it is
not anticipated to be pronounced, with the consensus
pencilling in growth of 1.4% for 2018. Long term, the UK
economy is set to outperform its peers.
The failure of the Conservative government to secure
a majority in the general election has created renewed
uncertainty. However, there is now a greater likelihood of
pursuit of a ‘softer’ Brexit. In addition, there seems to be
less appetite for more austerity policies. Accommodative
monetary policy continues with the Bank of England’s
base rate not expected to rise above 0.5% until 2019.
Economic strength moderates, but UK still on a firm footing
Economic momentum appears to have continued into
2017, but has been modest – growth in real GDP in
the first quarter, at 0.2%, was below expectations.
Consumer spending, the main driver of expansion in
recent years, is being undermined by higher inflation,
partly caused by sterling’s depreciation and modest
growth in average earnings. As disposable incomes
are being squeezed, households are under increasing
pressure to be more cost conscious in their spending.
While political uncertainty has been a consistent feature
in the UK recently, the labour market has been in rude
health. The rate of unemployment, at 4.5%, is the
lowest since 1975.
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Re
al G
DP
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wth
(%
p.a
.)
UK US Canada Eurozone
Germany France Italy Japan
Next 2 years Long Term
Fig. 2: Long term economic growth prospects remain strong for the UK
Source: Consensus Economics (June and April 2017), countries ranked by 2021-27 forecastFig. 1: Investment growth despite heightened
uncertainty
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row
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+1 SD
-1 SD
+1 Standard Deviation -1 Standard Deviation Investment Growth
Source: ONS, M&G Real Estate
Executive summary• UK economic growth moderates, but still
supportive of real estate fundamentals
• Some occupiers cautious due to heightened
uncertainty, but continue to take space in
certain sectors
• Industrials, offices and residential outside
central London remain favoured
• Net investment dominated by overseas buyers
• Performance potential supported by long term
UK fundamentals
42 years since UK
unemployment rate was lower1
10% expected
increase in average regional
office rents over the next 5 years2
3% Rest of the UK residential rental
growth expected for 20172
1Source: ONS, 2Source: M&G Real Estate
3Source: Consensus Economics
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c 2
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Retail Office Industrial
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Brexit
Referendum
Fig. 3: Rental growth continues with industrials leading the pack
Source: MSCI (IPD) Monthly Index for May 2017
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’00
0 o
f Lo
nd
on
jo
bs
1997 1999 2001 2003 2005
TMT Finance and Insurance
2007 2009 2011 2013 2015 2017
Fig. 4: London job market is well-diversified
Source: M&G Real Estate, ONS, Experian
London markets. Some financial institutions have
already announced plans to cut or relocate London-
based staff, but estimates are this will be only 5-10% of
the overall financial job market in London. In the long
run, we expect London to remain a global financial hub.
Traditional occupiers are likely to remain more cautious,
keeping demand for office space in the capital at bay.
Over the next two years, elevated supply of new office
stock does not bode well for positive rental growth.
We expect headline rents in the core office markets in
the City and West End to see downwards revisions of
5-7% by 2019, by which time the new supply should be
absorbed and the outcome of Brexit clarified.
Rental market conditions holding up, but some occupiers cautious
Compared to six months ago, occupier demand for
space is starting to ease, arguably reflecting the
uncertainty around Brexit. However, the economy’s
resilience immediately after the vote last year
suggests the link between political uncertainty and
economic activity is not overwhelmingly strong. This
uncertainty, however, creates an environment in
which it is difficult to make long-term decisions on
investment or employment – and therefore on taking
space. It is no surprise then that businesses are pausing
for breath and approaching certain decisions with
a ‘wait and see’ mentality. This is likely to continue
until there is more clarity on the final outcome of the
Brexit process.
Evidence from MSCI’s IPD index points to a reduction in
the pace of rental growth at the all property level, but
average rents for each of the broad property sectors
continue to grow. We expect the all property average
to see fairly flat rents over the next year or so, with
some segments seeing decline (notably central London
offices), but others, (such as industrials and residential
outside of central London), to deliver healthy uplifts.
Technology is radically changing the make-up of office
tenants, their business models and consequently their
requirements for space. There are now more technology,
media and telecoms (TMT) jobs in London than jobs in
finance and insurance.
A well-diversified job market in London may create
opportunities in the long-term. There is more demand
for technologically advanced, open and collaborative
workspace. A good example is WeWork agreeing to
take 280,000 square feet on London’s South Bank, to
provide its largest global office space. We believe office
buildings which meet occupiers’ requirements prompted
by technological transformation will offer firm rental
growth even in the current challenging environment.
In the regions, demand for office space has held up.
In the short term, the shortage of Grade A office stock
(particularly in Bristol, Edinburgh and Manchester) is set
to support rental growth. We anticipate rents rising by
just under 2% pa over the next five years. Supported by
major infrastructure projects, regeneration of city centres
and improved office stock with a greater emphasis on
facilitating work-life balance, the occupational markets in
UK regional cities should continue to fare relatively well in
the wake of Brexit.
