Pricing set to worsen - Capital Economics
UK Commercial Property

Pricing set to worsen

UK Commercial Property Chart Book
Written by Prohad Khan
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Though the slowdown in the pace of rental and capital value falls in recent months seems to suggest that pricing is stabilising, we expect there will be further upward pressure on yields this year. After all, the rental outlook has deteriorated. And with renewed fears about further lockdowns and a no-deal Brexit still on the table, the risks are skewed to the downside.

  • Though the slowdown in the pace of rental and capital value falls in recent months seems to suggest that pricing is stabilising, we expect there will be further upward pressure on yields this year. After all, the rental outlook has deteriorated. And with renewed fears about further lockdowns and a no-deal Brexit still on the table, the risks are skewed to the downside.
  • Economic indicators show that, even before the government’s tighter measures to contain the recent rise in COVID-19 infections, the economic recovery had already started to flatten out. Indeed, the composite PMI fell from 59.1 in August to 55.7 in September.
  • Market intelligence indicates that after gradually recovering from the lows of May, investment activity slowed again in August. According to Colliers, £1.1bn worth of deals were completed in August, down from around £2bn in July. We expect investment to remain subdued for the rest of the year.
  • For the seventh consecutive month, all-property rental values fell. Rents declined by 0.2% m/m in August. The fall in the all-property figure was largely driven by the retail and leisure sectors. Meanwhile, with government advice reverting to asking people to work from home if they can, further downward pressure on office rents this year is likely.
  • All-property equivalent yields fell by 1bp in August. As a result of this yield stabilisation, all-property capital values declined by just 0.2% m/m in August, following a 0.3% m/m fall in July. But with investor caution elevated we think that yields will rise in the coming months, causing the decline in capital values to accelerate. A marked decline in leisure returns led all-property returns to worsen slightly from minus 2.8% in July to minus 2.9% in August. (See Chart 1.) Looking ahead, we think that further falls in capital values will cause returns to deteriorate more.

Chart 1: Total Returns (% y/y)

Source: MSCI


Economic Indicators

  • The government has introduced tighter measures to contain the recent rise in COVID-19 infections, which we think will weigh on economic activity (2). Even before this, September’s composite PMI fell from 59.1 in August to 55.7, suggesting that the recovery has already started to flatten out (3).
  • As discretionary spending continues to recover, retail sales rose 4% above their pre-virus level in August (4). For now, the gradual unwinding of the furlough scheme since August has not led to a marked rise in job losses. Indeed, the 36,000 fall in PAYE employees in August wasn’t that much worse than the 19,700 decline in July (5). But, as the government’s new “Job Support Scheme” is not as supportive as the furlough scheme, we expect the unemployment rate to rise further, from 4.1% in July to at least 7% by the middle of next year.
  • Meanwhile, the VAT cut for the hospitality and tourism sectors and the “Eat Out to Help Out” discount scheme led to a sharp drop in CPI inflation, from 1% in July to 0.2% in August (6). As a result, we expect that the MPC will keep policy loose, with Bank Rate staying at 0.1% for the foreseeable future. What’s more, we think that they will eventually announce another £250bn of QE. The 10-year gilt yield is unchanged so far this month (7).

Chart 2: UK COVID-19 Cases

Chart 3: Composite PMI (Balance)

Chart 4: Retail Sales (February 2020 = 100)

Chart 5: Employment (Million)

Chart 6: CPI Inflation (% y/y)

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

Sources: Refinitiv, Markit, ONS, Capital Economics


Market Indicators

  • Having gradually recovered since the lows of May, investment activity slowed again in August. Colliers reported that £1.1bn worth of deals were completed in August, down from £2bn in July (8). The fall in investment was seen in most sectors apart from industrial. Indeed, industrial investment rose from £150m in July to £200m in August. Even so, investment in the sector remained low by recent standards (9).
  • As companies took a wait-and-see approach, Central London office demand waned in August. According to CBRE, take-up declined by 78% m/m in August, totalling just 79,000 sq. ft., which contributed to availability rising (10). Vacancy rose to 6% in August, from 5.7% in July (11), with subdued demand and a relatively large development pipeline pointing to further rises in the coming months.
  • As many smaller industrial occupiers in the Western Corridor service retailers and restaurants in London, this could explain the dramatic fall in industrial take-up (12). JLL reports that it fell by almost 60% y/y, to 1.1m sq. ft. in H1. Available space has risen by 7% to 7.7m sq. ft. in the corridor and, with fewer workers returning to the office and demand subdued, we expect downward pressure on rents in the near term (13).

