Lockdown pushes recovery into 2022 - Capital Economics
UK Commercial Property

Lockdown pushes recovery into 2022

UK Commercial Property Outlook
Written by Andrew Burrell
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The outlook for most commercial property sectors was already fragile and this has only been dampened by the second lockdown. Although transactions are set to pick up next year, we think property yields will edge higher and that all-property rents and capital values will decline further. Even as the recovery arrives during 2022, it will be unspectacular, with office and retail performance undermined by ongoing structural change. Only industrial property emerges from the pandemic in better shape, topping the rankings for returns over a five-year horizon.

  • Overview – The outlook for most commercial property sectors was already fragile and this has only been dampened by the second lockdown. Although transactions are set to pick up next year, we think property yields will edge higher and that all-property rents and capital values will decline further. Even as the recovery arrives during 2022, it will be unspectacular, with office and retail performance undermined by ongoing structural change. Only industrial property emerges from the pandemic in better shape, topping the rankings for returns over a five-year horizon.
  • Economic Backdrop – Even before the second lockdown, there were signs that the economy was slowing and the new wave of the virus is expected to set back the recovery. As a result, we think it will now take until 2023 for output to return to its pre-virus level. However, an effective vaccine would dramatically improve this outlook. In turn, this presents the most notable upside risk to our property forecasts.
  • Investment Market – Despite signs of a pick-up in Q3, we think investment activity will drop by about 40% this year given that Q4 will likely remain soft. We expect further yield increases in the short term as both sentiment and rental prospects remain bleak. Low interest rates provide room for yield reductions after 2022, but a subdued rental outlook means that these will be modest outside of industrial.
  • Office Market – We think that employment will continue to decline next year as government support is removed and while office-based sectors should be more resilient, they will not be immune. This implies further downward pressure on rents in 2021 and, further out, with occupiers reviewing their space needs, an anaemic recovery at best. Within the sector, regional offices are likely to see the strongest performance.
  • Retail Market – Lockdown means that most stores have had to close at the start of the crucial Christmas trading period. That worsens an already-dire outlook for retail property, with capital value falls now expected to extend into 2022. In fact, our Future of Property research indicates that rents are unlikely to return to growth over the forecast horizon, which reinforces retail’s position as by far the worst performing commercial sector.
  • Industrial Market – With online sales elevated, take-up reached another record high in Q3 and rents have continued to rise. But given the weak economic outlook, we don’t see a marked improvement in 2021. Over the next five years, however, we think capital values will increase by around 2% p.a., supporting average total returns of 7% p.a. This leaves industrial property well ahead of the other traditional sectors.
  • Leisure and Hotels – Lockdowns, weak tourist flows and subdued incomes will continue to undermine the hospitality sector well into next year. News of a vaccine is welcome, but may be too late to prevent further declines in capital values next year. Thereafter, leisure looks best placed to take advantage of the post-pandemic upturn.

Main Forecasts

Table 1: Key Commercial Property Forecasts (Year End)

 

