july 2018 uk real estate market outlook · 3.0 3.5 forecast source: ons, experian, june 2018....
TRANSCRIPT
For Investment Professionals only
July 2018
UK Real Estate Market Outlook
• Recent moderation in economic activity unlikely to continue
• Brexit transition period agreement provides some certainty for businesses
• Prime retail to remain most resilient against structural change
• The requirement for flexibility driving the shape of office demand
• Continued shift to alternatives as investors seek diversification opportunities
Executive summary
01
Some certainty on the road to Brexit
Brexit continues to affect business sentiment, with the uncertainty
around our future position in the European market meaning that
many corporations – and also investors – are maintaining a ‘wait
and see’ approach to investment. The path ahead for the economy
therefore continues to look volatile. That said, however, some
progress is being made, including an agreement regarding the
terms of the Brexit transition period being finalised, providing some
certainty over Britain’s relationship with the EU until the end of 2020.
In addition, the recent agreement by the cabinet on the UK’s ‘wish
list’ for Brexit has also created some clarity over what the nation
is aiming for in terms of its relationship with the EU. This is likely
to lend some support to the economy, boosting business investment
to some extent. As such, while Brexit-related uncertainty continues
to affect the economy, there remains the potential for upside as
talks progress.
Figure 2: Business investment still held back by Brexit worries
Busi
ness
inve
stm
ent g
row
th (%
p.a
., SA
)
Ma
r-1
8
Se
p-1
7
Ma
r-1
7
Se
p-1
6
Ma
r-1
6
Se
p-1
5
Ma
r-1
5
Se
p-1
4
Ma
r-1
4
Se
p-1
3
Ma
r-1
3
Se
p-1
2
Ma
r-1
2
Se
p-1
1
Ma
r-1
1
Se
p-1
0
Ma
r-1
0
-6
-4
-2
0
2
4
6
8
10
12
14
16 EUReferendumvote
Source: ONS, June 2018.
Property market returns holding up
Despite a slightly softer economic environment, total returns have
remained around their year-end 2017 highs, with the MSCI All
Property index showing performance of 11.1% over the 12 months
to May 2018.
This total return was split almost equally between income return and
capital growth, with continued yield compression largely responsible
for rising values. Rents are still rising on average, reflecting ongoing
demand, but also still-limited development. The average is, however,
increasingly masking a growing level of divergence between sectors.
The undersupplied and structurally-growing industrial market is
going from strength to strength, while e-tailing competition and
weaker consumer demand continues to impact the retail market.
Snow flurries mask the continued, modest economic expansion
The start of 2018 saw a slowdown in the UK economy, with real GDP
growing by only 0.2% over the first quarter. The arrival of the so-
called “Beast from the East” storm in March, bringing construction
to a standstill and deterring consumers from hitting the shops,
contributed in part to this lacklustre expansion.
The prevailing view is that the slowdown in Q1 was largely due to
one-off factors and that growth will start to pick up again. Indeed,
there are a number of reasons to remain optimistic about the UK
economy. The labour market remains buoyant, with the employment
rate reaching a new high in March. The number of unfilled job
vacancies also remains high (an indication of the tightness of the
labour market), placing upwards pressure on wages, while inflation
has been on a downwards trajectory since the start of 2018.
The combination of these factors should directly benefit workers
who are not only experiencing healthy nominal average earnings
growth (2.6% p.a. in April 2018), but also rising real earnings growth
too. After a year of falling real wages in 2017, this shift, which is
expected to continue as inflation eases further, should help to
underpin consumer spending as Britons start to feel better off.
Figure 1: Real wages start to rise
CPI InflationAverage earnings' growth
(%)
De
c-1
9
Ma
r-1
9
Jun
-18
Se
p-1
7
De
c-1
6
Ma
r-1
6
Jun
-15
Se
p-1
4
De
c-1
3
Ma
r-1
3
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Fore
cast
Source: ONS, Experian, June 2018.
Positive macro factors, such as stronger employment and rising real
wages, could push the Bank of England towards a rise in the base
rate, while easing inflation, a cooling housing market and more
moderate economic growth could act against this. These mixed
messages are enough to have led policymakers to hesitate in their
decision to tighten monetary policy, but the consensus still expects
interest rates to rise this year. The pace of hiking, however, is likely
to be slow and gradual.
