Coronavirus disruption likely to accelerate yield rises - Capital Economics
UK Commercial Property

Coronavirus disruption likely to accelerate yield rises

UK Commercial Property Chart Book
Written by Andrew Burrell
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The rise in yields in February suggests that even before the disruption from coronavirus worsened, investors had become more cautious. In the coming months, we expect this to hit transactions hard. As a result, yields are likely to rise at a faster pace and capital values could fall by as much as 10% this year.

  • The rise in yields in February suggests that even before the disruption from coronavirus worsened, investors had become more cautious. In the coming months, we expect this to hit transactions hard. As a result, yields are likely to rise at a faster pace and capital values could fall by as much as 10% this year.
  • Economic indicators show some signs of the hit from COVID-19 on business activity. Even before social distancing measures became more severe, March’s composite PMI fell to its lowest level since the index started in 1998. And the drop in the PMIs of other countries locked down before the UK suggest that the UK PMI will drop even further in April.
  • Market intelligence suggests that on a 12-month rolling average basis, investment values were up around 12% m/m in February. The improvement was largely due to a sizeable purchase by Blackstone. In the coming months though, we expect transactions will grind to a halt as containment restricts trading.
  • Annual all-property rental value growth was flat in February. Compared to a year ago, office rental growth improved slightly and industrial growth slowed, but a larger decline in retail rents weighed on all-property values. The effects of shops being shut across the country are likely to exacerbate the decline in the retail sector this year.
  • A slight reduction in the size of capital value declines meant that all-property returns edged up to 2.3% in February. Nevertheless, investors remained cautious as yields rose in February from a year ago. (See Chart 1) Looking ahead, we think yields will rise further and rents will fall by 3%-3.5% y/y, causing capital values to fall by around 10% in 2020.

Chart 1: All-Property Yields (%)

Source: MSCI


Economic Indicators

  • The UK government has introduced stricter containment measures as the cases of COVID-19 have risen sharply since the start of March (2). Even before this, March’s composite PMI fell from 53.0 in February to 37.1, its lowest level since the index started in 1998 (3).
  • Further, as all shops selling non-essential goods have closed, the retail sector will undoubtedly be hit in the coming months. In fact, weekly retail sales for the week commencing the 9th March show that sales were down by 11% y/y (4). Similarly, even before the closure of many restaurants, the number of people eating out had been falling drastically compared to a year ago (5).
  • With activity slowing and a negative contribution from fuel prices, we expect the effects of the crisis to drag inflation rates, which has already been softening, below 1% in the months ahead (6). The UK government has provided stimulus measures worth around 5% of GDP and the Bank of England cut rates to a historic low of 0.1% in an attempt to prevent a prolonged recession. Nevertheless, investors have looked for safe havens, driving the 10-year gilt yield down to just 0.37% in March, from 0.67% at the start of the year (7).

Chart 2: UK Coronavirus Cases (Number)

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

Chart 4: UK Weekly Retail Sales (% y/y)

Chart 5: Number of Diners at UK Restaurant (% y/y)

Chart 6: CPI Inflation (%)

Chart 7: 10-Year Gilt Yield (%)

Sources: Refinitiv, IHS Markit, CE, OpenTable, Springboard


Market Indicators

  • Colliers reported that on a 12-month rolling average basis, investment values were up around 12% m/m to £3.8bn in February (8). The boost to investment in February was largely due to Blackstone’s purchase of iQ’s student housing portfolio for £4.7bn, which drove up activity in non-traditional sectors (9). In the coming months though, transactions are likely to grind to a halt as containment restricts most trading.
  • Regional office investment and occupier markets slowed in 2019. JLL reported that investment in 2019 fell by 16% y/y (10). Despite take-up also falling around 15% y/y to 5.2m sq. ft. last year, it was above its historic average (11). While a slowdown in office space under construction in the past year could support rental values (12), a hit to activity from coronavirus will lead to a weaker regional occupier market.
  • Carter Jonas note, between 2017 and 2020, the strongest industrial land value growth in the UK was seen in locations in the South East and East (13). This correlates fairly well with rates of prime rental growth, suggesting that stronger rental prospects in these regions have supported higher land values. (See Update.)

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

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

Chart 10: Big 6 Office Investment (£m)

Chart 11: Big 6 Office Take Up

Chart 12: Speculative Development Under Construction (M. Sq. Ft.)

Chart 13: Top Markets for Land Value Growth

(2017-2020)

Sources: Carter Jonas, JLL, Colliers, Property Archive


Rental Values

  • All-property rental growth was flat on an annual basis in February and so growth was at its lowest level since 2013 (14). Compared to a year ago, office rental growth improved slightly and industrial growth slowed, but a larger decline in retail rents weighed on all-property values (15).
  • On a %3m/3m basis, retail rents declined by 1.6% in February, down from minus 1.5% in January, with falls accelerating steadily since September 2019 (16). Retail warehouse rents fell by 1.5% in February on the same basis, reflecting a slight improvement from minus 1.6% a month ago. Over the same period, at minus 1.7% in February, shopping centre and shop rental declines have quickened (17). With many shops now shut, this is likely to exacerbate the decline in the retail sector for this year.
  • Office rental growth slowed from 2.2% y/y in January to 2% y/y in February. While West End and Rest of UK office rental growth remained stable, Rest of South East and City rental growth slowed. In particular, City rental growth more than halved from 1.8% y/y in January to 0.8% y/y in February (18). In part, this can be explained by a slowing occupier market from November to January as well as vacancy rising by 20bps over this period (19).

