Real Estate Research
UK real estate market commentary – June 2017
UK real estate market commentary – June 2017
The sharp depreciation in sterling since last year’s Brexit vote has pushed up inflation to almost 3% and cut real incomes and consumer spending. While a lower exchange rate ought to boost exports, UK exports have so far been flat, possibly because foreign buyers are concerned about future tariffs.
The economy is therefore in limbo, facing below average growth and above average inflation through 2017-2018.
We expect that the Bank of England will leave interest rates on hold until there is greater clarity about the type of Brexit deal the UK strikes with the EU and in particular the chances of a transition period after March 2019.
The slowdown in consumer spending has come at an awkward time for the retail sector. Retailers are already having to contend with growing competition from online sales and a squeeze on profit margins from the increase in the national living wage and higher business rates in London and the South East.
In addition, although people continue to eat out, the restaurant sector seems to be suffering from indigestion after several years of rapid expansion. Consequently, retail vacancy in town centres has started to rise again – over 100 former Bhs stores remain empty – and rents in secondary pitches are falling.
Our retail strategy is to focus on convenience retail and retail parks with plentiful car parking and where rents are relatively affordable.
Conversely, the industrial sector continues to see steady rental growth of 2-4% per year.
While the sector is not immune to the economic cycle and demand from occupiers who rely on the housing market (e.g. builders’ merchants, self-storage) could weaken, demand is buttressed by the structural growth in internet retail.
Online retail sales are forecast to increase by a third between 2016 and 2021 (source: GlobalData).
Both pure internet and conventional retailers are reconfiguring their supply chains to deliver single items within 24 hours and to process the growing volume of returned items. We prefer multi-let industrial estates to distribution warehouses, because there is less risk of a big drop in income when leases expire and more potential for change of use in the long-term.
In the office market demand has held up reasonably well since the Brexit vote, although fewer tenants are taking extra space and letting deals are taking longer to conclude. Instead, the immediate issue is supply. In most regional office markets development has been modest over the last few years and vacancy rates have either fallen, or been stable over the last 12 months, supporting rents.
By contrast, developers in the City of London have continued to push ahead with projects, despite the possibility that Brexit will force financial services firms to transfer certain activities to the eurozone and reduce the inflow of skilled staff from the EU.
Consequently, although headline rents may be flat, net effective rents including incentives have started to fall not only in the City, but also in the West End. We expect this decline to continue through 2017-2018 as more office schemes are completed.
While UK institutions and REITs have been fairly quiet since the EU referendum, foreign investors have picked up the running. In part this is a response to the sharp fall in sterling and the willingness particularly of Asian investors to take currency risk.
Overseas investors accounted for 80% of London office transactions in the first five months of 2017. Partly, the inflow of capital also reflects the strategic goal of many international investors to diversify away from their domestic real estate and the relative liquidity of the UK market.
As a result, the CBRE all property initial yield has been stable at 5.1% since last July. Looking forward, our concern is that sentiment among foreign investors could turn if either the Brexit negotiations stall, or US bond yields rise as the Federal Reserve starts to reverse its longstanding QE policy.
Our strategy will be to continue to focus on owning assets offering good real estate fundamentals in winning towns and cities with diverse economies, good infrastructure and other differentiating factors such as good universities.
We prefer office and industrial assets in Brighton, Bristol, Cambridge, Leeds Manchester, Oxford, Milton Keynes and Reading.
We believe these towns and cities are well placed to outperform over the next few years, particularly in a period when there is generally little new development. We also favour certain alternative property types, with above average yields and index-linked rents.
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