Will the global real estate boom end in tears again? - Capital Economics
UK Commercial Property

Will the global real estate boom end in tears again?

UK Commercial Property Focus
Written by Andrew Burrell
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After a sustained upturn in commercial property, yields are well below their historic lows and there are concerns that the current cycle could end as badly as previous ones. But we don’t think a crash is likely yet. Nonetheless, while we expect a rare soft landing for property over the next year or so and a modest recovery after, there will be further downward pressure on global capital growth and returns longer term.

  • After a sustained upturn in commercial property, yields are well below their historic lows and there are concerns that the current cycle could end as badly as previous ones. But we don’t think a crash is likely yet. Nonetheless, while we expect a rare soft landing for property over the next year or so and a modest recovery after, there will be further downward pressure on global capital growth and returns longer term.
  • The upturn in global commercial markets is now over a decade old. But this long expansion has brought a steady decline in property yields across developed markets, including the US and the UK. While much of this can be attributed to ultra-low interest rates, low yields evoke bad memories of previous crashes.
  • On balance, the evidence does not point to an impending property crash. In comparison with past cycles, there are few signs of pre-crash overheating or overvaluation, while lending trends remain subdued. This is reinforced by the stable macroeconomic backdrop, with the risk of recession or sharp monetary tightening currently relatively low in most developed economies.
  • But even if the next crash is not imminent, there will be challenges for global property markets. For one, occupier demand is expected to weaken in the near term as the global slowdown continues, though a recovery follows further out. While the upside to yields is limited (at least outside the UK), the lack of further compression will reduce potential capital growth. This means that global returns are likely to decline further over the next half-decade.
  • The US led the global property upturn, but it is expected to slow in the short term. The domestic economic downturn means that US rental value growth decelerates over the next year or so, improving only slowly once the economy picks up. And without the positive yield impact of the recent past, sub-5% y/y capital value growth will be the norm. Despite this, comparison with other developed markets indicates that US property returns will continue to outperform.
  • By contrast, the UK is an outlier on the downside, with yields already rising and the immediate outlook significantly weaker. But despite the uncertainty created by Brexit and the General Election and the headwinds in the retail sector, the correction in UK all-property capital values is expected to be mild in comparison with previous crashes, with a cumulate fall estimated at between 5% and 7.5% over the next three years.
  • The downturn in UK retail is much steeper, as structural challenges bring a 20% fall in values by the early 2020s. But even there, an improvement is expected after 2021, as yields stabilise and a declining stock helps brings a revival in rental pressures. For UK office and industrial property, by contrast, where rental growth holds up much better, the outlook is for only a dip in capital values. Over the next half-decade, UK all-property total returns of about 4% a year are disappointing by past standards and relative to other developed markets, but conceal a strong rally in the later years, as retail returns rebound.
  • In conclusion, with no evidence of an impending property crash, we don’t think the global boom will end in tears, but in a soft landing. Despite this, with limited scope for yield compression and rental growth subdued, there will be further downward pressure on capital growth and returns.

Will the global real estate boom end in tears again?

This Focus is an adapted version of a presentation given at the Capital Economics Property Forecast Forum in London on 20th November 2019.

Three main issues will be addressed in this Focus. First, after a decade of growth, can the global real estate upturn continue. Second and related to this, what are the risks of a downturn in the larger markets, focussing on evidence from the UK and US. And finally, what are the implications for the outlook in these markets, including the most important risks.

How long can the global upturn continue?

The prolonged global recovery in commercial real estate can be seen in both capital values and direct investment totals. (See Chart 1.) In 2018, capital values rose for the tenth consecutive year to exceed their highs of 2007, while total returns were a respectable 7% worldwide. Meanwhile, global transactions (in dollar terms) have continued to rise since a dip in 2016 and, by late last year, activity also reached new peaks.

Chart 1: Global Capital Values and Property Investment

Sources: JLL, MSCI

Despite the sustained recovery, investors are concerned about how long the good times will last. Chart 2 shows why, highlighting yields that are exceptionally low by any historical standard across the larger developed markets. That means there is little scope for further compression at this stage of the cycle, and lots of potential upside. While this in part reflects a decade of ultra-low policy rates, low yields evoke bad memories of previous crashes.

So, is property heading for a crash, or will the growth continue? This is examined from three angles. First, looking at the patterns of previous cycles in the US and UK. Second, reviewing potential warning signals, in this case valuation and debt measures. And finally, given that the economy is the main driver of the property cycle, assessing the economic context.

Chart 2: All-Property Yields by Country (%)

Source: MSCI

What are the risks of a global downturn?

Table 1 summarises the four-and-a-half property cycles identified in the UK since the 1950s. It shows that each episode has averaged about 13 years, with 37% real capital value growth in the upturn and, alarmingly, a similar sized crash at the end. In this context, the current UK upturn does not look that mature, especially compared with most recent complete cycle. In addition, the 17% real value uplift seen since 2009 does not look excessive yet.

