Better signs, but more pain still expected - Capital Economics
UK Commercial Property

Better signs, but more pain still expected

UK Commercial Property Chart Book
Written by Prohad Khan
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Although there were further signs of stabilisation in June, we expect that the slow recovery in the economy will continue to put upward pressure on yields in the coming months. Meanwhile, rents fell by 0.4% m/m in June, the same pace as the previous month. Further, there was a less steep decline in capital values and annual returns remained in negative territory.

  • Although there were further signs of stabilisation in June, we expect that the slow recovery in the economy will continue to put upward pressure on yields in the coming months. Meanwhile, rents fell by 0.4% m/m in June, the same pace as the previous month. Further, there was a less steep decline in capital values and annual returns remained in negative territory.
  • Economic indicators show that May’s weaker than expected rebound in GDP kept output 25% below the pre-virus level. More encouragingly, retail sales climbed by 13% m/m in June leaving them only 1% below their February highs and survey-based indicators suggest a rebound in economic activity in the near term.
  • Market intelligence shows that the value of investment totalled £1.4bn in June, which was an 86% m/m increase following a very weak May. The pick-up in June’s investment activity suggest that May was probably the low point for transactions in 2020 and we expect a gradual recovery in activity into H2.
  • All-property rental values declined by 0.4% m/m in June, the same pace as in May. On the same basis, industrial rents increased slightly, though office rental values fell further. But, the fall in the all-property measure continued to be driven by declines in retail and leisure rents. With footfall not back to normal levels, social distancing measures combined with a gradual economic recovery will weigh on rents.
  • Meanwhile, yields seem to be stabilising. On a month-on-month basis, yields increased by only 2bps in June, having increased by 5bps in May. In turn, the 0.7% m/m fall in capital values was less steep in June than May’s 1.2% m/m decline. Although investor sentiment seems to be steadying, we expect yields to increase further in the near term and rents to fall further. With the retail sector weighing on the total, we expect returns to deteriorate to minus 5.5% by the end of the year. (See Chart 1.)

Chart 1: Annual Returns by Sector (%)

Source: MSCI


Economic Indicators

  • The weaker than expected rebound in GDP in May, at 1.8% m/m, kept GDP 25% below its pre-virus level (2). Even though activity picked up in June as lockdown measures were eased, we expect the data to confirm that the economy shrunk by about 20% q/q in Q2. While the rebound in the manufacturing and service PMIs to above the 50 mark in June is an encouraging sign of further recovery, it is not an indication that GDP will soon recover to its pre-virus level (3).
  • Retail sales climbed by 13% m/m in June leaving them only 1% below their pre-virus levels (4). A pick-up in non-food sales boosted the headline figure, whilst online sales remained strong. Meanwhile, the latest labour market data show that the furlough scheme has been effective in preventing a big rise in unemployment (5). But we expect jobless totals to rise when the scheme is wound down in the autumn.
  • We think there will be a brief spell of deflation later this year, as the Chancellor’s VAT cut for the hospitality and tourism sectors and “Eat Out to Help Out” scheme will put downwards pressure on consumer prices (6). As a result, the MPC will keep policy extremely loose. We expect more QE later in the year and the Bank Rate to remained unchanged at 0.10% for a long time yet. As such, 10-year gilts will remain close to zero (7).

Chart 2: GDP (February 2020 = 100)

Chart 3: Services and Manufacturing Flash PMI

Chart 4: Retail Sales (February 2020 = 100)

Chart 5: ILO Unemployment & Change in Employment

Chart 6: CPI Inflation (% y/y)

Chart 7: 10-Year Gilt Yield and Bank Rate (%)

Sources: Refinitiv, Markit, ONS, Capital Economics


Market Indicators

  • Investment totalled £1.4bn in June, up 86% on a very weak May (8). The improvement in activity hints that May was probably the low point for transactions and we expect a gradual recovery in the coming months. And while all sectors have seen a fall in activity from their 12-month averages, industrial held up best, partly due to SEGRO’s purchase of a large West London estate (9).
  • Savills reported that industrial take-up was up 33% y/y to 14.4 m. sq. ft. in Q2, which is the strongest second quarter on record (10). Meanwhile, regional take up increased by 52% y/y to 17.9m sq. ft. in H1. This was largely due to rises in the North West, East Midlands, and Yorkshire (11). There were some large one-off deals and several short leases signed in H1, so we think that take-up will probably ease in H2.
  • CBRE noted that Central London office take-up fell by 64% y/y to 1.1m. sq. ft. in Q2 (12). Availability rose by 15% and vacancy increased from 4.4% to 5.3%. With constructions delays, some completions have been pushed back into 2021. Completions are still expected to rise from 4.9m sq. ft. in 2019 to 5.6m sq. ft. in 2020, though most of the space is let or under offer, which will provide some relief to rents (13).

Chart 8: Investment Deals Completed (£bn, monthly)

Chart 9: Value of Deals Completed by Sector (£bn)

Chart 10: Industrial Take-Up (M. Sq. Ft.)

Chart 11: Regional Take-Up (M. Sq. Ft.)

Chart 12: C. Ldn Office Take-Up (M. Sq. Ft.)

Chart 13: C. Ldn Office Under Construction (M. Sq. Ft.)

