Office rents suffer and pricing stability set to unravel - Capital Economics
UK Commercial Property

Office rents suffer and pricing stability set to unravel

UK Commercial Property Chart Book
Written by Andrew Burrell
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A faster deterioration in office rents meant that all-property rental values fell at a quicker pace in September. As a result, with yields stable, all-property capital values declined less steeply. But with the rental outlook worsening amidst further lockdown restrictions and with yields set to rise further, we think capital values will fall faster in the coming months.

  • A faster deterioration in office rents meant that all-property rental values fell at a quicker pace in September. As a result, with yields stable, all-property capital values declined less steeply. But with the rental outlook worsening amidst further lockdown restrictions and with yields set to rise further, we think capital values will fall faster in the coming months.
  • Economic indicators show that, even before the full force of the latest containment measures are felt, the economic recovery had started to peter out. Indeed, the sharp fall in the composite flash PMI from 56.5 in September to 52.9 in October adds weight to our view that GDP will stagnate in Q4.
  • Market intelligence indicates a strong pick-up in investment activity in September, to its highest level since February. Colliers report that transactions totalled £3.2bn, up from £1.3bn in August. Nevertheless, we still expect investment activity to be around 30% y/y down by the end of the year.
  • As they have done for most of this year, all-property rental values declined by 0.3% m/m in September, down from minus 0.2% m/m in August. There was a notable deterioration in office rents. (See Chart 1.) And with reduced government support expected to bring a sharper fall in employment into next year, we think the outlook for office rents is likely to worsen in the coming months.
  • At an all-property level, equivalent yields declined by 2bps in September. With yields stabilising, all-property capital values fell by just 0.1% m/m in September, having fallen by 0.2% m/m in August. But if yields rise again in the coming months, as we anticipate, capital values will fall further. Meanwhile, annual all-property returns improved to minus 2.7% in September, from minus 2.9% in August, but further falls in capital values will cause returns to worsen again.

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

Source: MSCI


Economic Indicators

  • The further rise in COVID-19 cases has led to tighter containment measures, which will weigh on economic activity (2). And the fall in the composite flash PMI from 56.5 in September to 52.9 in October was its second consecutive drop, supporting our view that GDP will stagnate, if not contract, in Q4 (3).
  • Retail sales volumes grew by 1.5% m/m in September, meaning that sales volumes increased by 17.4% q/q in Q3, by far the largest quarterly rise on record (4). Meanwhile, the fallout in the labour market has been worse than previously thought. Initially, the LFS measure of employment was thought to have fallen by 94,000 since February. But it is now thought to have declined by 482,000 (5). The unemployment rate climbed from 4.0% in February to 4.5% in August. And with the national furlough scheme closing at the end of October and the new COVID-19 restrictions set to stall the economic recovery, a second bigger wave of unemployment is probably on its way.
  • The end of the “Eat Out to Help Out” scheme helped push CPI inflation from 0.2% in August to 0.5% in September (6). As this is still well below the Bank of England’s 2% target, we think that the MPC will keep Bank Rate low, at 0.1%, for the foreseeable future. While the 10-year gilt yield has edged up from 0.17% in September to 0.23% so far this month, we expect it to be closer to 0.15% at year-end (7).

Chart 2: UK COVID-19 Cases

Chart 3: Composite PMI

Chart 4: Retail Sales (February 2020 = 100)

Chart 5: Level of LFS Employment (Millions)

Chart 6: CPI Inflation (% y/y)

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

 

Sources: Refinitiv, Markit, ONS, Capital Economics


Market Indicators

  • The strong pick-up in investment in September meant that monthly activity reached its highest level since February. Colliers report that transactions totalled £3.2bn, up from £1.3bn in August. This was just 6% down compared to September 2019 (8). On a 12-month rolling basis, office investment fell almost 40% y/y in September (9). While retail investment also fell, industrial activity rose by 10% y/y.
  • The industrial occupier market strengthened in Q3, with take-up reaching another record high. CBRE reported that take-up increased from 12.8m. sq. ft. in Q2 to 13.3m. sq. ft. in Q3 (10). With speculative construction still low, availability is likely to remain in check in the coming months (11).
  • Meanwhile, Central London office take-up totalled just 1m. sq. ft. in Q3, down 10% on Q2, making it the lowest quarter on record (12). A rise in second-hand space being marketed pushed availability to its highest level since 2009. Vacancy also rose to 6.5% in Q3 from 5.3% in the previous quarter (13). With government advice reverting to employees working from home if they can and London entering tier two lockdown, we expect further rises in availability and downward pressure on rents in the near term.

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

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

Chart 10: Industrial Take-up and Availability

Chart 11: Industrial Under Construction (M. Sq. Ft.)

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

Chart 13: Central London Vacancy Rate (%)

 

Sources: Colliers, CBRE


Rental Values

  • At an all-property level, rents fell by 0.3% m/m in September, following the minus 0.2% m/m seen in August (14). Despite industrial rental growth improving in September, a worsening in office and retail rents weighed on all-property rental values (15).
  • With virus fears and government restrictions hurting footfall and accelerating the shift to e-commerce, a record number of stores have closed in the UK in H1. According to PwC and the Local Data Company, London and the South East saw particularly sharp net declines in H1 (16). This is likely to increase vacancy and put further downward pressure on retail rents, which declined faster again in September (17).
  • Meanwhile, office rents saw their sharpest monthly decline since November 2009 (18). And given that government advice reverted to work from home if you can in late September, they could fall faster still in October. Even before that, just under half of UK office workers had returned to their desks, which is much lower than in their European counterparts (19). At the same time, industrial rents edged up by 0.1% m/m, having been flat in August.

