COVID-19 scarring slow to heal - Capital Economics
UK Commercial Property

COVID-19 scarring slow to heal

UK Commercial Property Outlook
Written by Andrew Burrell
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Effective vaccines provide a path out of the COVID-19 economic slump, but commercial property will be slow to benefit. On the bright side, the real estate downturn has been milder than expected and we appear to be past the worst. But we think yields will stay elevated, and that all-property rents will decline further and capital values will stabilise in 2021. And even as the economy returns to normal, it will bring only an insipid property recovery, with office and retail sectors dogged by structural change. This means that industrial performance continues to stand out, topping the rankings for returns over a five-year horizon.

  • Overview – Effective vaccines provide a path out of the COVID-19 economic slump, but commercial property will be slow to benefit. On the bright side, the real estate downturn has been milder than expected and we appear to be past the worst. But we think yields will stay elevated, and that all-property rents will decline further and capital values will stabilise in 2021. And even as the economy returns to normal, it will bring only an insipid property recovery, with office and retail sectors dogged by structural change. This means that industrial performance continues to stand out, topping the rankings for returns over a five-year horizon.
  • Economic Backdrop – We think that vaccines will allow output to return to its pre-virus levels by next year and that, by mid-decade, it will be back on its pre-COVID growth path. And over the next couple of years, spare capacity will keep inflation at or below its 2% target. So we expect policy rates to stay put and, while 10-year gilt yields will drift higher, they will remain low.
  • Investment Market – Investment activity held up better than expected in late-2020 and is expected to revive later this year. But rental prospects remain poor and we expect yields to stay put over the next 12 months or so. Low interest rates provide scope for yield reductions after 2022, but, given the anaemic rental backdrop, a reversion to pre-COVID-19 levels is not expected outside of the industrial sector.
  • Office Market – Despite a brighter economic outlook, office rents are unlikely to recover before 2022. Improvements thereafter will be shaped by the shift to remote working. We think that will mean that Central London markets, where occupier costs are highest, will underperform, while the South East and regions will see stronger rental growth and returns.
  • Retail Market – The latest lockdown is a further blow for this sector and the recovery will be very slow as the effects of the pandemic such as an elevated level of online spending continue to be felt long after. We expect capital value falls to extend into 2022 and see no prospect of rental growth over a five-year horizon, confirming retail’s position as by far the worst performing sector.
  • Industrial Market – In stark contrast to all other sectors, industrial property values rose in 2020. With online sales elevated, we expect this strong performance to continue, though a return to more normal spending patterns and a supply response will slightly dampen rental growth over the medium term. Despite this, average total returns of 7% p.a. will leave industrial property well ahead of the other traditional sectors.
  • Leisure and Hotels – Tight lockdowns, travel bans and weak incomes will continue to undermine the hospitality sector in early 2021. But a vaccine-led recovery in spending will bring a better second half and support an upturn in capital values from next year. Thereafter, leisure looks better placed to take advantage of the post-pandemic recovery, with returns outstripping other commercial sectors by mid-decade.

Main Forecasts

Table 1: Key Commercial Property Forecasts (Year End)

 