02
1 Source: Cushman & Wakefield, Q1 2018.
Figure 3: Performance increasingly polarised by sector
All Property All Retail All Office All Industrial
MS
CI
tota
l re
turn
s (%
p.a
.)
Ma
y-1
8
Feb
-18
No
v-1
7
Au
g-1
7
Ma
y-1
7
Feb
-17
No
v-1
6
Au
g-1
6
Ma
y-1
6
Feb
-16
No
v-1
5
Au
g-1
5
Ma
y-1
5
Feb
-15
No
v-1
4
Au
g-1
4
Ma
y-1
4
Feb
-14
No
v-1
3
Au
g-1
3
Ma
y-1
3
0
5
10
15
20
25
30
Source: MSCI, June 2018.
Omni-channel retailing offers the path to success
News headlines over the last few months focusing on high-profile
administrations and portfolio ‘right-sizing’ have led to a general sense
of doom and gloom around the retail sector, resulting in muted rental
expectations. Retailers continue to experience rising costs in the face of
softer consumer demand, placing pressure on margins, particularly for
mid-market brands. E-tailing competition also continues to take its toll,
with retailers such as Toys ‘R’ Us, which perhaps focused on in-store to
the detriment of its online offer, suffering the consequences.
Although the shift to online shopping will continue to disrupt the
industry for some time, ‘bricks’ will remain important as will ‘clicks’
in the retail story. To maintain competitiveness, retailers will need to
focus increasingly on how they engage with their customers. Survey
evidence suggests that offering multi-sensory experiences and the
best possible one-to-one customer service will help retailers make
the most of the natural advantages that in-store has over online.
This will have an important impact on how retailers use physical
space and where that space is located.
We still believe that retail occupiers will increasingly focus on prime
locations, which are well-connected and accessible, as well as having
‘destination’ appeal and favourable demographics, to the detriment
of secondary and tertiary submarkets. Equally, assets which are both
functional and flexible will be of greater appeal than those older and
smaller units. These types of locations and assets are therefore more
likely to see the strongest rental growth going forward.
Physical retail format also plays an important part in this new retail
age. With retailers shifting towards omni-channel strategies, there
is a greater focus on the best click-and-collect locations. This type
of approach plays to the strengths of big-box retail parks, which
tend to be easier to access and offer extensive parking, as well as
being larger and more flexible in terms of their physical format.
Well-located assets in this category are likely to see better rental
performance.
Figure 4: Rental growth in prime locations remains resilient
Prime retail Secondary retail
Rent
al g
row
th (
%p.
a.)
Feb
-18
No
v-1
7
Au
g-1
7
Ma
y-1
7
Feb
-17
No
v-1
6
Au
g-1
6
Ma
y-1
6
Feb
-16
No
v-1
5
Au
g-1
5
Ma
y-1
5
Feb
-15
No
v-1
4
Au
g-1
4
Ma
y-1
4
Feb
-14
No
v-1
3
Au
g-1
3
Ma
y-1
3
-5
-4
-3
-2
-1
0
1
2
3
Source: CBRE, May 2018.
Industrials: rental growth spreads to fringe submarkets
While retail becomes increasingly polarised, the industrial market is
experiencing growth across the board. Industrial occupier demand
reached a three-year high in the first quarter,1 with almost 60% of
industrial demand coming from retailers looking to move into purpose-
built industrial space as part of the restructuring and future-proofing
of their supply chains. Some retailers, M&S and H&M for example, are
rationalising their store portfolios and instead investing in major new
distribution centres to service consumer online demand.
Logistics has been an important focus for retailers in recent years
(Figure 5), with major companies increasing their logistics portfolios
in line with their sales growth. Department store John Lewis, for
example, has invested heavily into its distribution network to offer
an omni-channel solution across the UK and build capacity for
expected future online demand. Its focus on logistics is certainly
proving beneficial and far-sighted. This symbiosis between retail
and industrial is likely to drive industrial rental growth going forward,
particularly in wealthier and supply-restricted areas, such as London
and the south east where there is strong competition for space.