Chart 14: All-Property Rental Value Growth (%)

Chart 15: Rental Value Growth by Sector (% y/y)

Chart 16: Retail Rental Values

Chart 17: Retail Sub-Sector Rental Value (% 3m/3m)

Chart 18: Office Rental Value Growth (% y/y)

Chart 19: City Office Take-Up and Vacancy

Sources: MSCI, Capital Economics, CBRE


Yields & Capital Values

  • All-property equivalent yields rose by 8bps y/y in February, a slightly slower pace than the month before (20). As there have been a high number of CVAs in the retail sector, yields have jumped by almost 50 bps y/y in February (21). And, as investors are likely to be very cautious in the near term, we expect yield rises to accelerate over the coming months, with yields ending the year around 30bps higher. (See our Update.)
  • The slowdown in yield rises meant that the negative yield impact has reduced in recent months and capital values fell by 2.9% y/y in February, from minus 3% in January (22 and 23). But, we think that the impact of COVID-19 on property will be severe, causing values to fall by around 9% this year. (See our Update.)
  • On an annual basis, as rental growth was flat, a slower fall in capital values meant that returns edged up to 2.3% in February (24). Office returns rose from 5.1% in January to 5.3% in the same month. In contrast, a slowdown in industrial rental growth meant that returns were 7.1% in February, their lowest since 2017 (25). Looking ahead, a notable rise in yields is likely to hit capital value growth and returns this year.

Chart 20: Equivalent Yields

Chart 21: Equivalent Yields by Sector (%)

Chart 22: Contribution to All-Property Capital Value Growth (%-pts y/y)

Chart 23: All-Property Capital Value Growth

Chart 24: Capital Values and Total Return

Chart 25: Total Returns by Sector (% p.a.)

Source: MSCI


Data Summary and the Month Ahead

Table 1: Economic Indicators

Q4 2018

Q1 2019

Q2 2019

Q3 2019

Q4 2019

GDP, %y/y

1.4

2.0

1.3

1.2

1.1

GDP, %q/q

0.2

0.6

-0.1

0.5

0.0

Financial and business services output, %y/y

1.7

0.6

0.3

0.7

0.5

FBS employment, %y/y

1.8

2.5

3.4

2.6

Distributive trades output, %y/y

4.1

4.7

2.9

1.8

0.8

Household spending, %y/y

1.6

1.5

1.4

1.3

1.3

Net new lending to commercial property, £bn

0.7

1.5

1.3

1.2

0.4

Total outstanding property debt, £bn

154.2

155.5

158.2

159.5

163.0

Lending to property as a % of all lending

6.8

6.8

6.9

6.8

6.9

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

1.38

1.24

1.06

0.70

0.81

Nov. 2019

Dec. 2019

Jan. 2020

Feb. 2020

Mar. 2020

Manufacturing output, %y/y

-3.3

-2.5

-3.6

Employment, %y/y

1.1

1.0

0.8

ILO unemployment rate, %

3.8

3.8

3.9

Retail sales volumes, %y/y

0.7

0.7

0.8

0.0

EC UK Economic sentiment index

89.7

87.3

90.7

95.5

CPI inflation, %y/y

1.5

1.3

1.8

1.7

Nationwide house prices, %y/y

0.8

1.4

1.9

2.3

Bank of England repo rate, %

0.75

0.75

0.75

0.75

0.10

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

0.53

0.78

0.71

0.56

0.39

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

0.72

0.87

0.78

0.67

0.55

Sources: Nationwide, Bank of England, Refinitiv

Table 2: Upcoming Data

 

Latest Number

Next Release Date

Period Covered

Nationwide house prices, %y/y

2.3

27-31st Mar.

Mar.

Mar.

CIPS manufacturing sector PMI

51.7

1st Apr.

Mar.

CIPS construction sector PMI

52.7

6th Apr.

Mar.

CIPS services sector PMI

53.3

3rd Apr.

Mar.

Manufacturing output, %y/y

-3.6

9th Mar.

Feb.

CPI inflation, %y/y

1.7

22nd Apr.

Mar.

Employment, %y/y

0.8

21st Apr.

Feb.

ILO unemployment, %

3.9

21st Apr.

Feb.

Retail sales volumes, %y/y

0.0

23rd Apr.

Mar.

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

16th Apr.

Mar.

Bank Lending to Property

30th Mar.

Feb.

BoE Credit Conditions Survey

16th Apr.

Q1

RICS Construction Survey

April (Prov.)

Q1

RICS Commercial Property Survey

April (Prov.)

Q1

Sources: Nationwide, IHS Markit, Refinitiv


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