Rental falls intensify, but yield increases slow - Capital Economics
UK Commercial Property

Rental falls intensify, but yield increases slow

UK Commercial Property Chart Book
Written by Andrew Burrell
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While rental values fell sharply in May, this was in part offset by yields increasing at a much slower pace than the previous month. In turn, this led to a less steep fall in capital values, but annual returns remained negative. As the negative impact of the downturn will continue for some months, we expect rental values to reduce further. Combined with elevated investor caution in the near term, we think capital values will decline by over 10% in 2020.

  • While rental values fell sharply in May, this was in part offset by yields increasing at a much slower pace than the previous month. In turn, this led to a less steep fall in capital values, but annual returns remained negative. As the negative impact of the downturn will continue for some months, we expect rental values to reduce further. Combined with elevated investor caution in the near term, we think capital values will decline by over 10% in 2020.
  • Economic indicators report that the economy took a big hit during the lockdown as GDP fell by 20.4% m/m in April. However, as the UK eases lockdown restrictions, survey-based indicators point to a rebound in activity in the coming months.
  • Market intelligence shows that landlords received less income from June’s quarterly rental payment than in March. In addition, the total value of investment fell by 10% m/m in May to its lowest value since April 2009 and while we expect a partial recovery in H2, we think activity will remain subdued this year.
  • All-retail rental values fell from minus 0.7% m/m in April to minus 1.3% m/m in May. (See Chart 1.) In turn, this weighed on all-property rental values, which edged down to 0.4% m/m from 0.2% m/m in April. On the same basis, office rents fell slightly while growth in internet sales helped support rental growth in the industrial sector.
  • On a month-on-month basis, yields rose by 5bps in May, slower than the 10bps rise in the previous month. In turn, capital values declined by 1.2% m/m, from minus 1.8% m/m in April. Despite signs of stabilising sentiment, we think that yields will rise further in the near term and rents will continue to decline, which will accelerate the drop in all-property capital values and result in negative returns throughout the year.

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

Source: MSCI


Economic Indicators

  • The negative effects of the lockdown saw GDP fall by 20.4% m/m in April and meant GDP is 25% below its pre-virus level (2). Meanwhile, the rise in the services and manufacturing PMI to 47.0 and 50.1 in June, from lows of 29.0 and 40.7 suggests activity began to rebound this month (3).
  • Retail sales fell by 22.7% between February and April. However, a surge in online sales and the reopening of DIY stores resulted in a 12% m/m pick up in May (4). Nevertheless, we expect depressed demand to weigh on inflation. Indeed, a further drop in fuel price inflation meant CPI inflation fell from 0.8% in April to a four-year low of 0.5% in May (5).
  • Labour market data for May show a rise in unemployment, albeit slower than we initially anticipated. On the face of it, the ILO figures suggests that the labour market has been hit hard by the fall in GDP (6). But the timelier claimant count unemployment rate surged from 6.3% to 7.8% in May, its highest since 1996. Further, the Bank Rate was unchanged at 0.1% after June’s MPC meeting and the 10-year gilt yield fell marginally to a new low of 0.16% in late-June, from 0.18% in May (7).

Chart 2: GDP (February 2020 = 100)

Chart 3: Services and Manufacturing PMI

Chart 4: Retail Sales (2006=100)

Chart 5: CPI Inflation (% y/y)

Chart 6: Measures of Labour Market Slack (%)

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

Sources: Refinitiv, IHS, ONS, Capital Economics


Market Indicators

  • While retail stores were able to re-open from June 15th, Knight Frank suggest that only 40-50% did so in the first week. With weak demand and absent employees still a problem, retailers face challenges (8). Indeed, Re-Leased report that retail tenants paid just 14% of rents in Q2, less than Q1’s record lows (9).
  • Investment activity fell 10% m/m in May to its lowest value since April 2009 (10). While office and industrial transactions dropped sharply from their 12-month averages, retail was broadly in line due to a portfolio sale of supermarkets (11). Nevertheless, Colliers report higher preliminary activity for June, which probably suggests the worst may be over. We expect a partial recovery in the coming months.
  • According to CBRE, Central London office take-up was the lowest on record in May (12). In turn, vacancy increased from 4.6% in April to 4.8% in May. Meanwhile, Deloitte report that completions will rise from 4.2m sq. ft. in 2019 to around 8.2m sq. ft. this year (13). We expect a rise in supply and weaker demand to push vacancy above 5% this year. (See our Update.)

Chart 8: Challenges for Re-opening Retail Business (%)

Chart 9: Rental Payment by Sector (%)

Chart 10: Investment Deals Completed (£bn, monthly)

Chart 11: Monthly Value of Deals Completed by Sector (£bn)

Chart 12: C. Ldn Office Take-Up and Availability

Chart 13: C. Ldn Office Under Construction (M. Sq. Ft.)

