UK Real Estate Market Commentary December 2016
Although the UK economy performed better than expected in the six months following the EU referendum, it was very dependent on consumer spending. Turning to this year, consumption is likely to lose momentum, as inflation overtakes annual wage awards. Inflation is forecast to rise to 3% by the end of 2017 partly due to the rebound in oil prices, but mainly because of the 18% fall in sterling’s trade weighted index over the last 12 months. While that should help UK exports, history suggests the impact will be limited and the uncertainty over the future terms of trade with the EU may depress investment. Schroders expects GDP growth to slow to around 1.0-1.5% in 2017.
The mixed outlook for the economy is reflected in occupier demand. Brexit has not so far deterred tech companies from taking more office space in central London and the volatility in financial markets has supported demand from hedge funds for offices in Mayfair and St James’s. Similarly, there is continued demand for regional offices from professional service firms and the government’s plan to consolidate the civil service outside London into 13 hubs will provide further support to office markets in cities such as Birmingham, Bristol, Leeds and Manchester. In addition, the industrial and distribution sectors continue to benefit from the growth of online retail, parcel deliveries and returned items. In fact the sector saw the strongest rental growth in the second half of 2016, albeit of 1%.
In contrast, the risk that banks and other financial services might lose automatic access to the EU single market has hit office demand in the City of London and Docklands. Office take up in the City was 25% lower in the first eleven months of 2016 than the corresponding period of 2015 and recent signs that developers are pushing ahead with a number of new towers suggest that City office rents could fall sharply over the next few years. Elsewhere, demand for retail space outside London is generally weak as retailers’ profit margins are squeezed between flat store sales and rising costs, due to the living wage and sterling’s depreciation. M&S plans to close 30 of its larger stores and we expect that clothing and footwear will see further rationalisation as sales migrate online.
In the investment market, initial yields rose by 0.25% in the two months after the EU referendum, according to CBRE, as investors downgraded their expectations for rental growth and as the authorised open ended retail funds sold assets to meet redemptions. However, the fourth quarter of 2016 saw a partial return to normality and real estate yields were broadly stable. While the majority of domestic and foreign institutions and REITs remained on the sidelines, the sharp fall in sterling encouraged foreign private buyers back into the market, particularly from Asia and the Middle East. UK local authorities were also very active, using their low cost of capital to acquire commercial properties in order to pay for local services.
The key unknown in 2017 is what happens to real estate yields. Theory suggests yields should increase, given the upturn in long dated UK and international bond yields since August and the growing prospect of a drop in London office rents and retail rents outside London. Schroders’ base case is for the all property initial yield to rise by 0.25-0.5% in 2017, with most of the increase affecting secondary property. Yields on prime assets with secure income streams should be less affected, although yields on “bond proxy” assets such as supermarkets are likely to rise. However, the outturn will depend on what happens once Article 50 is invoked.
Against a more uncertain outlook in 2017 our strategy will continue to focus on owning assets offering good fundamentals in towns and cities with diverse economies, good infrastructure and other differentiating factors such as good universities. We therefore prefer office and industrial assets in Brighton, Bristol, Cambridge, Leeds Manchester, Oxford, Milton Keynes and Reading. It is our view that these towns and cities should outperform over the next few years, particularly in a period when there is relatively little new development. We also favour certain alternative property types, with above average yields and index-linked rents.
The views and opinions contained herein are those of Schroder Real Estate Investment Management Limited and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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