03
2 Cushman & Wakefield, Q1 2018.
However, as is usually the case when new, larger players take a
greater share of space in a sector, pushing rents to ever-higher levels,
some of the more traditional players who cannot compete get
forced out into more peripheral locations. This is particularly true
of the multi-let sector, where this type of tenant displacement is
causing rents in more fringe areas to rise. We expect this trend to go
on as competition for space continues.
Figure 5: Retailers’ logistics floorspace versus retail sales
Source: PMA, Company reports, April 2018.
London office market continues to defy gloomy post-referendum predictions
Despite ongoing uncertainties surrounding Brexit, demand for
London office space remains relatively robust and overseas
employers, in particular, continue to form a significant proportion of
take-up in the Capital. London’s reputation as a market that provides
access to high-quality buildings and a deep, talented labour force
is helping to allay Brexit-related concerns. That said, cyclical factors
continue to affect the market and significant development is still
acting to constrain rental growth, particularly in the City and Canary
Wharf. As we move further into the development cycle, however, we
expect this effect to gradually subside, leading to the potential for a
recovery in values in around 18 to 24 months’ time.
Brexit aside, the shift towards flexible office space is increasingly
driving occupier demand in Central London. With the continued
growth in tech start-ups and the move towards entrepreneurialism
going hand-in-hand with the millennials’ mindset, this new-style
occupier is looking for more flexible space, both in terms of lease
and working environment. Even traditional occupiers are embracing
this greater workspace flexibility, meaning that landlords will need
to adapt their existing floorplates to include an element of flexible
or co-working space to maintain appeal to both new- and old-style
employers. We envisage that the demand for flexible office space
will only increase in the future. While reworking existing space may
increase landlords’ costs in the short term, it is sure to pay dividends
over the longer term.
Sales/Revenue (RHS)Total Logistics Floorspace (LHS)
Tota
l occ
up
ied
flo
or
spa
ce, m
illio
ns
sq f
t
Sa
les/
Re
ven
ue
(£
BN
)
0
5
10
15
20
25
20
17
20
15
20
13
20
11
20
09
20
07
20
05
20
03
20
01
20
17
20
15
20
13
20
11
20
09
20
07
20
05
20
03
20
01
20
17
20
15
20
13
20
11
20
09
20
07
20
05
20
03
20
01
20
17
20
15
20
13
20
11
20
09
20
07
20
05
20
03
20
01
Sainsbury’s Lidl John Lewis Amazon
4%p.a.
5%p.a.
12%p.a.
13%p.a.12%p.a.
6%p.a.
31%p.a.
23%p.a.
0
5
10
15
20
25
30
Figure 6: Flexible office space driving take-up in London
Take
-up
, mill
ion
s sq
ft
Fle
xib
le s
pa
ce o
ccu
pie
rs a
s %
all
Ce
ntr
al L
on
do
n t
ake
-up
WeWork
The Office Group
Regus
MWB Busi. Exchange
i2 Office
Executive Offices
Other
Flexible space occupiers
as % all Central London take-up
0
1
2
2017201620152014201320122011201020090
10
20
30
Source: PMA, December 2017.
Public sector continues to drive regional markets
Companies continue to gravitate towards the regional markets to
take advantage of lower occupational costs as well as lower living
costs for their employees. While take-up in the regions saw its usual
post year-end dip in Q1, volumes remained above five-year averages,
particularly in cities like Manchester, which is increasingly growing
its reputation as a great place to live and work. Nowhere is this shift
away from London more evident than in the public sector, which
accounted for almost a third of regional take-up in the first quarter,
similar to 2017.2
Resilient demand is, however, meeting restricted supply. Although
the supply pipeline has been firmly turned on in London for some
time, development remains more restricted in the regions and as
such, Grade A office space is increasingly competed for by occupiers.
Although the larger investors, in particular, are starting to build
selectively in the biggest regional cities, this lack of good space is
placing significant upwards pressure on prime rents.
