Further hit to values yet to come - Capital Economics
UK Commercial Property

Further hit to values yet to come

UK Commercial Property Chart Book
Written by Andrew Burrell
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Rents and capital values fell at a slower pace in July than was recorded in June. But, while values seem to be approaching a degree of stability, we expect a deterioration in the rental outlook will put renewed upward pressure on yields. Total returns were again in negative territory, where we expect them to stay this year.

  • Rents and capital values fell at a slower pace in July than was recorded in June. But, while values seem to be approaching a degree of stability, we expect a deterioration in the rental outlook will put renewed upward pressure on yields. Total returns were again in negative territory, where we expect them to stay this year.
  • Economic indicators show that, despite the largest quarterly fall on record in Q2, there were more encouraging signs for activity at the end of the quarter. Further, retail sales rose 3% above their pre-pandemic levels in July and survey-based indicators suggest that the recovery continued at a strong pace in Q3.
  • Market intelligence shows that a marked increase in office investment helped boost the total value of investment from £1.4bn in June, up to £2bn in July. Nevertheless, there are no signs of an acceleration in the rate of recovery and nor do we expect one.
  • At an all-property level, rental values fell at a slower pace in July than June. Indeed, rents declined by 0.2% m/m, down from minus 0.4% m/m. Although there was a notable slowing in retail rental declines, retail still drove the decline in all-property rents. And, we expect more pain ahead. This is in-line with the RICS survey, which showed that expectations for retail rental values over the next 12 months worsened.
  • Equivalent yields showed signs of stabilising in July, increasing by just 1bp. In turn, capital values fell by just 0.3% m/m in July, which was slower than the 0.7% m/m decline in the previous month. (See Chart 1.) If yield rises resume later this year, as we anticipate, capital value declines will accelerate. Annual returns were broadly unchanged in July, at minus 2.8%, but further falls in capital values would see them worsen.

Chart 1: Capital Values by Sector (% m/m)

Source: MSCI


Economic Indicators

  • The 20.4% q/q contraction in GDP in Q2 was the largest quarterly fall on record. But monthly data show that the fall came in the early part of the quarter, as activity grew again in May, by 2.4% m/m, and June, by 8.7% m/m (2). And the marked increase in the composite IHS Markit/CIPS Flash PMI in August suggests that the recovery continued at a strong pace in Q3 (3).
  • Thanks to a notable boost in discretionary spending, retail sales rose 3% above their pre-pandemic levels in July (4). Meanwhile, there are cracks evident in the latest labour market data. Weekly data show that employment fell by 455,000 (1.4%) between the start of February and the end of June (5). And while the success of the furlough scheme meant that the ILO unemployment rate stood at a relatively low 3.9% in June, there are likely to be further rises in unemployment in the coming months as the scheme unwinds.
  • CPI inflation jumped from 0.6% in June to 1% in July, partly due to a rise in oil prices and clothing prices. But we think the effects of the VAT cut for the hospitality and tourism sectors and the “Eat Out to Help Out” scheme will put downward pressure on prices (6). This will support the case for monetary policy staying loose, meaning that the Bank Rate should remain unchanged at 0.1% for a long time. As such, although the 10-year gilt yield rose from 0.1% in June to 0.22% in late-August, it still remains low (7).

Chart 2: GDP (February 2020 = 100)

Chart 3: Composite PMI (Balance)

Chart 4: Retail Sales (February 2020 = 100)

Chart 5: Employment (Mns)

Chart 6: CPI Inflation (% y/y)

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

Sources: Refinitiv, Markit, ONS, Capital Economics


Market Indicators

  • Investment has gradually improved from May’s low point. Colliers report values totalled £2bn in July, up from £1.4bn in June (8). July’s pick-up was largely due to a rise in office investment, which totalled £1bn (9). Nevertheless, there are no signs of an acceleration in the rate of recovery and nor is one likely.
  • In Q2, office demand across most of the regional city centres was weak. Avison Young report that take-up fell by 80% y/y to 330,000 sq. ft. across the top nine regional markets (10). But, more positively, there is less than a year’s worth of new supply under construction in most markets (11). This should limit rises in vacancy and prevent rents from falling significantly in the regions, although Glasgow may be an exception.
  • Occupier demand for Central London offices also eased this month. CBRE report that despite a pick-up in June, demand dropped back in July. Twelve-month rolling take-up declined by 11% m/m, which contributed to availability increasing (12). Consistent with this, vacancy rose to 5.7% in July, from 5.2% in June (13). Weaker demand and the relatively large size of London’s development pipeline for the next couple of years points to vacancy remaining elevated.

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

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

Chart 10: Regional City Centre Take-Up (000s Sq. Ft.)

Chart 11: Years of Supply in the Regions (Based on 5-Yr Avg. Take-Up)

Chart 12: Central London Office Take-Up (M. Sq. Ft.)