Table 1: UK Real Estate Cycles

Period

Length
(Years)

Real Capital Value

(Cumulative %)

Boom

Bust

1955-74

19

24

-49

1974-85

9

16

-18

1985-90

5

37

-42

1990-2009

19

70

-39

2009-

10

17

Avg. pre- 2009

13

37

-37

Sources: MSCI, Scott

In the larger US market, cycles have been similar, but not identical. (See Table 2.) They have on average been shorter and with less severe crashes than the UK. The comparison raises slightly more concerns about the cyclical position of the US, with real capital values up by a punchier 28% since 2009. But much of this increase occurred in the early stages of the recovery. Since 2016, US capital values have been roughly flat in real terms, with no sign of a typical late-cycle acceleration.

Table 2: US Real Estate Cycles

Period

Length
(Years)

Real Capital Value

(Cumulative %)

Boom

Bust

1966-83

17

137

-17

1983-93

10

3

-28

1993-2001

8

21

-10

2001-09

8

19

-31

2009-

10

28

Avg. pre-2009

11

45

-20

Sources: MSCI, Federal Reserve

Valuation measures compare how fairly property is priced relative to other assets, as measured by UK dividend and bond yield spreads. (See Chart 3.) These can provide warnings of an impending crash by pointing to persistent overvaluation. Indeed, in the last stages of past booms as circled, property looked expensive on both indicators.

Currently, bond spreads suggest UK property is undervalued. Other global markets show a similar pattern and, with bond yields expected to stay low for some time, this provides some comfort about values. By contrast, property looks as expensive as before the previous two crashes relative to equities. However, this may also reflect the undervaluation of UK shares, where dividend yields have been unusually high in the last decade. On balance, the evidence from the UK looks inconclusive.

Chart 3: UK Property Yields Less 10-Year Gilt and Equity Yields (bps)

Sources: Refinitiv, MSCI

Borrowing has usually played a critical role in fuelling past property booms. In the late 1980s and early 2000s for instance, UK real estate loans grew far more rapidly than lending by other sectors. (See Chart 4.) This coincided in both cases with an acceleration in real capital value growth. In contrast, UK property lending has languished since 2009, which is perhaps why the recovery in capital values has not been dramatic this time. More important, it suggests property is currently less exposed to the interest rate shocks that have brought past cycles to an abrupt close.

Chart 4: UK Property Debt and Real Capital Values

Sources: Refinitiv, MSCI

So far then, the evidence does not seem to point to an impending property crash with no clear signs of overvaluation or overheating. This view is reinforced by the macroeconomic backdrop. Most property crashes have coincided with economic recessions in the past. Currently, we think the probability of a US recession is low at about 1 in 10, while UK risks have receded as no deal Brexit has become less likely.

In addition, past property downturns have usually been triggered by sharp rises in interest rates. But, with central banks easing policy globally, this looks a remote possibility. This is not to be complacent, as it wouldn’t take that much of a tightening to put pressure on property yields. But our current view is that this will not happen over a three to five-year horizon.

Global slowdown brings soft landing

But even if the current cycle has some time to run, global property markets face important challenges. For one, the economic environment is set to remain soft in the near term and this will weaken occupier demand and rents. Nonetheless, we expect a rare soft landing for commercial markets. (See Chart 5.) Global GDP growth dips below 3% y/y over the next year or so, before a modest recovery in 2021. This implies a further deceleration in real global capital value growth, pushing it close to zero next year, after which it revives again.

Chart 5: Global GDP and Real Capital Values (% y/y)

Sources: Refinitiv, MSCI, Capital Economics

The US has the led the global property upturn, but it too is expected to slow in the short term. We are planning to launch a US commercial property service in early 2020 and this is a preview of our initial views. A rental slowdown is expected over the next year or more, as US employment growth dips. (See Chart 6.) For the office sector, we expect a mild deceleration, not a repeat of 2009, and recovery follows 12 months or so later.

Chart 6: US Employment and Office Rents (% y/y)

Sources: Refinitiv, Reis, Capital Economics

US capital values follow from the rental profile, with growth slowing in the next year or so, but improving once the economy picks up. (See Chart 7.) The Fed’s recent rate cuts have eased the upward pressure on property yields, which still maintain a healthy spread against bonds. With cap rates broadly flat over the period, this means that US capital values will continue to rise. But without the strong positive yield impact of the recent past and with rental growth solid at best, sub-5% annual capital value growth will be the norm.

Chart 7: US All-Property Capital Value Growth

(% y/y)

Sources: MSCI, Capital Economics

UK faces headwinds in the near term

In contrast, the UK property view is more negative in the near term. This is because the UK yield cycle is already turning, with recent rises driven by the retail sector. We expect this to go further, broadening to all sectors during 2020 and 2021. But the speed of adjustment will depend on Brexit. (See Chart 8.)

Under a scenario where the Conservatives win a majority and the UK leaves the EU in January 2020, stronger GDP growth leads to higher policy rates. But against this backdrop, the property yield response is relatively slow, an increase of about 25bps over the next two years or so. (See Chart 8.) In the alternative, where there are repeated extensions to the exit deadline, we expect rate cuts. But in this scenario persistent uncertainty pushes up property yields more swiftly than if there is an early Brexit.

