Capital value falls in March just the tip of the iceberg - Capital Economics
UK Commercial Property

Capital value falls in March just the tip of the iceberg

UK Commercial Property Chart Book
Written by Andrew Burrell
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Early signs of the impact of COVID-19 on property were seen in the MSCI monthly data for March. While rental values did not see much of a deterioration, yields saw their biggest rise since after the EU Referendum in 2016, causing capital values to fall by 2.4% m/m in April. As caution among investors is likely to persist in the near term, we expect transactions will slump in Q2 and yields will rise further, driving deeper capital value declines in the next few months.

  • Early signs of the impact of COVID-19 on property were seen in the MSCI monthly data for March. While rental values did not see much of a deterioration, yields saw their biggest rise since after the EU Referendum in 2016, causing capital values to fall by 2.4% m/m in April. (See Chart 1.) As caution among investors is likely to persist in the near term, we expect transactions will slump in Q2 and yields will rise further, driving deeper capital value declines in the next few months.
  • Economic indicators point to an unprecedented hit to the economy in the near term, with the flash composite PMI falling sharply in April from an already-weak March total. And we think that the PMIs may not fully capture the extent of inactivity and we see GDP falling by as much as 25% q/q in Q2.
  • Market intelligence shows a downward trend in investment activity, after a surprisingly strong deal total in February. With distance restrictions limiting viewing and prospective buyers extremely cautious in the near term, we think it is increasingly likely that investment activity will slump to record low levels in Q2. (See our Update.)
  • With the UK in lockdown since late March, businesses have seen revenues fall and some have sought to defer or delay rents. At the all-property level, rental values fell by 0.2% m/m in March. While retail is at the forefront of the disruption, we expect occupier demand to also weaken in the other sectors in Q2.
  • On a month-on-month basis, investor caution led to yields rising in March at their fastest pace since immediately after the UK’s vote to leave the EU. The impact of rising yields meant that capital values declined by 2.4% m/m and all-property returns were just 0.1%, down from 2.3% in February. Looking ahead, we think that yields will continue to rise in the near term, which will accelerate the decline in all-property capital values and push monthly total returns negative in the coming months.

Chart 1: Contribution to All-Property Capital Value Growth (%-pts y/y)

Source: MSCI


Economic Indicators

  • Following lockdowns in most advanced economies, April’s flash PMIs for these countries have notably worsened since March (2). The UK’s composite PMI slumped from an already low 37.1 in March to just 12.9 in April. This would be consistent with GDP declining by at least 6% m/m in April, however we think that the PMIs could underplay the actual fall in output (3).
  • As consumers are keeping away from the high street even before the lockdown, non-food sales excluding petrol and online sales were down by 19.4% m/m in March (4). As April’s numbers will show the impact of a full month in lockdown, we expect a bigger decline. Lower petrol prices were a key factor in CPI inflation easing from 1.7% in February to 1.5% in March (5).
  • Labour market data for February suggest that conditions were softening before the lockdown, with ILO unemployment rising from 3.9% in January to 4% in February. Since then, the ONS flash estimate suggests that employment fell by 17,500 in March, which is likely to be the start of a much bigger decline – we are predicting a 5% fall in employment in Q2 (6). Meanwhile, the Bank Rate remained at 0.1% and the 10-year gilt yield fell to 0.25% in late-April, from 0.38% in March (7).

Chart 2: Developed Markets Services & Mfg. PMIs

Chart 3: GDP and IHS/Markit All-Sector PMI

Chart 4: Retail Sales (% m/m)

Chart 5: CPI Inflation (%)

Chart 6: Change in Employment
(Rolling 3 Month Change, 000s)

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

 

Sources: Refinitiv, IHS Markit, CE, ONS, OBR


Market Indicators

  • After February’s strong outturn, the value of investment deals dropped back in March, so that the 12-month average was nearly 20% below the level seen a year earlier (8). The office sector’s decline was particularly steep at -42% y/y, by far the largest fall of the traditional sectors (9). We see total transactions slumping further in Q2 before recovering somewhat in H2. (See our Update.)
  • In occupier markets, there was a slowdown in Central London office demand. Knight Frank noted that take-up in the West End was particularly weak at 600,000 sq. ft. in Q1, down 50% from a year ago (10). Despite this, vacancy in the West End edged down in Q1 but given that demand will soften, we think this fall in vacancy is likely to reverse in the coming quarters though (11).
  • CBRE noted that industrial take-up rose by 40% y/y in Q1 2020 (12). Some occupiers saw a surge in online sales due to the lockdown, which caused an increase in short-term requirements. But this may not lead to occupiers taking longer leases. More positively, in Q1, there was a 15% y/y fall in the development pipeline, though this may offset some of the impact of weak demand on rents in 2020 (13).

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

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

Chart 10: Central London Office Take-Up (M. Sq. Ft.)

Chart 11: Central London Office Vacancy Rate (%)

Chart 12: Industrial Take-Up (M. Sq. Ft.)

Chart 13: Industrial Development Pipeline (M. Sq. Ft.)