2020

2021

2022

2023

2024

2025

2021-25

2022-25

ALL PROPERTY

Rental value growth, % y/y

-3.1

-1.2

0.6

0.8

1.0

1.0

0.4

0.9

End yr equiv. yield, %

5.8

5.8

5.7

5.7

5.7

5.7

5.7

5.7

Capital value growth, % y/y

-6.6

0.1

1.5

1.8

1.2

1.2

1.2

1.4

Income return, % y/y

4.6

4.6

4.7

4.7

4.6

4.6

4.7

4.7

Total return, % p.a

-2.3

4.7

6.2

6.4

5.9

5.9

5.8

6.1

OFFICE PROPERTY

Rental value growth, % y/y

-0.8

-0.6

0.3

0.9

1.3

1.3

0.6

0.9

End yr equiv. yield, %

5.8

5.8

5.7

5.7

5.7

5.7

5.7

5.7

Capital value growth, % y/y

-5.5

-0.9

1.5

1.8

1.6

1.3

1.0

1.5

Income return, % y/y

4.0

4.0

4.0

4.0

4.0

4.0

4.0

4.0

Total return, % p.a

-1.7

3.1

5.5

5.7

5.6

5.3

5.0

5.5

RETAIL PROPERTY

Rental value growth, % y/y

-9.4

-5.9

-0.9

-0.2

0.0

0.0

-1.4

-0.3

End yr equiv. yield, %

6.8

6.7

6.7

6.6

6.6

6.5

6.6

6.6

Capital value growth, % y/y

-17.1

-4.6

-0.2

0.6

0.1

0.7

-0.7

0.3

Income return, % y/y

5.5

5.8

5.9

5.9

5.9

5.9

5.9

5.9

Total return, % p.a

-12.4

1.2

5.8

6.5

6.0

6.6

5.2

6.2

INDUSTRIAL PROPERTY

Rental value growth, % y/y

2.3

2.7

2.2

1.7

1.7

1.7

2.0

1.8

End yr equiv. yield, %

5.2

5.0

4.9

4.9

4.9

4.9

4.9

4.9

Capital value growth, % y/y

4.6

6.2

3.2

2.7

1.7

1.7

3.1

2.3

Income return, % y/y

4.4

4.1

4.2

4.1

4.1

4.1

4.1

4.1

Total return, % p.a

9.2

10.3

7.4

6.8

5.8

5.8

7.2

6.5

LEISURE PROPERTY

Rental value growth, % y/y

-7.1

-3.0

0.0

1.0

2.0

2.0

0.4

1.3

End yr equiv. yield, %

6.7

6.8

6.7

6.6

6.5

6.5

6.6

6.6

Capital value growth, % y/y

-18.8

-4.3

0.7

2.5

3.6

2.0

0.9

2.2

Income return

5.1

5.4

5.3

5.2

5.1

5.1

5.2

5.2

Total return, % p.a

-14.6

1.0

6.1

7.8

8.7

7.1

6.1

7.4

HOTEL PROPERTY

Rental value growth, % y/y

-1.6

-1.0

0.5

0.7

1.0

1.0

0.4

0.8

End yr equiv. yield, %

4.7

4.8

4.8

4.7

4.7

4.7

4.7

4.7

Capital value growth, % y/y

-6.5

-2.4

1.6

1.8

1.0

1.0

0.6

1.3

Income return

4.2

4.4

4.4

4.3

4.3

4.3

4.4

4.4

Total return, % p.a

-2.6

2.1

5.9

6.1

5.3

5.3

5.0

5.7

Sources: MSCI, Capital Economics

Table 2: Key UK Economic Forecasts (Year Average)

 

2018

2019

2020e

2021f

2022f

GDP, % y/y

1.3

1.4

-9.9

5.5

6.5

5-yr swap rate, % (end-period)

1.38

0.54

0.04

0.40

0.65

10-yr gilt yield, % (end-period)

1.38

0.74

0.39

0.75

1.0

CPI inflation, % y/y

2.5

1.8

0.8

1.3

1.7

$/£ (end-period)

1.28

1.33

1.37

1.40

1.45

Euro/£ (end-period)

1.11

1.18

1.12

1.12

1.12

Household spending, % y/y

1.3

1.1

-11.7

7.4

8.8

Unemployment rate (ILO measure), %

4.1

3.8

4.5

6.0

5.5

Employment, % y/y

1.2

1.1

-0.4

-1.3

2.0

Average earnings, % y/y

2.9

3.5

1.4

4.0

1.7

Nationwide house prices, % y/y in Q4

0.5

1.4

7.2

-4.7

2.5

Sources: Refinitiv, Capital Economics


Sectoral Rankings

Chart 1: CE Forecasts for Rental Value Growth in 2021 (% y/y)

Chart 2: CE Forecasts for Rental Value Growth in 2021-2025 (% y/y)

Chart 3: CE Forecasts for Capital Value Growth in 2021 (% y/y)

Chart 4: CE Forecasts for Capital Value Growth in 2021-2025 (% y/y)

Chart 5: Equivalent Yields, Q4 2021 (%)

Chart 6: Equivalent Yields, Q4 2025 (%)

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Chart 7: CE Forecasts for Total Returns in 2021 (% p.a)

Chart 8: CE Forecasts for Total Returns in 2021-2025
(% p.a)