Sources: CBI, Re-Leased, Colliers, Property Archive, CBRE, Deloitte


Rental Values

  • Despite an improvement in economic conditions, there was a sharper decline in rents in May. Indeed, rental values fell by 0.4% m/m, compared with minus 0.2% m/m in April. (14). On a monthly basis, industrial rents rose slightly, though offices edged lower (15). But the all-property fall was driven by a deterioration in retail and leisure rents (16).
  • According to Re-Leased, initial rental payments for June at an all-property level were just 18%, down from 25% in March (17). While this will improve in the coming days, it is still likely to remain weak. In particular, given sharp falls in revenues for retail and leisure occupiers since the lockdown, collection rates will remain the worst in these sectors. Further, the tentative re-opening of non-essential stores is unlikely to stem the pace of rental falls in the near term. In our view, retail rents will drop by a huge 9% this year.
  • After being flat in April, industrial rents rose by 0.1% m/m in May (18). Meanwhile, occupier demand for offices fell, particularly in the City and West End. As such, on a month-on-month basis, office rents turned negative, at minus 0.1% m/m in May, for the first time since April 2012 (19). And we expect them to fall further as weak employment growth keeps a lid on demand for office space.

Chart 14: All-Property Rental Values

Chart 15: Chart 18: Rental Values by Sector (% m/m)

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

Chart 17: All-Property Rental Payment (%)

Chart 18: Industrial Rental Value Growth (% m/m)

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

Sources: MSCI, Capital Economics, Re-Leased


Yields & Capital Values

  • All-property equivalent yields rose by 5bps m/m in May, compared with a 10bps m/m increase in April, and suggest investor sentiment may be stabilising as the crisis appears to be past the worst (20). This was consistent in all sectors, where yields increased at a slower pace (21). In line with investor concern about retail assets, yields rose the most in May at 8bps m/m, but much less than the 17bps rise in April. Of the retail sector, retail warehouses and shopping centres saw the largest rises, at 8bps and 5bps (22).
  • The rise in yields and fall in rents meant that all-property capital values fell by another 1.2% m/m in May, slightly less than the 1.8% m/m decline in April (23). On an annual basis, a rise in yields and fall in rents meant a further deterioration in capital values (24). And, as investor sentiment will be slow to recover, we expect more upward pressure on yields and capital values to fall by just over 10% this year.
  • In turn, annual returns fell from minus 1.4% to minus 2.3% in May. These were weighed down by retail and leisure returns, which were minus 12.8% and minus 8.4% respectively. With social distancing reducing the capacity of businesses, returns in these sectors will remain under pressure (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 (% y/y)

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

2.0

2.0

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

Feb. 2020

Mar. 2020

Apr. 2020

May. 2020

June. 2020

Manufacturing output, %y/y

-4.3

-9.7

-28.5

Employment, %y/y

1.1

1.4

0.7

ILO unemployment rate, %

4.0

3.9

3.9

Retail sales volumes, %y/y

0.2

-5.9

-22.6

-13.2

EC UK Economic sentiment index

95.5

92.0

62.4

61.7

CPI inflation, %y/y

1.7

1.5

0.8

0.5

Nationwide house prices, %y/y

2.3

3.0

3.7

1.9

Bank of England repo rate, %

0.75

0.10

0.10

0.10

0.10

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

0.56

0.39

0.28

0.18

0.19

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

0.67

0.55

0.50

0.36

0.31

Sources: Nationwide, Bank of England, Refinitiv

Table 2: Upcoming Data

 

Latest Number

Next Release Date

Period Covered

Nationwide house prices, %y/y

1.9

30 th Jun – 3rd Jul

Mar.

Jun.

CIPS manufacturing sector PMI

40.7

1st Jul.

Jun.

CIPS construction sector PMI

28.9

6th Jul.

Jun.

CIPS services sector PMI

29.0

3rd Jul.

Jun.

Manufacturing output, %y/y

-28.5

14th Jul.

May.

CPI inflation, %y/y

0.5

15th Jul.

Jun.

Employment, %y/y

0.7

14th Jul.

May.

ILO unemployment, %

3.9

14th Jul.

May.

Retail sales volumes, %y/y

-13.2

24th Jun.

Jun.

Bank of England repo rate, %

0.10

6th Aug.

Aug.

MPC minutes (tighten/no change/loosen)

9/0/0

6th Aug.

Aug.

MSCI Quarterly index

16th Jul.

Q2

MSCI Monthly index

14th Jul.

Jun.

Bank Lending to Property

29th Jun.

May.

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