The recovery in capital values unlikely to last - Capital Economics
UK Commercial Property

The recovery in capital values unlikely to last

UK Commercial Property Chart Book
Written by Andrew Burrell
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Rental falls slowed and capital values returned to growth in November, suggesting that we may be too pessimistic in predicting further falls in values. But, with tight virus restrictions remaining and structural shifts weighing on the rental outlook, we think yields are set to rise again. As such, we still believe that all-property rents and capital values will fall next year.

  • Rental falls slowed and capital values returned to growth in November, suggesting that we may be too pessimistic in predicting further falls in values. But, with tight virus restrictions remaining and structural shifts weighing on the rental outlook, we think yields are set to rise again. As such, we still believe that all-property rents and capital values will fall next year.
  • Economic indicators show that the economy grew at a slower pace in October than the previous two months. GDP increased by just 0.4% m/m, leaving the economy about 8% smaller than it was in February.
  • Market intelligence show that weak occupier demand and rising availability in Central London offices have pushed vacancy up from 7% in October to 7.7% in November. With completions set to rise next year, we expect further increases in vacancy in the next 12 months.
  • All-property rental values declined at their slowest pace since July in November. Rental values fell by 0.1% m/m, compared to a 0.3% drop m/m in the previous month. Once again, falls were driven by declines in leisure and retail rents.
  • At the all-property level, equivalent yields edged down by 2bps in November, the fourth consecutive monthly decline. With yields falling, capital values grew by 0.2% m/m in November, the first rise since October 2018. (See Chart 1.)
  • Meanwhile, annual total returns improved for the fourth consecutive month from minus 2.5% in October, to minus 1.9% in November. Further ahead, we expect a decline in all-property capital values will result in returns deteriorating more in the coming months.

Chart 1: Contribution to All-Property Capital Value Growth (%-pts m/m)

Source: MSCI


Economic Indicators

  • The economy grew at a slower pace in October than the previous two months. GDP increased by just 0.4% m/m in October, leaving the economy still 7.9% smaller than it was in February (2). And the relatively small rebound in the composite flash PMI from 49 in November to 50.7 in December suggests that GDP did not make much of a recovery after the lockdown (3).
  • Despite the 3.8% m/m fall in retail sales in November, sales were still 2.7% above their pre-virus level (4). Meanwhile, with firms contributing more to the cost of their furloughed employees, employment fell by 144,000 in the three months to October (5). This led to the unemployment rate rising from 4.8% to 4.9%. With the furlough scheme being withdrawn in April next year, we think the unemployment rate will increase to 7% in mid-2021.
  • The sharp fall in CPI inflation, to 0.3% in November from 0.7% in October, was driven by one-off factors such as a marked decline in clothing inflation (6). With inflation well below the 2% target, we expect the Bank of England will complete the quantitative easing it has already announced and keep interest rates at 0.1% for at least the next couple of years. Meanwhile, the 10-year Gilt yield has edged down from 0.34% in November to 0.29% so far this month and we expect it will remain low in the coming months (7).

Chart 2: Level of Monthly GDP (February 2020 = 100)

Chart 3: Composite PMI

Chart 4: Retail Sales (February 2020 = 100)

Chart 5: 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

  • According to Colliers, transaction totals were £2.8bn in November, down from £3.2bn a year ago (8). This was mostly due to weaker investment in alternatives. By the same measure, while retail and office activity was close to last November’s totals, industrial investment was up from £460m to £830m (9).
  • CBRE report that Central London office take-up was just 130,000 sq. ft. in November, down 30% from an already weak October (10). Over the year, there has been a marked rise in tenant-controlled (grey space) availability (11). This has seen available second-hand space rise, with total availability edging up 4% m/m to 22m. sq. ft. As a result, vacancy rose from 7% in October to 7.7% in November. With completions set to peak next year, we expect further increases in vacancy in the next 12 months (12 and our Update.)
  • Meanwhile, Savills report that value-oriented brands such as Lidl and Aldi – major drivers of demand in the grocery sector since 2015 – have accounted for 75% of store openings this year. What’s more, between Q1 and Q3 openings had already exceeded the 10-year annual average (13).

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

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

Chart 10: Central London Office

Chart 11: Tenant-controlled CL Availability (M. Sq. Ft.)

Chart 12: Central London Office Development Pipeline (M. Sq. Ft.)

Chart 13: Number of Grocery Store Openings

Sources: Colliers, CBRE, Deloitte, Savills


Rental Values

  • In November, all-property rents fell at their slowest pace since July. Having fallen by 0.3% m/m in October, rental values dropped by 0.1% m/m in November (14). The decline in all-property rents was still driven by the retail and leisure sectors, although there was a marked slowing in leisure rental falls (15).
  • Indeed, leisure rents saw a less steep fall than the 1.8% m/m decline in October, at minus 0.8% m/m in November (16). And second national lockdown in November causing a sharp fall in business for most leisure operators (17). However, we think tight restrictions across the country will lead to more insolvencies in the industry and this will result in sharper rental falls in the coming months.
  • Meanwhile, all-industrial rents grew at their fastest pace since December 2019 (18). Industrial rental growth was 0.3% m/m in November, up on the 0.1% m/m rise in October. With an accelerated shift to online spending, we think that industrial will be the only sector to record rental growth next year. This is consistent with the latest RICS survey, which showed that industrial rental expectations for the next 12 months improved further (19).

