Further yield rises to weigh on capital values - Capital Economics
UK Commercial Property

Further yield rises to weigh on capital values

UK Commercial Property Chart Book
Written by Andrew Burrell
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Yields rose again in April and there is more of the same to come over the summer months. While rental values fell slightly, the rise in yields meant that capital values declined by 1.8% m/m in April. This saw annual returns turn negative for the first time since November 2009. As investor caution is likely to persist and rental values weaken, capital values will fall by over 10% this year, keeping returns in negative territory.

  • Yields rose again in April and there is more of the same to come over the summer months. While rental values fell slightly, the rise in yields meant that capital values declined by 1.8% m/m in April. This saw annual returns turn negative for the first time since November 2009. As investor caution is likely to persist and rental values weaken, capital values will fall by over 10% this year, keeping returns in negative territory.
  • Economic indicators show that activity is taking a hit from the lockdown. Survey-based indicators point to little improvement in activity and we think GDP could fall by as much as 25% q/q in Q2.
  • Market intelligence reflect a further deterioration in investment activity in April, with investment values at their weakest monthly level since April 2009. As investors remain concerned about further falls in capital values, we expect investment activity to decline further in Q2 before a partial recovery in H2.
  • Due to the drop in activity as a result of the COVID-19 lockdown, tenants have seen revenues slump, which has led to reduced rent collection rates. With retail seeing a fall in rents, all-property rental values edged down by 0.2% m/m in April. Although industrial and office rents flatlined, we expect rents to decline in both sectors too in Q2.
  • Meanwhile, yields increased by 8bps m/m in April, the same rate as March. The impact of rising yields was the most significant contributor to falls in capital values in all sub-sectors. (See Chart 1.) All-property capital values declined by 1.8% m/m and returns fell to minus 1.4% from plus 0.1% in March. Looking ahead, we expect that yields will continue to rise in the coming months and rents will fall, which will lead to all-property capital values falling further and returns remaining negative in 2020.

Chart 1: Contribution to Sub-Sector Capital Value Growth (%-pts y/y)

Source: MSCI


Economic Indicators

  • Ahead of the hard data for Q2, survey-based indicators signal the extent of the disruption from the lockdown. While the flash PMIs suggest an improvement in May, it still points to a substantial fall in GDP (2). The forward-looking element of the Economic Sentiment Indicator show the balance of firms report that levels of activity remains weak and there has been little improvement in expectations for activity (3).
  • The lockdown and reduction in confidence meant that retail sales volumes fell by 18.1% m/m in April. Compared to February, before lockdown began, clothing sales were down by almost 70% and petrol sales by 60% (4). Although we think April will be a low point, we don’t expect activity to rebound in May. Lacklustre demand is expected to weigh on inflation, which fell from 1.5% in March to 0.8% in April as a result of energy prices and this was the biggest monthly decline since December 2008 (5).
  • Labour market data suggest that a large rise in unemployment is underway. The increase in the claimant count from 1.2 million in March to 2.1 million in April, meant the share of the labour force claiming out-of-work benefits rose from 3.5% to 5.8% (6). We expect the unemployment rate will rise further in the coming months, particularly if firms must contribute to furloughed employees’ wages. Meanwhile, the Bank Rate remained at 0.1% and the 10-year gilt yield fell to 0.14% in late-May, from 0.27% in April (7).

Chart 2: UK Flash PMI & GDP

Chart 3: Bal. of Current & Expected Demand

Chart 4: Retail Sales Vol. (% Change Since February)

Chart 5: CPI Inflation (% y/y)

Chart 6: Measures of Labour Market Slack (%)

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

Sources: Refinitiv, European Commission, ONS, Capital Economics


Market Indicators

  • Investment activity deteriorated further in April, with investment values falling to their weakest monthly level since April 2009. This meant the 12-month average also softened (8). Transaction values for retail assets recorded the steepest fall, declining by 20% m/m in April. Meanwhile, the value of office investment fell by 4% m/m, while industrial assets saw a 3% m/m rise (9). We expect investment activity to decline further in Q2 before a partial recovery in H2. (See our Update.)
  • Similarly, Central London office leasing activity showed further signs of slowing. CBRE reported that take-up in April fell to its lowest level since 1999, which led the 12-month average to decline by 4% m/m (10). While the vacancy rate remained stable at 4.6% in April, but weaker occupier demand and the size of the development pipeline for the next couple of years points to vacancy rising substantially (11).
  • By contrast, regional office take-up increased by 20% y/y in Q1, although cities such as Leeds and Cardiff still saw falls (12). But based on the average level of take-up over the past five years, there is less than a year’s worth of new supply under construction and we expect this will provide some support to rents (13).

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

Chart 9: Value of Deals by Sector (£bn, 12-mth avg.)

Chart 10: C. Ldn Office Take-Up and Availability

Chart 11: C. Ldn Office Under Construction (M. Sq. Ft.)

Chart 12: Office City-Centre Take-Up (M. Sq. Ft.)