Chart 8: UK All-property Equivalent Yields (%)

Sources: MSCI, Capital Economics

The impact on capital values in our Brexit scenarios is shown in Chart 9. Rising yields mean that values fall in both, though the difference is not wide, with a 5% fall under the early exit compared with a 7.5% drop if there are repeated delays. Even in the delay scenario, this would only take values back to their mid-decade levels – a relatively mild setback compared with past UK downturns.

Chart 9: UK Capital Value Impact

(Cumulative %, 2019-21)

Sources: MSCI, Capital Economics

The probabilities of our Brexit scenarios will clearly be shaped by the looming UK General Election. This also brings other risks, notably the chance of a Labour government promising a radical break in policy. Of course, an outright Labour victory looks remote, at less than 1 in 10 based on current polling, but it could bring significant downside to our UK property outlook. We see several concerns.

Although we think the short-term occupier outlook may be brighter thanks to more expansionary policy and a softer Brexit, the boost may not last. And for property investment, there are other risks. It is likely confidence will suffer as investors re-assess the new regime, while sterling weakness could create further uncertainty. If landlord-unfriendly policies follow, such as higher capital gains tax or stamp duty, this could have lasting effects on activity and, in the worst case, if interest rates were forced up by higher borrowing, this would add to yield pressures.

In our central forecasts, based on the repeated delays scenario, divergent sector trends are a key feature of the UK outlook. Despite healthy demand, UK retail rents have plummeted this year, as a result of multiple setbacks in the sector, including the rising use of Company Voluntary Arrangements. (See Chart 10.) The UK is heavily exposed to the global retail malaise and these rental declines are expected to continue for another 12 months at least, with downside risks to the forecast further out.

Chart 10: UK Retail Rental Values (% y/y)

Sources: MSCI, Capital Economics

This means UK retail is an outlier in the near-term. At the all-property level, the declines expected in UK capital values look relatively mild in comparison to previous downturns. But in retail, capital values fare significantly worse with a 20% decline forecast over the next three years – reversing all the growth seen in the sector since 2009. (See Chart 11.) This is closer in severity to past end-cycle crashes and makes a big contribution to the overall UK market correction.

Chart 11: UK Capital Values by Sector

(Cumulative %, 2019-21)

Sources: MSCI, Capital Economics

UK outlook lifted by retail turnaround after 2021

But we are relatively optimistic about the retail sector in the longer term, in part based on our estimates for retail space. (See Chart 12.) We expect retail demand will remain healthy and the shift to online will slow as the market matures. But on supply, a very limited development pipeline and extensive change of use will act to curb growth. This means that the bricks and mortar retail stock will start to shrink early in the next decade. We think that this will help support a revival in rents in the final years of the forecast. As a result, retail capital values are expected to rebound longer term, though this only partly reverses the initial slump. (See Chart 13.)

Chart 12: UK Retail Floorspace (Bn Sq. Ft.)

Sources: Refinitiv, VOA, Capital Economics

For office and industrial property, by contrast, the outlook is significantly better in the short term. Capital values are still expected to fall in the office market, albeit by only 2-3%. Meanwhile, the rate of capital growth slows in industrial, but there is no decline. Although rental growth is expected to slow outside of retail, there are no declines, with rents underpinned by solid UK economic activity. When the recovery comes, these sectors lag retail, although sector performance is much less polarised after 2021.

Chart 13: UK Capital Values by Sector

(Cumulative %)

Sources: MSCI, Capital Economics

On average over the next half-decade, UK total returns of just over 4% a year are disappointing compared with the past, but hide a recovery in later years. (See Chart 14.) As expected, the retail sub-sectors perform worst overall, despite the late rebound. By contrast, the strongest sector is industrial where rental growth remains most vigorous. Offices outside of London and leisure also do better than average.

Chart 15 summarises our global forecasts for total returns. The Major Markets indicator averages the forecasts for the UK, US and euro-zone, which together account for about 65% of the MSCI Global Index.

Chart 14: UK Total Returns by Sector
(Annual Average 2019-23, %)

Sources: MSCI, Capital Economics

In these markets, the total returns picture diverges. For the US, we expect a brief slowdown in returns next year, followed by a rise as the economy recovers. As a result, the US consistently outperforms the other markets we forecast. By contrast, in the UK, returns dip close to zero over the next two years, then rebound as yields stabilise. By the end of the forecast, both UK and US are ahead of the average. The margin of outperformance is not wide, but in a low-return world, this is significant.

Chart 15: All-Property Market Returns (%)

Sources: MSCI, Capital Economics

Conclusion

In conclusion, with no evidence of an impending property crash, we don’t think the global boom will end in tears, but in a soft landing. Despite this, with limited scope for yield compression and rental growth unspectacular, there will be further downward pressure on global capital growth and returns.


Andrew Burrell, Chief Property Economist, +44 20 7808 3909, andrew.burrell@capitaleconomics.com