Central London offices remain challenged, but there may be opportunities in the long-term
A gradual weakening of rental growth in the office
sector appears imminent. This is particularly so in
London, which is much further ahead in its cycle and
looks most susceptible to downside risks from Brexit
negotiations. The drop in sentiment in the financial
services sector towards the end of 2016 was significant
enough to reduce take-up levels across all central
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ila
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an
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olli
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Take-upNew/modern
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can
cy r
ate
(%
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Fig. 5: Demand remains strong whilst new supply wanes
Source: Gerald Eve, M&G Real Estate
Bright rental outlook for industrials
The industrial sector remains one of our top picks for
rental growth potential. The structural changes created
by e-commerce have prompted a significant pick-up
in occupational demand for logistics space. When
combined with the limited availability of the right
quality and specification of industrial stock, this means
that the sector continues to deliver very healthy rental
growth (3.9% y-o-y to Q1 2017 and c.3.2% pa over the
past four years according to MSCI).
With large retailers such as Amazon, Lidl and Aldi, as
well as many smaller retailers, expanding their supply
chains further and enhancing the online distribution
capabilities to satisfy consumer demand for ‘everything,
everywhere, anytime’, we believe strong demand for
industrial space will continue. According to Lambert
Smith Hampton, unsatisfied active demand stood
higher in March of this year than it did in 2016, which
bodes well for decent levels of take-up going forward.
That said, the dramatic jump in leasing reported last
year, boosted by huge requirements by Amazon, may
not be matched this year or next. The market is far
from complete reliance upon Amazon, but unless the
company surprises analysts by continuing to take such
large volumes of space, it seems plausible to expect
take-up – and consequently rental growth – to moderate
somewhat and be driven more by other retailers and
traditional industrial occupiers.
Tight supply should also support healthy rental growth.
Development starts for distribution warehouses remain
50% above trend, but they have dropped significantly
since last year’s Brexit referendum result, while the
majority of development is pre-let. Meanwhile the
supply of multi-let industrial units continues to
underwhelm given the demand, putting more pressure
on existing stock. The prospect for further rental
growth are evident.
In London and larger cities like Manchester and
Birmingham, the lack of available land on which to
build, given competing higher value uses and green belt
restrictions, is likely to accelerate a shift towards more
innovative design solutions. These include multi-storey,
subterranean, and mixed use space like ‘beds and sheds’
assets which combine industrial with residential uses.
The use of mezzanine floors, advanced robotics and
increased racking automation could eventually lead
to improvements in occupier productivity, enabling
higher rents to be more affordable, thereby offering the
potential for more rental appreciation.
Flight to prime in retail; better outlook for retail warehousing
While the industrial sector is benefiting from
e-commerce, retail continues to have to adapt. In
addition, the introduction of the higher National Living
Wage has increased staff costs for many retailers, and
the business rates review has resulted in higher costs
of occupation for retail space in the most successful
markets (notably in London).
Higher inflation is another challenge. Retailers may
pass on higher costs to their customers, but whether
consumers will accept this is debatable. The significant
discounting seen over the last few years, as a function
of food store price wars alongside the competition
and price transparency brought by online retailing, has
continued up until recently.
The BRC Nielson Shop Price Index is still negative but
has reached -0.4%, its highest level since the end of
2013. Retail sales picked up in June, boosted by the
hot weather, but the outlook is far from strong for high
street spending in the near term. Consequently, rental
growth for the retail sector is likely to be muted at best,
with declines expected for some parts of the market.
Many retailers are experimenting with new formats and
physical space rationalisations, while the successful in-
town retailers are expanding out of town (e.g. Smiggle
and Paperchase).
Faced with the challenging environment, retail occupiers
are focusing on prime pitches and prime assets. Demand
for the best-in-class shops and shopping centres
remains solid. Secondary and tertiary assets, however,
are increasingly falling out of favour with retailers and
consequently investors. The best opportunities for rental
growth remain in major cities and regional centres with
attractive public space and leisure offerings. In London,
supported by tourism and a strong, often luxury,
occupier base, rents are likely to continue rising, but at
a slow pace given stretched affordability for occupiers.
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Re
nta
l Gro
wth
In
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Resi: Central London Resi: Rest of London/SE Resi: Rest of UK
150
2000 2002 2004 2006 2008 2010 2012 2014 2016
160
Fig. 6: IPD Residential Index – rental growth outside of central London more evident recently
Source: MSCI (IPD) Annual Residential Index for 2016
Solid demand from investors… for the right stock
Brexit uncertainty doesn’t seem to have deterred
overseas investors from buying UK real estate. According
to JLL, London was the largest recipient of foreign
investment in Q1 2017 (c. £6.5bn).
Sterling’s weakness has surely contributed, but the
long-term characteristics of UK property and especially
London, such as a liquid and highly transparent market
supported by a very well-established and respected legal
system, have contributed to attracting international
capital. For Asian investors in particular, a desire to
diversify away from their own domestic markets remains
a key motivation. The acquisition of the landmark
‘Cheesegrater’ office building in London, by CC Land, a
Hong Kong listed company, at c. 3.4% net initial yield,
looks at least 50 bps cheaper compared to pricing in
Hong Kong.