Sources: MSCI, Capital Economics


Economic Backdrop

A rebound is around the corner

  • Recent headlines focused on the record-breaking 9.9% decline in annual GDP during 2020. But the rise in output in Q4, despite the lockdown in November and tighter measures in December, is evidence that the economy has built up some immunity to virus restrictions. This means that, even though the third COVID-19 lockdown means another step down in activity is likely in January, a technical double-dip recession will be avoided. (See Chart 9.)
  • And GDP should rebound sharply in the second half of 2021. If the promising start to the rollout of vaccines is maintained, then some easing in restrictions is likely from Q2, allowing GDP to rebound rapidly through the year. (See Chart 10.) This explains why, unlike most, we think that output will reach its pre-virus peaks by next year and that, by mid-decade, it will be back to where it would have been had COVID-19 never existed.
  • Of course, the path to that point won’t be smooth. The scheduled expiry of the furlough scheme at the end of April will mean that employment will continue to fall, with levels expected to drop a further 1.3% y/y in 2021. (See Chart 11.)
  • But that would be seen as a success if the scheme meant that the 25% peak-to-trough fall in GDP during last year led a peak unemployment rate of only 6.5% this year, falling back to 5.0% by the end of 2022. (See Chart 12.)
  • With household saving rates rising during the crisis, consumer spending is better placed to lead the upturn than business investment. (See Chart 13.) Our view is that people will quickly go back to travel and leisure and that the economy’s supply potential won’t be permanently damaged by the crisis.
  • Admittedly, this will be partly offset by less spending on goods, so retail sales growth may slow after the pandemic. This effect will be worse if the mini-boom in the housing market runs out of steam later this year as we expect. But overall consumer spending will still lead the recovery and be back to its pre-crisis level in early 2022. (See Chart 14.)
  • That said, COVID support has come at a huge cost with the government’s direct help for the economy so far at £285bn (14% of GDP). After pencilling in an extra £15bn of spending this year and adding in the indirect effects of the weak economy, the budget deficit in 2020/21 may be close to 20% of GDP. But if we are right in expecting GDP to regain its pre-crisis trend, then the resulting rise in revenues and fall in spending means the budget deficit will drop back to 2% of GDP by 2023/24 without the need for major tax hikes.
  • There is a growing risk of a sustained rise in inflation once the economy has fully recovered. But over the next couple of years the large amount of spare capacity means that inflation will probably spend more time below the 2% target than above it. (See Chart 15.)
  • While this implies that monetary policy can remain lose, we think the markets have been wrong to price in negative interest rates. And while we do not expect policy rates to move for the foreseeable future, 10-year gilt yields may see further upward pressure. They have edged up from near zero lows in the summer and we expect them to rise to 0.75% by the end of this year. (See Chart 16.)

Economic Backdrop

Chart 9: Monthly Real GDP (February 2020 = 100)

Chart 10: Quarterly Real GDP (Q4 2019 = 100)

Chart 11: GDP & Employment

Chart 12: ILO Unemployment Rate (%)

Chart 13: H’hold Saving Ratio (% of Disposable Income)

Chart 14: Consumer Spending Growth

Chart 15: CPI Inflation (% y/y)

Chart 16: Bank Rate & Gilt Yields (%)

Sources: CEIC, Refinitiv, Capital Economics, ONS, Bloomberg, BoE


Investment Market

Activity to revive, but no quick turnaround in pricing

  • Investment activity rebounded in Q4 2020, boosted by a strong December outturn, though this momentum is not expected to be sustained in early 2021. (See Chart 17.) This meant that investment in 2020 totalled £38bn according to LSH, about 20% lower than 2019’s total. This was a less steep fall than we expected, but still left investment at an eight-year low. And with the UK back in lockdown, the outlook remains weak for early 2021.
  • A further steep decline in office investment led the contraction in overall activity. (See Chart 18.) A year-on-year fall of 34% in this sector followed a 45% y/y slump in 2019, leaving totals two-thirds below their peak. Concerns about the future of the City post-Brexit in part explain this, as do longer-term structural worries. As such, we expect weakness in office investment to continue.
  • Any recovery in 2021 is expected to start slowly. (See here.) Admittedly, RICS report that investment sentiment has improved in recent quarters, but it is still as negative as at any time since the euro-zone debt crisis. Given uncertainty about the path out of the current lockdown, activity is likely to remain weak in H1. But with the vaccine rollout, we expect sharp improvements in H2, although this will still leave activity below its pre-pandemic levels.
  • All-property yields fell in Q4 for the first time since 2018. (See Chart 19.) Further rises were registered in most office and retail sectors, but this was offset by sizeable falls in industrial yields. While we think further significant rises are now unlikely, Q4’s drop is expected to be a one-off. We expect lockdowns will put pressure on yields in the weaker sectors and limit falls elsewhere in early 2021. And even after, the removal of government support will initially bring out occupier distress that was hidden during the crisis.
  • Property valuations improved in Q4 2020, as vaccine news reduced dividend yields, while gilt yields were unchanged. (See Chart 20 and here.) The retail and office sectors look either undervalued or fairly valued by our measure. But we don’t think that this will translate into sustained declines in property yields in the next year or so, given that rental growth will remain weak even after the economy rebounds.
  • We expect yields to tread water over the next two years. (See Chart 21.) Although rental growth returns in most sectors by 2022, for office and retail in particular any expansion is weak and yields are only expected to drift down slowly longer term. This means that only industrial yields will be lower than their pre-virus levels by end-2025. As a result, all-property yields remain above their pre-virus lows until the end of the forecast.
  • A better-than-expected end to 2020 meant the fall in all-property capital values was limited to around 7% y/y. But with some rental fallout still to come and yields flat, we expect a further 1% drop in 2021. And as the pandemic passes, any revival will be sluggish. (See here.) Growth of close to 1% p.a. is weak compared with the recent past, as structural change continues to weigh on performance. (See Chart 22.)
  • After annual all-property property returns of minus 2.3% last year, they are expected to average around 5.5% p.a. over 2021-25. (Chart 23.) Over this period, returns in retail, leisure and hotels fare worst, while industrial and regional offices are most resilient. (See Chart 24.)