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

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

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

Chart 11: Central London Vacancy Rate (%)

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

Chart 13: Industrial Availability (M. Sq. Ft.)

Sources: Colliers, CBRE, JLL


Rental Values

  • All-property rents fell by 0.2% m/m in August, the seventh consecutive month of falls (14). Despite rents in all sectors performing worse in August than in July, the drop in all-property values was largely due to the retail and leisure sectors (15).
  • According to Springboard, UK retail vacancy increased to 10.8% in July, up from 9.8% in January, marking a six-year high. This is largely due to a raft of CVAs and administrations this year (16). This will continue to put downward pressure on retail rents (17).
  • All-office rental values were pretty much flat again in August (18). But, with government advice reverting to asking people to work from home if they can, further downward pressure on rents this year is likely. Meanwhile, all-industrial rents were flat, after 0.1% m/m growth in July. Nevertheless, tight supply and the acceleration of spending online meant that Rest of South East and Distribution Warehouse rents outperformed (19).

Chart 14: All-Property Rental Values (%)

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

Chart 16: Retail Administrations

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

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

Chart 19: Rental Values by Sub-Sector (% m/m)

Sources: MSCI, Capital Economics, Centre for Retail Research


Yields & Capital Values

  • Although all-property equivalent yields fell by 1bp in August, we still expect yields to rise in the coming months as investor caution remains (20). Yields fell in some sectors in August, but not by enough to offset July’s rise (21). For instance, the 4bps m/m decline in leisure yields left yields still 5bps higher than in June and almost 100bps up on the start of the year (22). Further this is a risk that yields could rise by more than expected, with virus cases rising and a no-deal Brexit still on the table
  • This year, most of the falls in property values have come from yield rises (23). With yields stabilising, all-property capital values declined by just 0.2% m/m in August, following a 0.3% m/m fall in July (24). Nevertheless, we expect yields have further to rise and capital values will fall further in H2.
  • Annual all-property total returns worsened slightly from minus 2.8% in July to minus 2.9% in August. Returns were broadly stable, aside from leisure where they deteriorated from minus 11.5% to minus 12.7% (25). We expect a further capital value fall will see returns deteriorate more in the coming months.

Chart 20: Equivalent Yields

Chart 21: Equivalent Yields by Sector (Bps m/m)

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

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

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

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

1.9

-1.8

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

May. 2020

June. 2020

Jul. 2020

Aug. 2020

Sept. 2020

Manufacturing output, %y/y

-23.1

-14.6

-9.4

Employment, %y/y

0.5

1.2

0.2

ILO unemployment rate, %

3.9

3.9

4.1

Retail sales volumes, %y/y

-12.9

-1.6

1.4

2.8

EC UK Economic sentiment index

61.7

65.2

75.5

75.1

CPI inflation, %y/y

0.5

0.6

1.0

0.2

Nationwide house prices, %y/y

1.8

-0.1

1.5

3.7

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

0.18

0.10

0.17

0.18

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

0.36

0.30

0.20

0.20

0.18

Sources: Nationwide, Bank of England, Refinitiv

Table 2: Upcoming Data

 

Latest Number

Next Release Date

Period Covered

Nationwide house prices, %y/y

3.7

29-30th Oct.

Mar.

Sept.

CIPS manufacturing sector PMI

55.2

1st Oct.

Sept.

CIPS construction sector PMI

54.6

6th Oct.

Sept.

CIPS services sector PMI

58.8

5th Oct.

Sept.

Manufacturing output, %y/y

-9.6

9th Oct.

Aug.

CPI inflation, %y/y

0.2

21st Oct.

Sept.

Employment, %y/y

0.2

13th Oct.

Aug.

ILO unemployment, %

4.1

13th Oct.

Aug.

Retail sales volumes, %y/y

2.8

23rd Oct.

Sept.

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

16th Oct.

Q3

MSCI Monthly index

14th Oct.

Sept.

.

Bank Lending to Property

29th Sept

Aug.

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