Sources: Colliers, Savills, CBRE


Rental Values

  • In June, all-property rental values fell by 0.4% m/m, the same rate as the month before. (14). Within this, industrial rents edged up slightly while offices saw a modest fall. However, the drop in the all-property measure continued to be driven by declines in retail and leisure rents (15).
  • Retail rents fell by 1.1% m/m in June, a slightly less steep decline than the minus 1.3% m/m in May (16). Despite support from government-backed loans, retailers have struggled. This is highlighted by the high number of retail stores affected by administrations in the half-year to June, which was already above last year’s total (17). With footfall not back to normal levels, social distancing measures combined with a gradual economic recovery will weigh on rents. We expect retail rents to decline by 9% y/y in 2020.
  • As noted, industrial rents were the only sector to see growth in recent months (18). With supply tight and an unexpected Covid-related pick-up in demand in Q2, Rest of South East industrial outperformed (19). Admittedly, recent rental trends have been more positive than expected. But given lags in valuation and economic headwinds, we still expect downward pressure in the second half of this year. (See our Update.)

Chart 14: All-Property Rental Values

Chart 15: Rental Values by Sector (% m/m)

Chart 16: Retail Rental Values (% m/m)

Chart 17: Retail Stores Affected by Administrations

Chart 18: Industrial Rental Value Growth (% m/m)

Chart 19: Rental Values by Sub-Sector (% m/m)

Sources: MSCI, Capital Economics, Centre for Retail Research


Yields & Capital Values

  • Investor caution appears to be easing as all-property equivalent yields rose by just 2bps m/m in June, from 5bps m/m in May (20). Office and industrial yields were broadly flat in June (21). On the other hand, retail yields climbed the most, increasing by 5bps. Admittedly, shopping centre saw a slight decline in June. But yields have risen by just over 100bps since the start of the year, so we still think it will be the worst performing sub-sector this year (22).
  • At an all-property level, capital values fell by 0.7% m/m in June, slower than the 1.2% m/m drop in the previous month (23). And with investor sentiment likely to remain soft this year on the back of the gradual economic recovery, we expect a further deterioration in capital values (24).
  • All-property total returns deteriorated from minus 2.3% in April to minus 2.7% in June. While offices and industrial returns were less positive, retail weighed most on the all-property figure. Indeed, returns for retail worsened from minus 12.8% to minus 13.4% in June. Looking ahead, we expect all-property returns to worsen to minus 5.5% this year (25).

Chart 20: Equivalent Yields

Chart 21: Equivalent Yields by Sector (%)

Chart 22: Retail Equivalent Yields (%)

Chart 23: All-Property Capital Values

Chart 24: Contribution to All-Property Capital Value Growth (%-pts y/y)

Chart 25: Total Returns by Sector (% y/y)

Source: MSCI


Data Summary and the Month Ahead

Table 1: Economic Indicators

Q2 2019

Q3 2019

Q4 2019

Q1 2020

Q2 2020

GDP, %y/y

1.3

1.2

1.1

-1.7

GDP, %q/q

-0.1

0.5

0.0

-2.2

Financial and business services output, %y/y

0.3

0.9

0.8

0.7

FBS employment, %y/y

3.4

2.7

2.0

2.0

Distributive trades output, %y/y

3.0

2.0

1.2

-4.3

Household spending, %y/y

1.3

1.1

0.9

-1.0

Net new lending to commercial property, £bn

1.3

1.2

0.0

4.8

Total outstanding property debt, £bn

158.2

159.5

163.0

167.7

Lending to property as a % of all lending

6.9

6.8

6.9

6.9

5-year swap rate, %, average over the quarter

1.06

0.70

0.81

0.66

0.38

Mar. 2020

Apr. 2020

May. 2020

June. 2020

Jul. 2020

Manufacturing output, %y/y

-9.7

-28.5

Employment, %y/y

1.4

0.7

ILO unemployment rate, %

3.9

3.9

Retail sales volumes, %y/y

-5.9

-22.6

-13.2

-1.7

EC UK Economic sentiment index

92.0

62.4

61.7

65.2

CPI inflation, %y/y

1.5

0.8

0.5

0.6

Nationwide house prices, %y/y

3.0

3.7

1.9

-0.1

Bank of England repo rate, %

0.10

0.10

0.10

0.10

10-year gilt yield, %, average over the month

0.39

0.28

0.18

0.18

0.11

5-year swap rate, %, average over the month

0.55

0.50

0.36

0.31

0.22

Sources: Nationwide, Bank of England, Refinitiv

Table 2: Upcoming Data

 

Latest Number

Next Release Date

Period Covered

Nationwide house prices, %y/y

-0.1

30th Jul. – 31st Jul.

Mar.

Jul.

CIPS manufacturing sector PMI

50.1

3rd Aug.

Jul.

CIPS construction sector PMI

47.1

5th Aug.

Jul.

CIPS services sector PMI

55.3

6th Aug.

Jul.

Manufacturing output, %y/y

0.10

6th Aug.

Aug.

CPI inflation, %y/y

0/9/0

6th Aug.

Aug.

Employment, %y/y

0.6

11th Aug.

Jun.

ILO unemployment, %

3.9

11th Aug.

Jun.

Retail sales volumes, %y/y

-22.8

12th Aug.

Jun.

Bank of England repo rate, %

0.6

19th Aug.

Jul.

MPC minutes (tighten/no change/loosen)

-1.7

21st Aug.

Jul.

MSCI Quarterly index

31st Jul.

Q2

MSCI Monthly index

14th Aug.

Jul.

Bank Lending to Property

29th Jul.

Jun.

BoE Credit Conditions Survey

15th Oct.

Q3

RICS Construction Survey

6th Aug.

Q2

RICS Commercial Property Survey

30th Jul.

Q2

Sources: Nationwide, IHS Markit, Refinitiv


Andrew Burrell, Chief Property Economist, andrew.burrell@capitaleconomics.com
Prohad Khan, Property Economist, prohad.khan@capitaleconomics.com
James Yeatman, Research Assistant, james.yeatman@capitaleconomics.com