Investment Market

Chart 17: Value of UK Commercial Property Deals Completed (£bn per Quarter)

Chart 18: Commercial Property Deals by Sector (£bn, 12-month rolling )

Chart 19: All-Property Equivalent Yields (q/q, bps)

Chart 20: CE Valuation Score by Sector

Chart 21: All-Property and 10-Year Bond Yields (%)

Chart 22: All-Property Capital Values (Index, 2000 Q4 = 100)

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Chart 23: All-Property Total Returns, Income Return and Capital Values

Chart 24: Total Returns by Sector (% p.a., 2021-25)

Sources: Property Archive, LSH, Colliers, Refinitiv, MSCI, CE


Office Market

Rents expected to fall further this year

  • Office rents held up better than anticipated in 2020, falling by less than 1% y/y, but we think there is more pain to come. The short-term economic outlook remains uncertain and will weigh on office rents in Q1. Even when restrictions ease, the ending of the furlough scheme will continue the shake-out of jobs, with employment not expected to return to growth until early 2022.
  • While office jobs are likely to see a less sharp decline, they will not be unaffected. (See Chart 25.) Admittedly, vaccinations significantly improve the outlook from 2020 H2, but we think the impact on occupier activity may initially be slow. And more remote working represents a negative demand shock for the office sector longer term. (See our Focus and Update.) As such, any rental recovery is likely to be subdued.
  • Central London office take-up remained exceptionally weak in Q4, with the quarterly and 2020 annual totals both at all-time lows. (See Chart 26.) By any standards the falloff in demand has been precipitous, with levels more than halving in the last year, and broad-based, with minimal differences between City and West End. With the capital in lockdown for at least Q1 and other uncertainties clouding the outlook, including post-Brexit arrangements for finance, it is difficult to see much upside to occupier demand this year.
  • Given the demand picture, it is no surprise that vacancy has risen steeply in Central London. 2020 Q4 saw a further steep rise, most notably in the West End. Nonetheless, these rates are still below the peaks of the post-Brexit-vote downturn in 2016-17, with combined rate at 7.4%. (See Chart 27.) Nonetheless, vacancy is a lagging indicator and will continue to rise in 2021, though it is likely to remain well below the double-digit peaks of the GFC aftermath.
  • The capital’s current development pipeline remains significant. Around 5m. sq. ft. is expected to complete both this year and next, which will maintain new supply at similar levels to 2019-20. (See Chart 28.) Less than a half is pre-let and, while some of the rest could be shelved, this will add to the upward pressure on vacancy. Along with weak occupier demand and an expected release of second-hand space, this will all be negative for rents.
  • Last year, City rents fell by around 1% y/y, while West End rents dropped by over 2% y/y. These were the first sustained falls in the capital’s markets since 2009. A Central London vacancy rate above 7% is usually consistent with falling office rents. (See Chart 29.) We expect a further rise this year and we think this will mean rental declines of around 0.5% in the City and 1.5% in the West End.
  • Despite a strong UK economic recovery, London office rents are slow to revive longer term and growth will remain weaker than other office subsectors. This in part reflects structural change, as occupiers reassess their expensive space in the capital as remote working becomes more prevalent. The resulting slow reduction in vacancy is expected to hold rental growth in the capital below 1% p.a. over the forecast.
  • There may be other headwinds too. A Brexit trade deal did avert an economic cliff edge in January, but without resolving the future for London’s large financial sector. Talks are deadlocked and the UK’s bargaining power is now weaker. Though we think that the City will adapt whatever, there is already evidence that financial business may be lost to the Continent.

Office Market

Chart 25: Office Rents and Jobs (% y/y)

Chart 26: Central London Take-Up (M. Sq. Ft.)

Chart 27: City and West End Vacancy Rate (%)

Chart 28: Under Construction (M Sq. Ft.)

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Chart 29: London Office Rents and Vacancy

Chart 30: Regional Take-Up (M. Sq. Ft.)

Chart 31: Years of Supply in the Regions (Based on 5-Yr Avg. Take-Up)

Chart 32: South East Take-Up and Availability

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Sources: MSCI, Various Agents, Capital Economics