Chart 13: Years of Supply Pipeline in the Regions

Sources: Colliers, Property Archive, CBRE, Avison Young


Rental Values

  • Due to the drop in activity from the lockdown, tenants have seen a sharp fall in revenues, which has led to lower rent collections in Q1 than pre-COVID (14). There was a slight deterioration in rental values in April, with rents falling by 0.2% m/m. This took 3m/3m declines to -0.3%, from -0.2% in March (15).
  • Retail saw rents fall again in April, but office and industrial rental values flatlined, causing 3m/3m rental growth to soften (16). For industrial, this was the first time that rents haven’t grown m/m since 2013. With retail at the forefront of disruption, rental falls have accelerated. This has particularly been the case for shopping centres, where vacancy has been rising for some time, notably as anchor tenants such as Debenhams and House of Fraser have closed stores (17).
  • On a 3m/3m basis, office rental growth slowed from 0.4% in March to 0.3%. Rental growth was dragged lower as Central London rental values declined slightly in April (18). Looking ahead, although office occupiers have faced less disruption than other sectors as more employees are able to work from home, this is unlikely to prevent office rental values from declining this year (19).

Chart 14: Decline in Rent Collection in Q1 Compared to Two-year Average (%)

Chart 15: All-Property Rental Values

Chart 16: Rental Values by Sector (% 3m/3m)

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

Chart 18: Office Sub-Sector Rental Values

Chart 19: Most Likely to Work From Home (%)

Sources: Re-Leased, YouGov, MSCI, Capital Economics


Yields & Capital Values

  • An 8bps m/m rise in all-property equivalent yields in April meant yields rose at the same rate as the previous month (20). A similar picture was seen for offices, where yields rose by 7bps m/m and also maintained the same rate of increase as in March. On the other hand, retail and industrial saw a slower rate of yield rises in April. That said, retail yields still climbed by 17bps, which suggests investors are still most concerned about this sector (21). Unsurprisingly, shopping centre yields saw the greatest rise (22).
  • With yields rising and rents declining, all-property capital values fell by 1.8% m/m in April, albeit slower than the minus 2.4% m/m in March (23). With sentiment likely to remain weak in the coming months, we expect more upward pressure on yields, causing capital values to continue to fall.
  • While rental values saw a slight deterioration, the rise in yields had a significant contribution to the decline in capital values in April (24). In turn, annual returns turned negative for the first time since November 2009. Indeed, returns fell to minus 1.4% from plus 0.1% in March. Though on a month-on-month basis, as the rise in yields eased, most sub-sectors saw returns improve but remain negative in March (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 (% m/m)

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

-1.6

GDP, %q/q

0.6

-0.1

0.5

0.0

-2.0

Financial and business services output, %y/y

0.6

0.3

0.9

0.8

0.7

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

-4.3

Household spending, %y/y

1.3

1.3

1.1

0.9

-1.0

Net new lending to commercial property, £bn

1.5

1.3

1.2

0.0

4.8

Total outstanding property debt, £bn

155.5

158.2

159.5

163.0

167.7

Lending to property as a % of all lending

6.8

6.9

6.8

6.9

6.9

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

1.24

1.06

0.70

0.81

0.66

Jan. 2020

Feb. 2020

Mar. 2020

Apr. 2020

May. 2020

Manufacturing output, %y/y

-3.9

-4.3

-9.7

Employment, %y/y

0.8

1.1

1.4

ILO unemployment rate, %

3.9

4.0

3.9

Retail sales volumes, %y/y

0.9

0.2

-5.9

-22.6

EC UK Economic sentiment index

90.7

95.5

92.0

62.4

61.7

CPI inflation, %y/y

1.8

1.7

1.5

0.8

Nationwide house prices, %y/y

1.9

2.3

3.0

3.7

Bank of England repo rate, %

0.75

0.75

0.10

0.10

0.10

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

0.71

0.56

0.39

0.28

0.18

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

0.78

0.67

0.55

0.50

0.36

Sources: Nationwide, Bank of England, Refinitiv

Table 2: Upcoming Data

 

Latest Number

Next Release Date

Period Covered

Nationwide house prices, %y/y

3.7

2nd Jun.

Mar.

May.

CIPS manufacturing sector PMI

32.6

1st Jun.

May.

CIPS construction sector PMI

8.2

4th Jun.

May.

CIPS services sector PMI

13.4

3rd Jun.

May.

Manufacturing output, %y/y

-9.7

12th Jun.

Apr.

CPI inflation, %y/y

0.8

17th Jun.

May.

Employment, %y/y

1.4

16th Jun.

Apr.

ILO unemployment, %

3.9

16th Jun.

Apr.

Retail sales volumes, %y/y

-22.6

19th Jun.

May.

Bank of England repo rate, %

0.10

18th Jun.

Jun.

MPC minutes (tighten/no change/loosen)

9/0/0

18th Jun.

Jun.

MSCI Quarterly index

16th July

Q2

MSCI Monthly index

12th Jun.

May.

Bank Lending to Property

2nd Jun.

Apr.

BoE Credit Conditions Survey

16th Jul.

Q2

RICS Construction Survey

23rd Jul.

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