Demand for real estate assets has also come from
local authorities aiming to take a more active role in
the regeneration of their locations, who can also take
advantage of the low cost of debt on offer from the
Public Works Loan Board (PWLB).
Central London offices, which appear expensive for
domestic players, remain attractive to overseas investors.
Whilst the compelling occupational fundamentals and
income return perspective of the industrial sector is
appealing, pricing is getting more aggressive. Where a
lack of suitable investment stock and development land
exists coupled with growing investor competition for the
same product, yields are reaching record lows. In contrast,
retail sector transaction volumes are low. Yields on retail
warehouse assets in particular are elevated, following
fairly significant softening post the Brexit referendum. We
believe there now exists buying opportunities with good
investment performance potential.
Retail warehouses, in our view, offer the potential for rental
growth, and favourable pricing can be found. This type of
property is a good income play given current elevated
yields and is better placed than other types of retail
property to benefit from click-and-collect. In addition, by
positioning themselves as lifestyle shopping destinations
with landscaping and Food & Beverage (F&B) offerings,
retail warehouses should attract more occupiers and
visitors. The constrained development pipeline lends
further support for some modest rental growth.
Residential Private Rented Sector (PRS) benefiting from heightened uncertainty
The Nationwide House Price index has shown three
consecutive months of decline in June for the first time
since the height of the financial crisis in 2009, dragging
down the rate of growth over the last 12 months to just
2.1%. However, with rock bottom interest rates, limited
supply and ongoing demand, house price growth is likely
to remain positive. A lack of affordability for would-be
first time buyers and the heightened uncertainty which
contributes to caution towards big purchase decisions,
such as buying a home, continue to underpin demand
for rented accommodation.
The RICS UK Residential Market Survey suggests tenant
demand has continued to rise across the country, with
the exception of central London. With a substantial
development pipeline contributing to more new space,
our rental projections for the central London PRS market
remain negative.
Conversely, rents in the rest of London and the wider South
East are set to rise faster than inflation going forward.
Tenant demand in these markets maintains momentum.
Regional residential in large urban centres is becoming
more favoured. According to MSCI, residential rents
in the rest of the UK grew by 2.5% in 2016 (ahead of
rents in London and the South East), driven by healthy
demand and decent rental growth prospects (JLL).
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2
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4
-6
Ne
t In
vest
me
nt
(£b
n)
Overseas Investors UK Institutions Quoted Prop. Companies
Private Companies and Individuals Other
Q2
’14
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’14
Q1
’14
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Q3
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Fig. 7: Overseas buyers dominating net investment
Source: PropertyData.com (April 2017)
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Supported by attractive pricing relative to government
bonds – the spread of the IPD All Property equivalent
yield over 10-year gilt yields is around 500bps – we
anticipate investors will continue to favour real estate.
This spread offers a significant ‘cushion’ against upwards
yield pressure should bond yields start rising.
Uncertainty has contributed to increasing risk aversion
and pricing for secondary assets has weakened, which
we expect to continue. However, we also believe that
ongoing risk aversion and yield expansion for non-core
stock creates opportunities. Higher yielding assets with
challenges, such as refurbishment or repositioning
needs, vacancies or short leases, have a future if they
are managed well. These assets, particularly if bought
when taking advantage of cheap pricing, can offer
healthy investment returns for those willing to take on
the potential for volatility.
Reason for cautious optimism on UK real estate
While we are aware of downside risks related to the
uncertain political backdrop, we believe there is reason
for cautious optimism on UK real estate. Rental growth
may soften, but in some markets the supply/demand
dynamics point to further uplifts in rents, particularly for
better quality space. In addition, interest from investors
given UK real estate’s attractive characteristics and
pricing compared to competing investments should
continue to support yields for prime assets. Investors
should remain cautious, but they should also be ready to
take advantage of the opportunities that will emerge.
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0
10
-2
Yie
ld (
%)
UK 10-year Government Bond Yield
Yield Spread
2
4
6
8
IPD All Property Equivalent Yield
May
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May
96
May
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May
00
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02
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May
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May
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Fig. 8: Real estate investors offered significant risk premium
Source: Bloomberg, MSCI (IPD) Monthly Index for May 2017
Brexit – mitigate risks• Remain cautious
• Focus on property fundamentals and long term attractions of the UK and London
• Maintain a balanced, diversified portfolio
Disruptive technologies – rental growth potential• Future proof retail assets through active management
• Access industrial benefitting from e-commerce-driven change
• Embrace potential of modernised offices
Risk aversion – opportunities emerge• Investor focus on short term risk influencing pricing
• Identify underpriced riskier assets with viable long term future
• Be wary of London office market in short term, seek opportunities there for long term
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Aneta Wiak Research Manager
+44 (0)20 7548 6829
Richard Gwilliam Head of Property Research
+44 (0)20 7548 6863
Christopher Andrews, CFA Head of Client Relationships and Marketing, Real Estate
+(65) 6436 5331
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+44 (0)20 7548 6585
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