Office Market

Central London markets underperform

  • The regional market has been hit less hard than in London. Nonetheless, according to Avison Young, while take-up increased by 20% q/q to 1.6 m. sq. ft. in Q4, it was still down by around a third over the year. (See Chart 30.) And despite the recent revival, the level of activity in the regions remains low by recent standards.
  • But Rest of UK rents were more resilient than expected in 2020. Overall, they rose by 0.6% y/y. With the UK economy recovering later this year, we expect improved fortunes for occupier demand, though the initial recovery will be slow, with rents rising by just 0.5% y/y in 2021.
  • Longer term, rents are expected to revive faster in the regions. This is in part driven by tighter supply. In most of the Big 6 markets, there is currently less than a year’s worth of space under construction based on annual take-up for the past five years. (See Chart 31.) This position has not deteriorated during COVID-19 and suggests that even if demand remains below par, there is limited upside risk to vacancy.
  • In addition, real office rents in regional offices remain undervalued compared with other office sub-sectors. In our view, this means more growth potential and helps explain the above-average increases we expect over the next five years. But, while regional cities are less exposed to remote working than the capital, given lower occupation costs, they will not be immune. This drag will prevent a faster take-off in rental growth.
  • Activity in the South East market declined sharply in 2020. CBRE reported take-up of 1.9m. sq. ft., about one fifth lower than a year before. Not surprisingly, availability has also risen sharply, climbing to 6.2% of stock by year-end, the highest since 2016. (See Chart 32.) Last year, Rest of South East rents fell by 0.6% y/y, ending a decade of sustained growth. A slow start to this year is expected to push vacancy higher and we expect rents to edge down further in 2021.
  • Beyond this, the recovery will be slow, though we expect South East markets to be less affected by negative structural change. While this region’s out-of-town offices have fallen out of favour, the rise of remote working is expected to bring a reassessment. Suburban locations may provide an alternative for occupiers and workers fleeing city centres, notwithstanding concerns about accessibility and amenity. Over the forecast, we expect rental growth in South East offices to be second to the regional cities amongst the office subsectors. (See Chart 33.)
  • Office yields did not respond as much as we expected last year, rising by less than 20bps. With the downward pressure on rents persisting this year, yields are expected to hold broadly stable. Thereafter, we think the rental upturn will allow some easing, but yields remain above their 2019 levels throughout the next five years. (See Chart 34.)
  • Office capital values fell by 5.5% y/y in 2020 – the worst drop since 2009 and was second only to the retail sector in terms of severity. This year, with rents falling and yields flat, a further fall is in prospect, albeit relatively mild at minus 1% y/y. Capital values will start to recover in 2022, but that upturn will be subdued. In fact, we expect values will rise by less than 1% a year on average over the forecast. (Chart 35.)
  • We think office returns will be close to 3% this year, after hitting a decade-low of minus 1.7% in 2020. And between 2022-25, returns average just 5% p.a., much weaker than pre-COVID-19 averages. At a sub-sector level, Central London returns lag. (See Chart 36.)

Office Market

Chart 33: Office Rental Value Growth (% y/y)

Chart 34: Office Equivalent Yields (%)

Chart 35: Office Capital Value Growth

Chart 36: Office Property Forecasts

(% y/y, 2021-25, Annual Average)

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Sources: MSCI, Capital Economics


Table 3: CE Office Sector Forecasts (% y/y, Year-End)

 