 

Sources: Colliers, Property Archive, Knight Frank, CBRE


Rental Values

  • With the UK in lockdown since late March, businesses have seen revenues fall severely and many have sought to defer or delay rents. So far there has been a limited impact on March rental values, with 3m/3m declines essentially unchanged from February at -0.2% (14). But we expect a deterioration over the coming months. On the same basis, there was a small deceleration in office and industrial rental growth (15).
  • Meanwhile, rents in all three retail sub-sectors have been in decline since 2018 (16). As the sector at the forefront of the disruption, we think rent falls will accelerate this year. (See our Update.) Online sales have held up better than high street demand, which may support industrial demand. Indeed, this may help to explain why the industrial sector saw rents grow across all its sub-sectors in March (17). But given ongoing supply disruption, this is unlikely to be enough to prevent industrial rents from falling this year.
  • Leisure rental values have held up surprisingly well recently (18). However, due to the lockdown, revenues for many hotels, restaurants and pubs will have fallen very sharply and we would expect occupancy and rents in the sector to suffer over the rest of this year. Places such as Blackpool, Liverpool and Manchester, which have a higher exposure to the leisure industry, could be worse affected (19).

Chart 14: All-Property Rental Values

Chart 15: Rental Values by Sector (% 3m/3m)

Chart 16: Retail Sub-Sector Rental Values (% y/y)

Chart 17: Sub-Sector Rental Values (% m/m)

Chart 18: Rental Values (Index, Jan 2007=100)

Chart 19: Places with Highest Exposure to Leisure (%)

 

Sources: MSCI, Capital Economics, Local Data Company


Yields & Capital Values

  • All-property equivalent yields rose by 8bps m/m in March, the fastest rise since immediately after the UK’s EU referendum, when yields increased by 22bps m/m (20). Yields jumped in all sectors, but the retail sector saw the highest rise of 36bps m/m in March (21). With major concerns about the short and longer-term outlook for shopping centres, yields for the asset class rose the most (22).
  • The rise in yields meant that all-property capital values declined by 2.4% m/m in March, the largest fall since July 2016 (23). We expect transaction activity to collapse, at least in the short-term, which will put further upward pressure on yields and weigh on capital values over the next few months.
  • The acceleration in the fall in capital values was the main reason that annual total returns dropped to just 0.1% in March, from 2.3% in February (24). This was the lowest monthly reading since the GFC and further deterioration is likely in Q2. With yields rising across the board, all property sub-sectors have seen some deterioration in returns in the three-months to March compared to the previous month (25).

Chart 20: Equivalent Yields

Chart 21: Equivalent Yields by Sector (%)

Chart 22: Retail Equivalent Yields (%)

Chart 23: All-Property Capital Values

Chart 24: Capital Values and Total Return

Chart 25: Total Returns by Sector (% 3m/3m)

 

Source: MSCI


Data Summary and the Month Ahead

Table 1: Economic Indicators

 

Q1 2019

Q2 2019

Q3 2019

Q4 2019

Q1 2020

           

GDP, %y/y

2.0

1.3

1.2

1.1

GDP, %q/q

0.6

-0.1

0.5

0.0

 

Financial and business services output, %y/y

0.6

0.3

0.9

0.8

FBS employment, %y/y

2.5

3.4

2.7

2.1

Distributive trades output, %y/y

4.7

3.0

2.0

1.2

Household spending, %y/y

1.5

1.4

1.3

1.3

 

Net new lending to commercial property, £bn

1.5

1.3

1.2

0.0

Total outstanding property debt, £bn

155.5

158.2

159.5

163.0

Lending to property as a % of all lending

6.8

6.9

6.8

6.9

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

1.24

1.06

0.70

0.81

0.66

 
 

Dec. 2019

Jan. 2020

Feb. 2020

Mar. 2020

Apr. 2020

 

Manufacturing output, %y/y

-2.9

-3.7

-3.8

Employment, %y/y

1.0

0.8

1.1

ILO unemployment rate, %

3.8

3.9

4.0

Retail sales volumes, %y/y

0.8

0.8

0.1

-5.9

EC UK Economic sentiment index

87.3

90.7

95.5

92.0

CPI inflation, %y/y

1.3

1.8

1.7

1.5

Nationwide house prices, %y/y

1.4

1.9

2.3

3.0

 

Bank of England repo rate, %

0.75

0.75

0.75

0.10

0.10

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

0.78

0.71

0.56

0.39

0.28

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

0.87

0.78

0.67

0.55

0.50

Sources: Nationwide, Bank of England, Refinitiv

Table 2: Upcoming Data

 

Latest Number

Next Release Date

Period Covered

       

Nationwide house prices, %y/y

3.0

30th Apr. – 1st May

Mar.

Apr.

CIPS manufacturing sector PMI

47.9

1st May

Apr.

CIPS construction sector PMI

39.3

6th May

Apr.

CIPS services sector PMI

34.5

5th May

Apr.

Manufacturing output, %y/y

-3.8

9th Mar.

Mar.

CPI inflation, %y/y

1.5

20th May.

Apr.

Employment, %y/y

1.1

19th May

Mar.

ILO unemployment, %

4.0

19th May

Mar.

Retail sales volumes, %y/y

-5.9

22nd May

Apr.

Bank of England repo rate, %

0.10

7th May.

Apr.

MPC minutes (tighten/no change/loosen)

9/0/0

7th May.

Apr.

       

MSCI Quarterly index

 

4th May.

Q1

MSCI Monthly index

 

14th May.

Apr.

Bank Lending to Property

 

30th Mar.

Feb.

BoE Credit Conditions Survey

 

16th July.

Q2

RICS Construction Survey

 

July (Prov.)

Q2

RICS Commercial Property Survey

 

30th Apr.

Q1

       

Sources: Nationwide, IHS Markit, Refinitiv


Andrew Burrell, Chief Property Economist, andrew.burrell@capitaleconomics.com
Prohad Khan, Property Economist, prohad.khan@capitaleconomics.com