Regional demand drives the residential Private Rented Sector
Polarisation remains an important theme for the Private Rented
Sector’s (PRS) occupational market. With affordability constraints
and Brexit uncertainty affecting tenant demand in London and the
more central submarkets seeing high levels of housing development,
rental growth remains subdued. However, prime Central London
rents, which fell first and furthest, appear to be stabilising, partly
as reluctant landlords feel more confident about their prospects
for selling, reducing the rental supply on the market. We also seem
04
05
to be moving past the peak in the development pipeline and this
should lend support to rental values going forward, especially
when combined with rising real wages. The regional markets are
currently holding up better, as lower living costs and a greater focus
from employers on the regional office markets are driving occupier
demand, while development pipelines remain at a relatively early
stage. This should boost rental values in the main urban centres
across the UK.
Figure 7: Polarisation in the PRS’ rental markets
London South East GB excluding London
Ind
ex
of
Pri
vate
Ho
usi
ng
Re
nta
l Pri
ces
(% p
.a.)
Ma
y 2
01
8
Jan
20
18
Se
p 2
01
7
Ma
y 2
01
7
Jan
20
17
Se
p 2
01
6
Ma
y 2
01
6
Jan
20
16
Se
p 2
01
5
Ma
y 2
01
5
Jan
20
15
Se
p 2
01
4
Ma
y 2
01
4
Jan
20
14
Se
p 2
01
3
Ma
y 2
01
3
-1
0
1
2
3
4
5
Source: ONS, June 2018.
Build-to-Rent also continues to gain traction, both in London and
further afield, with British Property Federation figures saying that
there are now 120,000 such homes in the pipeline. The input from
institutional investors may, however, be needed now more than ever
as ARLA Propertymark, the professional body for lettings agents,
has indicated that April saw the greatest number of Buy-to-Let
landlords leaving the market in three years, with more likely to follow
as anti-landlord regulation and political uncertainty reduce the
attractiveness of the market. This potential easing in rental supply
comes as research from the Resolution Foundation indicates that
up to one third of millennials may never be able to own their own
homes, suggesting that tenant demand, and thus rental values, will
continue to rise over the long term.
Transaction volumes show greater breadth in interest
Investment volumes saw their usual seasonal dip in the first
quarter, recording £12.7 billion of transactions, a 30% drop on Q4.
Nevertheless, this figure was broadly comparable with levels for the
same period in 2017, suggesting that it is very much business-as-
usual when it comes to the UK investment market.
An increasingly notable trend is the changing nature of activity from
a sector perspective. With investors becoming increasingly selective
when it comes to retail assets, this is facilitating a push towards
broadening portfolios more generally. Although industrial, backed
by a strong structural and cyclical story, is seeing increased activity,
it is the non-mainstream sectors that are mostly benefitting from
investors’ change in appetite. Just over a fifth of deals in Q1 were
within the Alternatives sector, more than twice the 10-year average.
Figure 8: Transaction volumes by sector
Offices
Industrials
Leisure/hotels
Alternatives (incl. PRS)
Retail
Outer circle: Q1 2018
Inner circle: 10-year average (Q2 2008-Q1 2018)
Source: Property Data, Q2 2018.
This shift away from the mainstream is reflected in the fact that the
top three deals since the start of the year were for portfolios in the
‘other’ sectors, focusing on hotels or residential-related assets. This
broadening in activity will likely pay off for investors as portfolios
benefit from greater diversification, whilst also accessing long-term
trends such as the ongoing shift towards private renting. Indeed,
many of the Alternative property sectors are benefiting from
fundamental supply and demand imbalances, often exacerbated
by structural change in terms of housing, demographics or spending
patterns. Therefore, as well as the diversification potential of adding
such exposure, investors can also tap into strong long-term rental
and capital growth potential.
Structural change leading to sector role reversals
Investors have traditionally viewed the three main sectors in
particular ways: retail has tended to be classed as the sector for
growth, both in rental and capital terms; offices for cyclical plays;
and industrials for income. However, the ongoing structural change
in the market is turning this on its head. Evidencing this, the income
return on industrial property dipped below that of retail (4.9% p.a.
vs. 5.1% p.a.) in the first quarter of the year for the first time for over
40 years.