2020

2021

2022

2023

2024

2025

2020

2021

2022

2023

2024

2025

All Office

Rest of South East 30% of office stock by value

Rental value growth

-0.8

-0.6

0.3

0.9

1.3

1.3

Rental value growth

-0.6

-0.5

0.0

1.0

1.5

1.5

End yr equiv. yield, %

5.8

5.8

5.7

5.7

5.7

5.7

End yr equiv. yield, %

6.6

6.6

6.5

6.4

6.4

6.4

Capital value growth

-5.5

-0.9

1.5

1.8

1.6

1.3

Capital value growth

-6.0

-0.6

1.5

2.6

1.5

1.5

Income return

4.0

4.0

4.0

4.0

4.0

4.0

Income return

4.3

4.3

4.4

4.3

4.3

4.3

Total return, % p.a

-1.7

3.1

5.5

5.7

5.6

5.3

Total return, % p.a

-2.0

3.7

5.9

6.9

5.8

5.8

London City 11% of office stock by value

Rest of UK 24% of office stock by value

Rental value growth

-0.9

-0.5

0.5

0.8

1.0

1.0

Rental value growth

0.6

0.5

1.0

1.5

1.5

1.5

End yr equiv. yield, %

5.3

5.3

5.3

5.3

5.3

5.3

End yr equiv. yield, %

6.6

6.5

6.5

6.5

6.5

6.5

Capital value growth

-2.2

-0.8

0.5

0.8

1.0

1.0

Capital value growth

-4.2

-0.8

2.6

1.5

1.5

1.5

Income return

3.3

3.2

3.3

3.3

3.3

3.3

Income return

4.8

4.7

4.7

4.7

4.7

4.8

Total return, % p.a

1.1

2.4

3.8

4.1

4.3

4.3

Total return, % p.a

0.3

3.9

7.3

6.2

6.2

6.3

London West End 34% of office stock by value

Rental value growth

-2.3

-1.5

0.0

0.5

1.0

1.0

End yr equiv. yield, %

4.6

4.6

4.6

4.6

4.5

4.5

Capital value growth

-7.0

-1.3

0.9

1.6

2.1

1.0

Income return

3.4

3.5

3.4

3.4

3.3

3.3

Total return, % p.a

-3.8

2.1

4.3

5.0

5.4

4.3

Sources: MSCI, Capital Economics


Retail Market

No rental growth before 2025

  • Although retail sales quickly recovered their pre-pandemic levels last summer, as restrictions have tightened demand has fallen back. (See Chart 37.) A miserable seasonal period for retailers and a sharper-than-expected contraction in January confirm the near-term economic outlook is poor and we think that sales will deteriorate further in the coming months. With all but essential stores closed, physical retail sales will continue to be hit hardest.
  • Given this, it was no surprise that there was a marked rise in store closures in 2020. Levels were already elevated at the start of the year but ended at post-GFC highs. (See Chart 38.) The BRC-LDC reported that a rise in store closures pushed vacancy up by 50bps q/q to 13.7% in Q4. This was reflected in another sharp decline in retail rents, which fell by 2.4% q/q in Q4 and were down 9.4% y/y. And although the quarterly declines have eased since Q2, we still expect more pain ahead for retailers.
  • Admittedly, there is upside to demand. Our expectation is that consumer spending will rebound strongly, with a rapid rollout of vaccines allowing an easing of restrictions in Q2. But we don’t think this will be enough to reverse the fortunes of UK physical retailers.
  • For one, while we expect online penetration to fall from its current highs, it will remain elevated, which will not help high street sales. (See Chart 39.) Also, the pandemic has distorted demand patterns, with a shift away from services and towards goods spending, as many leisure activities (for instance holidays and eating out) were restricted. After lockdowns, we expect this will shift back the other way and this will limit the benefits to retailers.
  • There is also likely to be a pandemic hangover as government support is removed. A moratorium on bankruptcy, eviction bans and other relief has kept a lid on retailer failures since the start of the crisis. But the removal of this support, along with many occupiers in rent arrears, will pave the way for more distress in the market this year. As a result, we expect retail rental growth of minus 5.9% and minus 0.9% y/y in 2021 and 2022 respectively.
  • Post-COVID-19, we think that UK retail will remain highly exposed to the impact of online spending. (See our Global Focus.) Along with a legacy of over-capacity and a CVA process that works to speed up rental adjustments, we think that a return to rental growth over the next five years is unlikely. (See Chart 40.)
  • All-retail yields rose by 76bps in 2020. But we expect consumer demand to improve, we may now be close to the peak. A poor rental outlook and structural headwinds mean yields will remain elevated this year. Beyond this, as rents begin to bottom out, we think yields will inch lower over the longer term. (See Chart 41.)
  • All-retail capital values fell by an eye-watering 17% y/y in Q4. Within this, shopping centres were worst hit, declining almost a third in value. In 2021, we expect all-retail capital values will drop a further 5% y/y in 2021. Thereafter, we think, on average, values will show only minimal increases.
  • Annual retail returns were minus 12.4% in 2020, but we expect a modest positive return of 1% this year. (See Chart 42.) Given poor capital value prospects, we expect returns to average about 5% p.a. over the forecast, with shopping centres the strongest performer and standard shops faring worst.

Retail Market

Chart 37: Retail Sales Index (Feb 20 =100)

Chart 38: Store Closures

Chart 39: Retail Sales as a Share of Total Sales (%)

Chart 40: Retail Rental Value Growth by Sector (% y/y)

Chart 41: Retail Yields by Subsector (%)

Chart 42: Retail Property Forecasts (% y/y, 2021-25)

Sources: LDC-BRC, CRR, MSCI, Refinitiv, Capital Economics

Table 4: CE Retail Sector Forecasts (% y/y, Year-End)

 