Chart 14: All-Property Rental Values (%)

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

Chart 16: Number of UK Diners (% y/y)

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

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

Chart 19: RICS Surveyors Expecting Rising Industrial Rental Values (% Net Balance)

Sources: MSCI, Capital Economics, Open Table, RICS


Yields & Capital Values

  • All-property equivalent yields edged down by 2bps in November, the third consecutive month of decline (20). While yields rose in the office and retail sectors, this was offset by a 9bps fall in all-industrial yields (21). That fall in yields was seen across the industrial sub-sectors with Rest of South East yields falling to historic lows (22). Further ahead, as rental growth accelerates, we think that industrial yields will continue to nudge lower in the next few years. (See our Outlook.)
  • On a month-on-month basis, all-property capital values returned to growth for the first time since October 2018 (23). They grew by 0.2% m/m in November, having fallen 0.1% m/m in October. The improvement in all-property capital values was driven by industrial capital value growth accelerating in November. Indeed, at 1.9% m/m, industrial capital values grew at their fastest pace since December 2017 (24).
  • Annual total returns improved for the fourth consecutive month from minus 2.5% in October, to minus 1.9% in November. While the industrial and retail sectors saw returns strengthen, office returns turned negative for the first time since December 2009 (25). Further ahead, we expect a decline in all-property capital values will result in returns deteriorating more in the coming months.

Chart 20: All-Property Equivalent Yields (%)

Chart 21: Equivalent Yields by Sector (%)

Chart 22: Industrial Equivalent Yields (%)

Chart 23: All-Property Capital Values

Chart 24: Capital Values by Sector (% m/m)

Chart 25: Total Returns by Sector (% p.a.)

Source: MSCI


Data Summary and the Month Ahead

Table 1: Economic Indicators

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Q3 2020

Real GDP, %y/y

1.0

1.0

-2.1

-21.5

-9.6

Real GDP, %q/q

0.3

0.1

-2.5

-19.8

15.5

Financial and business services output, %y/y

0.8

0.4

0.2

-10.9

-7.6

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

-6.2

Household spending, %y/y

0.9

0.0

-2.9

-26.2

-12.7

Net new lending to commercial property, £bn

1.2

0.0

4.8

0.0

0.6

Total outstanding property debt, £bn

159.5

163.0

167.7

170.6

169.8

Lending to property as a % of all lending

6.8

6.9

6.9

7.0

6.9

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

0.70

0.81

0.66

0.38

0.58

Jul. 2020

Aug. 2020

Sept. 2020

Oct. 2020

Nov. 2020

Manufacturing output, %y/y

-8.4

-8.0

-7.0

Employment, %y/y

-0.3

-0.8

-0.9

ILO unemployment rate, %

4.5

4.8

4.9

Retail sales volumes, %y/y

2.6

4.6

5.8

2.4

EC UK Economic sentiment index

75.5

75.1

83.0

84.6

78.4

CPI inflation, %y/y

0.2

0.5

0.7

0.3

Nationwide house prices, %y/y

3.7

5.0

5.7

6.4

Bank of England repo rate, %

0.10

0.10

0.10

0.10

0.10

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

0.10

0.17

0.17

0.20

0.25

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

0.20

0.20

0.18

0.20

0.34

Sources: Nationwide, Bank of England, Refinitiv

Table 2: Upcoming Data

 

Latest Number

Next Release Date

Period Covered

Nationwide house prices, %y/y

6.4

30th Dec.

Mar.

Nov.

CIPS manufacturing sector PMI

55.6

4th Jan.

Dec.

CIPS construction sector PMI

54.7

7th Jan.

Dec.

CIPS services sector PMI

47.6

6h Jan.

Dec.

Manufacturing output, %y/y

-7.0

15th Jan.

Sept.

CPI inflation, %y/y

0.3

20th Jan.

Dec.

Employment, %y/y

-0.9

26th Jan.

Nov.

ILO unemployment, %

4.9

26th Jan.

Nov.

Retail sales volumes, %y/y

2.4

22nd Jan.

Dec.

Bank of England repo rate, %

0.10

4th Feb.

Feb.

MPC minutes (tighten/no change/loosen)

0/9/0

4th Feb.

Feb.

MSCI Quarterly index

Feb.

Q4

MSCI Monthly index

Jan.

Dec.

.

Bank Lending to Property

4th Jan

Nov.

BoE Credit Conditions Survey

21st Jan.

Q4

RICS Construction Survey

4th Feb.

Q4

RICS Commercial Property Survey

28th Jan.

Q4

Sources: Nationwide, IHS Markit, Refinitiv


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