Chart 13: Central London Vacancy Rate (%)

Sources: Colliers, Avison Young, CBRE


Rental Values

  • Rents fell at a slower monthly pace in July (14). All-property rents fell by 0.2% m/m in July, after minus 0.4% m/m in June. The falls in all-property rents was still driven by the retail and leisure sectors, despite a notable slowing in retail rental declines (15).
  • Indeed, retail rents fell by 0.6% m/m in July, a less steep fall than the 1.1% m/m decline in June (17). Nevertheless, we expect more pain ahead. This is consistent with the latest RICS survey, which showed that retail rental expectations for the next 12 months deteriorated further (18).
  • According to a Morgan Stanley survey, UK office workers were slow to return to the office in July (18). Nevertheless, having fallen consecutively by 0.1% m/m in the previous two months, all-office rental values were pretty much flat in July (19). But, as tenants review their space requirements in the coming months, occupier demand could worsen, causing rental falls to accelerate again.

Chart 14: All-Property Rental Values (%)

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

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

Chart 17: RICS Surveyors Expecting Falling Retail Rental Values (% Net Balance)

Chart 18: Office Workers that have Returned to the Office since July (%)

Chart 19: Office Rental Values
(% m/m)

Sources: MSCI, Capital Economics, RICS, Morgan Stanley


Yields & Capital Values

  • All-property equivalent yields barely rose in July, rising by just 1bps. This followed a measly 2bps increase in June (20). Although this implies that pricing may have fully adjusted, we expect further yield rises in H2. At a sector level, industrial yields were unchanged in July, and office and retail yields rose by 2bps and 3bps m/m respectively (21). Despite government support, investors remain cautious about leisure assets, where yields rose 9bps m/m in July and have now increased by 105bps since January (22).
  • At an all-property level, capital values declined by 0.3% m/m in July, which was slower than the 0.7% m/m fall in June (23). If yield rises resume later this year, as we expect, capital value declines will accelerate.
  • Annual total returns were broadly unchanged in July, at minus 2.8% (24). Only the office sector saw a reduction in returns, worsening from 1.5% to 1.2%. That said, since the start of the year, returns have deteriorated across all the sub-sectors. Further falls in capital values would see them worsen further (25).

Chart 20: Equivalent Yields

Chart 21: Equivalent Yields by Sector (%)

Chart 22: Leisure Equivalent Yields (Bps m/m)

Chart 23: All-Property Capital Values

Chart 24: Total Returns by Sector (% y/y)

Chart 25: Total Returns by Sub-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

21.7

GDP, %q/q

-0.1

0.5

0.0

-2.2

20.4

Financial and business services output, %y/y

0.3

0.9

0.8

0.8

-11.3

FBS employment, %y/y

3.4

2.7

2.0

2.0

Distributive trades output, %y/y

3.0

2.0

1.2

-4.5

-36.3

Household spending, %y/y

1.2

0.9

0.7

-2.5

-25.2

Net new lending to commercial property, £bn

1.3

1.2

0.0

4.8

0.1

Total outstanding property debt, £bn

158.2

159.5

163.0

167.7

170.7

Lending to property as a % of all lending

6.9

6.8

6.9

6.9

7.0

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

1.06

0.70

0.81

0.66

0.38

Apr. 2020

May. 2020

June. 2020

Jul. 2020

Aug. 2020

Manufacturing output, %y/y

-28.5

-23.1

-14.6

Employment, %y/y

0.7

0.6

0.3

ILO unemployment rate, %

3.9

3.9

3.9

Retail sales volumes, %y/y

-22.7

-12.9

-1.6

1.4

EC UK Economic sentiment index

62.4

61.7

65.2

75.5

CPI inflation, %y/y

0.8

0.5

0.6

1.0

Nationwide house prices, %y/y

3.7

1.8

-0.1

1.5

Bank of England repo rate, %

0.10

0.10

0.10

0.10

0.10

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

0.28

0.18

0.18

0.10

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

0.50

0.36

0.30

0.20

Sources: Nationwide, Bank of England, Refinitiv

Table 2: Upcoming Data

 

Latest Number

Next Release Date

Period Covered

Nationwide house prices, %y/y

1.5

2nd Sept

Mar.

Aug.

CIPS manufacturing sector PMI

53.3

1st Sept.

Aug.

CIPS construction sector PMI

58.1

4th Sept.

Aug.

CIPS services sector PMI

56.5

3rd Sept.

Aug.

Manufacturing output, %y/y

-14.6

11th Sept.

Jul.

CPI inflation, %y/y

1.0

15th Sept.

Aug.

Employment, %y/y

0.3

15th Sept.

Aug.

ILO unemployment, %

3.9

15th Sept.

Jul.

Retail sales volumes, %y/y

1.4

18th Sept.

Aug.

Bank of England repo rate, %

0.10

17th Sept.

Sept.

MPC minutes (tighten/no change/loosen)

0/9/0

17th Sept.

Sept.

MSCI Quarterly index

16th Oct.

Q3

MSCI Monthly index

14th Sept.

Aug.

.

Bank Lending to Property

1st Sept

Jul.

BoE Credit Conditions Survey

15th Oct.

Q3

RICS Construction Survey

7th Nov.

Q3

RICS Commercial Property Survey

26th Oct.

Q3

Sources: Nationwide, IHS Markit, Refinitiv


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