2020

2021

2022

2023

2024

2025

2020

2021

2022

2023

2024

2025

All Retail

Shopping Centres21% of retail stock by value

Rental value growth

-9.4

-5.9

-0.9

-0.2

0.0

0.0

Rental value growth

-14.6

-8.0

-2.0

-1.0

0.0

0.0

End yr equiv. yield, %

6.8

6.7

6.7

6.6

6.6

6.5

End yr equiv. yield, %

9.3

9.1

8.9

8.8

8.8

8.7

Capital value growth

-17.1

-4.6

-0.2

0.6

0.1

0.7

Capital value growth

-30.3

-5.7

0.2

0.1

0.6

0.6

Income return

5.5

5.8

5.9

5.9

5.9

5.9

Income return

5.2

6.5

6.8

7.0

7.0

7.0

Total return, % p.a

-12.4

1.2

5.8

6.5

6.0

6.6

Total return, % p.a

-26.6

0.8

7.0

7.1

7.6

7.6

Retail Warehouses – 48% of retail stock by value

Standard Shops – 32% of retail stock by value

Rental value growth

-7.8

-5.0

-1.0

0.0

0.0

0.0

Rental value growth

-11.4

-6.0

0.0

0.0

0.0

0.0

End yr equiv. yield, %

7.6

7.6

7.6

7.6

7.6

7.5

End yr equiv. yield, %

5.8

5.6

5.6

5.5

5.5

5.5

Capital value growth

-15.8

-5.3

-1.0

0.7

0.0

0.7

Capital value growth

-20.4

-2.9

0.9

0.9

0.0

0.9

Income return

6.7

6.6

6.7

6.6

6.6

6.6

Income return

4.3

4.3

4.2

4.2

4.2

4.1

Total return, % p.a

-10.1

1.3

5.7

7.3

6.6

7.2

Total return, % p.a

-16.9

1.4

5.1

5.1

4.2

5.0

Sources: MSCI, Capital Economics

Industrial Market

Stronger rental prospects mean returns outperform

  • Industrial take-up was exceptionally strong last year. Although it dipped a little in Q4, the 2020 total of 10.4m sq. ft. was still high by past standards. (See Chart 43.) This meant that availability fell to 21.3m sq. ft. by year-end, causing the vacancy rate to fall to 5.6%. In turn, rental growth rose to 1% q/q in Q4 and was up by 2.3% y/y in 2020.
  • We think that tight COVID-19 restrictions will last until Q2 at least. This will mean further demand by retailers for online capacity, which will help keep occupier demand at high levels. Combined with low industrial availability in the near term, we expect this to push up rental growth to 2.7% y/y this year.
  • Further ahead, we think behaviour changes will support a higher level of online spending than would have otherwise been the case pre-virus. (See our Focus and Chart 44.) However, we don’t think that the high levels of 2020 and 2021 will be sustained and therefore expect that the online demand will fall back in 2022.
  • Moreover, it’s likely that supply will respond relatively quickly to that additional demand. Space under construction was up by 30% y/y in Q4, suggesting that developers are reacting to strong demand and solid rental growth. (See Chart 45.) This is likely to gradually dampen rents in the coming years and we expect that growth will slow from 2021.
  • As a result, we expect industrial rental growth to average around 2% p.a. over the forecast horizon. While this is notably weaker than the 4.2% p.a. seen over the five years prior to the pandemic, it is far stronger than the other commercial property sectors.
  • South East industrials have seen faster rental growth than those in the Rest of UK in recent years. We think the factors that have driven that outperformance will persist. One of those is growing demand for faster delivery, which has boosted the demand for space close to UK cities, but particularly in the densely populated London and South East region.
  • This has been reinforced by supply factors. As demand grows, the limited availability of development sites in the South East will continue to drive land prices higher, pushing up the required rents. This will boost rental growth in the RoSE and so this region will continue to outperform. (See Chart 46.) Between 2021 and 2025, we think rental growth will average just over 2% p.a. in the RoSE, compared with 1% p.a. in the RoUK.
  • Industrial yields fell by 23bps q/q in Q4, which left them 14bps y/y down in the year and at new historic lows. We think the solid outlook for rents, along with the low level of gilt yields, mean that yields will fall by another 15bps this year. (See Chart 47.) And given the relatively poor rental prospects for the other sectors, there is a risk that yields fall even faster. Further ahead, we expect weaker rental growth and gradual rises in gilt yields will stabilise property yields.
  • On the back of those yield falls and an acceleration in rental growth, we expect capital values to rise by 6.2% y/y in 2021. Over the five-year forecast period, we expect capital value growth of around 3% p.a., supporting average total returns of 7% p.a. (See Chart 48.) Though this is a slowdown from the double-digit returns of the past five years, it will still reflect a significant outperformance of the other traditional sectors.

Industrial Market

Chart 43: Industrial Take-Up (M. Sq. Ft.)

Chart 44: Internet Sales as Share of Total Retail Sales (%)

Chart 45: Under Construction (M. Sq. Ft.)

Chart 46: Industrial Rental Value Growth (% y/y)

Chart 47: Industrial Equivalent Yields (%)

Chart 48: Forecasts (% y/y, 2021-25, Annual Avg.)

Sources: CBRE, ONS, MSCI, Capital Economics

Table 5: CE Industrial Sector Forecasts (% y/y, Year-End)

 