Chart 14: All-Property Rental Values (%)

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

Chart 16: Net Change in the Number of Stores

Chart 17: Retail Rental Values (% m/m)

Chart 18: Office Rental Values (% m/m)

Chart 19: Office Workers Returning to Desks (%)

 

Sources: MSCI, CE, PwC and Local Data Company, Morgan Stanley


Yields & Capital Values

  • All-property equivalent yields edged down again in September (20). While this may reflect demand for certain sectors such as industrial, with the Brexit deadline fast approaching and restrictions likely to get tighter, we expect this to peter out and yield falls to reverse. With demand for industrial assets strong, yields fell at a slightly faster rate (21). Meanwhile, with shopping centres seeing a marked decline in footfall since the pandemic and landlords suffering, yields rocketed in September. The 81bps m/m rise in shopping centre yields was the largest monthly increase in the sector for three decades (22).
  • With yields stabilising, the fall in rents is beginning to have a greater impact on property values (23). But, the fall in all-property capital values slowed slightly from minus 0.2% m/m in August to just minus 0.1% m/m in September (24). Yet, we think yields will rise again, putting downward pressure on capital values.
  • Annual total returns were minus 2.7% in September, from minus 2.9% in the previous month. While returns improved in the industrial and retail sectors, office returns slowed to 0.6% from 1.1% (25). Looking ahead, we think that further all-property value falls will see returns deteriorate in the near term.

Chart 20: Equivalent Yields

Chart 21: Industrial Equivalent Yields (Bps m/m)

Chart 22: Shopping Centre Equivalent Yields (Bps m/m)

Chart 23: Contribution to All-Property Capital Value Growth (%-pts y/y)

Chart 24: All-Property Capital Values

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

 

Source: MSCI


Data Summary and the Month Ahead

Table 1: Economic Indicators

 

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Q3 2020

           

GDP, %y/y

1.0

1.0

-2.1

-21.5

GDP, %q/q

0.3

0.1

-2.5

-19.8

 

Financial and business services output, %y/y

0.8

0.4

0.2

-10.3

FBS employment, %y/y

2.7

2.0

1.9

-1.8

Distributive trades output, %y/y

1.8

1.2

-4.4

-37.4

Household spending, %y/y

0.9

0.0

-2.9

-26.2

 

Net new lending to commercial property, £bn

1.2

0.0

4.8

0.1

Total outstanding property debt, £bn

159.5

163.0

167.7

170.7

Lending to property as a % of all lending

6.8

6.9

6.9

7.0

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

0.70

0.81

0.66

0.38

 
 

May. 2020

June. 2020

Jul. 2020

Aug. 2020

Sept. 2020

 

Manufacturing output, %y/y

-15.7

-10.1

-8.4

Employment, %y/y

-0.4

-0.3

-0.3

ILO unemployment rate, %

3.9

4.3

4.5

Retail sales volumes, %y/y

-2.0

1.2

2.6

4.6

EC UK Economic sentiment index

65.2

75.5

75.1

83.0

CPI inflation, %y/y

0.6

1.0

0.2

0.5

Nationwide house prices, %y/y

-0.1

1.5

3.7

5.0

 

Bank of England repo rate, %

0.10

0.10

0.10

0.10

0.10

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

0.18

0.10

0.17

0.18

0.20

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

0.30

0.20

0.20

0.18

0.20

Sources: Nationwide, Bank of England, Refinitiv

Table 2: Upcoming Data

 

Latest Number

Next Release Date

Period Covered

       

Nationwide house prices, %y/y

5.0

30th Oct.

Mar.

Sept.

CIPS manufacturing sector PMI

53.3

2nd Nov.

Oct.

CIPS construction sector PMI

56.8

5th Nov.

Oct.

CIPS services sector PMI

52.3

4th Nov

Oct.

Manufacturing output, %y/y

-8.4

12th Nov.

Aug.

CPI inflation, %y/y

0.5

18th Nov.

Oct.

Employment, %y/y

-0.3

10th Nov.

Sept.

ILO unemployment, %

4.5

10th Nov.

Sept.

Retail sales volumes, %y/y

4.6

20th Nov.

Oct.

Bank of England repo rate, %

0.10

5th Nov.

Nov.

MPC minutes (tighten/no change/loosen)

0/9/0

5th Nov.

Nov.

       

MSCI Quarterly index

 

2nd Nov.

Q3

MSCI Monthly index

 

13th Nov.

Oct.

.

Bank Lending to Property

 

29th Oct

Sept.

BoE Credit Conditions Survey

 

21st Jan.

Q4

RICS Construction Survey

 

7th Nov.

Q3

RICS Commercial Property Survey

 

5th Nov.

Q3

       

Sources: Nationwide, IHS Markit, Refinitiv


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