05
06
Figure 9: Industrial income return falls below retail
Industrial Office Retail
MS
CI
inco
me
re
turn
s (%
p.a
.)
Ma
rch
20
18
Ma
rch
20
17
Ma
rch
20
16
Ma
rch
20
15
Ma
rch
20
14
Ma
rch
20
13
Ma
rch
20
12
Ma
rch
20
11
Ma
rch
20
10
Ma
rch
20
09
Ma
rch
20
08
Ma
rch
20
07
Ma
rch
20
06
Ma
rch
20
05
Ma
rch
20
04
Ma
rch
20
03
Ma
rch
20
02
3
4
5
6
7
8
9
Source: MSCI, May 2018.
With industrial now also providing the highest rate of rental growth
(5.3% p.a. in Q1 2018) and retail the lowest (0.9% p.a.), it seems
the switch of industrial to growth sector and retail to income play
is well underway. Although highlighting the current potential
for outperformance from overweighting industrial, this also
demonstrates the importance of maintaining a diversified portfolio
throughout the property cycle, in order to ensure that investors
are always in a strong position to benefit from new short and
long-term trends.
Risk aversion provides long-term opportunities
While continuing uncertainty means that investor focus remains
on the highest-quality assets in the most prime markets, pricing on
these assets appears keen. As such, those investors who are willing
to take on a little more risk in the search for value may find that
this approach can open up the potential for higher returns in the
medium to long term.
Good secondary assets across the sectors continue to offer a healthy
yield premium above prime. Even assets in the highly competitive
industrial sector display premiums of c.100bps for good secondary or
above 200bps for standard secondary versus prime yields, while the
premiums on offer for the other sectors are higher still. With careful
consideration of the risk/reward trade-off, underpinned by strong
knowledge of local market fundamentals and a focus on active asset
management initiatives, investors could look to take advantage of
current market mispricing.
UK offers value in a global context
Although Brexit uncertainty is still affecting the outlook for the UK
economy, overseas investors remain attracted to the real estate
market due to its strong underlying fundamentals. The UK continues
Focus on structural change
• Take advantage of the shift to e-tailing by looking for well-
located industrial assets
• Embrace flexibility by repositioning retail and office assets
for changing occupier needs through active management
• Look for PRS assets in major urban centres set to benefit
from the continued trend towards city-living
Mitigate cyclical uncertainty
• Seek quality assets in strong locations to withstand any
short-term economic concerns
• Maintain a balanced and diversified portfolio
• Add alternative assets with defensive characteristics
and favourable long-term demand fundamentals, such
as residential property
Take advantage of investor caution
• Look to develop/redevelop assets in the most attractive cities
to capitalise on limited supply
• Consider investing further up the risk curve to take
advantage of mispriced assets
• Get ready to look for opportunities in Central London, once
supply issues are resolved
to offer value, particularly in an international context, with prime
office yields in London at a discount to those in many other core
markets, such as Hong Kong, Paris and Frankfurt. Indeed, with the
Central London occupier market starting to see signs of stabilisation,
this will start to provide the opportunity for investment, particularly
from an overseas perspective. However, risks remain for this market,
notably related to Brexit, and so strong local market knowledge will
be vital when considering buying into the Capital.
The UK market as a whole also offers yields that are significantly
over comparable government bond rates. At 5.9%, the MSCI All
Property equivalent yield is well above the UK 10-year gilt rate of
1.2%, providing a yield premium of 4.6%, significantly higher than
the long-term historic average. Such a healthy cushion implies
that UK property is likely to remain protected from the impact of
expected moderate rises in interest rates.
As progress continues to be made on Brexit negotiations, any short-
term impact of more moderate economic growth on the occupier
markets is also likely to fade, leaving the UK commercial property
market in a strong position to outperform in the future.
06
Contact
Emma Grew Associate Director: Property Research +44 (0)20 7548 6676
Richard Gwilliam Head of Property Research +44 (0)20 7548 6863
Lucy Williams Director, Institutional Business UK and Europe, Real Estate +44 (0)20 7548 6585
Stefan Cornelissen Director of Institutional Business Benelux, Nordics and Switzerland +31 (0)20 799 7680
www.mandgrealestate.com
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