2020

2021

2022

2023

2024

2025

2020

2021

2022

2023

2024

2025

All Industrial

Rest of UK Industrial 34% of industrial stock by value

Rental value growth

2.3

2.7

2.2

1.7

1.7

1.7

Rental value growth

1.5

2.0

1.5

1.0

1.0

1.0

End yr equiv. yield, %

5.2

5.0

4.9

4.9

4.9

4.9

End yr equiv. yield, %

5.9

5.8

5.7

5.7

5.7

5.7

Capital value growth

4.6

6.2

3.2

2.7

1.7

1.7

Capital value growth

2.3

3.8

2.4

1.9

1.0

1.0

Income return

4.4

4.1

4.2

4.1

4.1

4.1

Income return

5.2

4.9

5.0

5.0

5.0

5.0

Total return, % p.a

9.2

10.3

7.4

6.8

5.8

5.8

Total return, % p.a

7.6

8.7

7.4

6.9

6.0

6.0

South East Industrial 66% of industrial stock by value

Rental value growth

2.8

3.0

2.5

2.0

2.0

2.0

End yr equiv. yield, %

4.8

4.6

4.6

4.5

4.5

4.5

Capital value growth

5.9

7.4

3.6

3.1

2.0

2.0

Income return

4.0

3.7

3.8

3.7

3.7

3.7

Total return, % p.a

10.1

11.1

7.4

6.8

5.7

5.7

Sources: MSCI, Capital Economics


Leisure and Hotels

Third lockdown prolongs pain for hospitality sector

  • Lockdowns in November and late December forced most leisure venues to close during the busiest time of year, meaning that operators had a tough end to 2020. According to CGA and AlixPartners, for instance, there was a 5.1% y/y net decline in licensed premises such as bars, pubs and restaurants last year (See Chart 49.)
  • With occupiers struggling, leisure rents fell by 7.1% y/y in Q4. And since restrictions are still in place, the near-term economic outlook is weak and we expect that operators will be squeezed further by prolonged closure. But government support such as the furlough scheme, the VAT cut for hospitality, limits on bankruptcies, and eviction bans have prevented the closure of more leisure properties so far.
  • Once this support is removed, we think there will be more distress in the market later this year. Some of this will be offset by a pick-up in consumer demand. After all, there is plenty of scope for household spending to rebound strongly once restrictions are eventually lifted. (See Chart 50.) And we think consumers will be especially eager to spend on leisure activities that have been closed during lockdown. On balance, we have pencilled in a smaller rental fall of 3% y/y in 2021.
  • Thereafter, as the recovery in the economy gets underway, we expect rental growth to average just over 1% p.a. between 2022 and 2025. Combined with yield falls, this will support capital growth of about 2.2% p.a. and annual total returns of around 7% over this period. (See Chart 51.) As such, we expect leisure to outperform most other commercial sectors after this year.
  • In the hotel sector, staycations provided some relief to regional hotels in Q3 2020. But the rise in infections that led to national lockdowns in Q4 meant a restriction on visitors once again and hit the bottom line of operators.
  • According to PWC, last year, revenue per available room (RevPAR) fell at the sharpest rate since their hotel benchmarking began in the 1970s. They estimate that RevPAR has fallen by 80% y/y in London and by 60% y/y in the regions. (See Chart 52.) With incomes low, some operators have fallen into distress already and hotel rents fell by 1.6% y/y in 2020.
  • This year, a rapid vaccine roll-out could mean restrictions are lifted from Q2. (See Chart 53) This will allow domestic tourists to travel around the UK during the busy summer holiday period, which would benefit regional occupiers the most. (See our Global Update.) However, with concerns around new strains of the virus and costly quarantines, we think there will be a much slower recovery in international tourism, which will be a big blow to the London market this year.
  • As with the leisure sector, we think the removal of government support will crystallise more casualties among hotel operators. We expect that this will lead to hotel rents falling by a further 1% y/y in 2021. After this year, with the economy recovering and international travel returning closer to normal, we think hotel rents and capital values will slowly begin to recover.
  • Over the five-year forecast horizon, we expect that hotel rents and capital values will see only modest increases of 0.4% and 0.6% a year respectively. And we have pencilled in returns of 5% p.a. over this period. (See Chart 54.) This is notably worse than before the pandemic, when hotel returns averaged 7.5% a year.

Leisure and Hotels

Chart 49: Net Decline in Licensed Premises (% y/y)

Chart 50: Household Saving Ratio (%)

Chart 51: Leisure Property Forecasts (% y/y)

Chart 52: Hotel Revenue per Available Room (£)

Chart 53: UK Vaccine Roll-Out

Chart 54: Hotel Property Forecasts (% y/y)

Sources: Refinitiv, PwC, MSCI, Capital Economics


Table 6: CE Leisure and Hotel Sector Forecasts (% y/y, Year-End)

2020

2021

2022

2023

2024

2025

 

2020

2021

2022

2023

2024

2025

All Leisure

All Hotels

Rental value growth

-7.1

-3.0

0.0

1.0

2.0

2.0

Rental value growth

-1.6

-1.0

0.5

0.7

1.0

1.0

End yr equiv. yield, %

6.7

6.8

6.7

6.6

6.5

6.5

End yr equiv. yield, %

4.7

4.8

4.8

4.7

4.7

4.7

Capital value growth

-18.8

-4.3

0.7

2.5

3.6

2.0

Capital value growth

-6.5

-2.4

1.6

1.8

1.0

1.0

Income return

5.1

5.4

5.3

5.2

5.1

5.1

Income return

4.2

4.4

4.4

4.3

4.3

4.3

Total return, % p.a

-14.6

1.0

6.1

7.8

8.7

7.1

Total return, % p.a

-2.6

2.1

5.9

6.1

5.3

5.3

Sources: MSCI, Capital Economics


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