2019

2020

2021

2022

2023

2024

2020-24

2021-24

ALL PROPERTY

Rental value growth, % y/y

-0.6

-3.5

-1.7

0.3

0.8

1.0

-0.6

0.1

End yr equiv. yield, %

5.6

5.9

6.0

5.9

5.9

5.8

5.9

5.9

Capital value growth, % y/y

-3.3

-8.6

-1.8

1.0

2.1

2.0

-1.0

0.9

Income return, % y/y

4.6

4.8

5.1

5.1

5.1

5.1

5.0

5.1

Total return, % p.a

1.2

-3.8

3.3

6.2

7.2

7.1

4.0

5.9

OFFICE PROPERTY

Rental value growth, % y/y

1.5

-0.9

-0.5

0.0

0.7

0.9

0.0

0.3

End yr equiv. yield, %

5.6

5.7

5.7

5.7

5.6

5.6

5.7

5.7

Capital value growth, % y/y

0.3

-3.6

-1.1

0.5

2.3

0.9

-0.2

0.6

Income return, % y/y

4.1

4.3

4.2

4.3

4.2

4.2

4.2

4.2

Total return, % p.a

4.4

0.7

3.1

4.8

6.5

5.1

4.0

4.9

RETAIL PROPERTY

Rental value growth, % y/y

-4.9

-9.6

-5.6

-0.9

-0.2

0.0

-3.3

-1.7

End yr equiv. yield, %

6.1

6.7

6.7

6.7

6.6

6.6

6.7

6.6

Capital value growth, % y/y

-11.6

-18.4

-5.1

-0.3

0.3

1.0

-4.5

-1.0

Income return, % y/y

5.3

5.4

6.2

6.3

6.3

6.3

6.1

6.3

Total return, % p.a

-6.8

-12.9

1.1

6.0

6.7

7.3

1.6

5.3

INDUSTRIAL PROPERTY

Rental value growth, % y/y

2.9

1.5

1.5

2.0

2.1

2.3

1.9

2.0

End yr equiv. yield, %

5.3

5.4

5.4

5.3

5.2

5.1

5.3

5.3

Capital value growth, % y/y

2.4

-0.1

1.4

2.9

3.9

4.3

2.5

3.1

Income return, % y/y

4.4

4.5

4.5

4.6

4.5

4.4

4.5

4.5

Total return, % p.a

6.9

4.3

5.9

7.5

8.4

8.7

7.0

7.6

LEISURE PROPERTY

Rental value growth, % y/y

0.0

-8.0

-1.5

0.0

1.0

2.0

-1.3

0.4

End yr equiv. yield, %

5.7

6.8

6.8

6.6

6.5

6.4

6.6

6.6

Capital value growth, % y/y

-1.6

-22.9

-1.5

2.4

3.2

3.6

-3.0

1.9

Income return

5.3

6.5

6.5

6.3

6.2

6.1

6.3

6.3

Total return, % p.a

3.6

-16.4

5.0

8.7

9.3

9.7

3.3

8.2

HOTEL PROPERTY

Rental value growth, % y/y

1.8

-2.0

0.0

0.5

0.7

0.7

0.0

0.5

End yr equiv. yield, %

4.5

4.8

4.8

4.8

4.7

4.7

4.8

4.7

Capital value growth, % y/y

1.8

-8.2

0.0

1.6

1.8

1.8

-0.6

1.3

Income return

4.1

4.5

4.5

4.5

4.4

4.4

4.5

4.5

Total return, % p.a

6.0

-3.7

4.5

6.0

6.2

6.2

3.9

5.7

Sources: MSCI, Capital Economics

Table 2: Key UK Economic Forecasts (Year Average)

 

2017

2018

2019

2020f

2021f

GDP, % y/y

1.9

1.4

1.5

-11.5

4.0

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

1.32

1.38

0.54

0.15

0.15

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

1.19

1.38

0.74

0.50

0.50

CPI inflation, % y/y

2.7

2.5

1.8

0.9

1.3

$/£ (end-period)

1.35

1.28

1.33

1.35

1.35

Euro/£ (end-period)

1.13

1.11

1.18

1.13

1.13

Household spending, % y/y

2.3

1.6

1.0

-14.3

5.8

Unemployment rate (ILO measure), %

4.4

4.1

3.8

4.6

7.6

Employment, % y/y

1.0

1.2

1.1

-0.7

-3.5

Average earnings, % y/y

2.3

2.9

3.5

1.2

1.2

Nationwide house prices, % y/y in Q4

3.2

0.5

1.4

4.1

0.0

Sources: Refinitiv, Capital Economics


Sectoral Rankings

Chart 1: CE Forecasts for Rental Value Growth in 2020 (% y/y)

Chart 2: CE Forecasts for Rental Value Growth in 2020-2024 (% y/y)

Chart 3: CE Forecasts for Capital Value Growth in 2020 (% y/y)

Chart 4: CE Forecasts for Capital Value Growth in 2020-2024 (% y/y)

Chart 5: Equivalent Yields, Q4 2020 (%)

Chart 6: Equivalent Yields, Q4 2024 (%)

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Chart 7: CE Forecasts for Total Returns in 2020 (% p.a)

Chart 8: CE Forecasts for Total Returns in 2020-2024
(% p.a)

Sources: MSCI, Capital Economics


Economic Backdrop

Lockdown sets back the recovery

  • If our assumption that virus restrictions stretch into next year is correct, it will take many years for the economy to recover and employment will fall further. But if an effective vaccine is rolled out early next year, GDP will rebound quicker and employment will fall by less. (See Chart 9.)
  • Following the surge in coronavirus cases, it is likely that severe restrictions remain in place during the rest of December and most of January. (See Chart 10.) Then we think lighter, but diminishing, restrictions will remain in place during February, March and April. Under these assumptions, we doubt GDP will return to its pre-virus level until 2023.
  • While the furlough scheme has been extended to the end of March 2021, we still think employment will drop when it is removed. So far, employment has fallen by 566,000 since February, much less than the fall in GDP. But, once the furlough scheme ends, employment will likely drop back in line with GDP. That suggests that employment will fall by a further 1.3 million. (See Chart 11.)
  • Meanwhile, the jobless rate has already risen from 4% in February to 4.8% in September and we think it will reach a peak of 9% next year. (See Chart 12.)
  • Continued restrictions will hit consumer-facing sectors hard. Of course, these sectors should rebound once the restrictions are lifted. But in Q4 we expect consumer spending to fall by 4.5% q/q. (See Chart 13.) Looking further ahead, the rise in unemployment next year will dampen consumer spending. As a result, although growth will return from next year, we don’t think that consumer spending will return to its pre-virus level until 2023, similar to GDP.
  • That said, the possibility of an effective COVID-19 vaccine being rolled out is growing. This would dramatically improve the economic outlook and presents significant upside risks to our forecasts. An effective vaccine may allow GDP to return to its pre-virus level in 2022 rather than 2023 and would mean that the jobless rate peaks at 7% in 2021 instead of 9%. (See our Update.)
  • After rising from 0.2% in August to 0.7% in October, we think that inflation will continue to rise towards the 2% target in 2021. But we suspect that spare capacity will result in it falling back to 1.5% in 2022. (See Chart 14.)
  • Brexit poses an upside risk to our inflation forecast. In the event of a no deal Brexit, the boost to imported inflation from a weaker pound could push up inflation to between 3% and 4%. That said, the economic costs of a no deal Brexit have diminished now that various arrangements have been put in place. Even under an “uncooperative no deal”, we think that any hit would be small relative to the COVID-19 crisis. (See our Focus.)
  • Below-target inflation and higher unemployment will allow monetary policy to remain very loose. We expect the Bank to keep interest rates at 0.10% or below for the next five years. (See Chart 15.)
  • After announcing £150bn of QE this month, we think there is still room for the Bank to increase QE by another £135bn. (See Chart 16.) While an effective vaccine would reduce the need for further monetary easing, it is unlikely that the Bank will reverse QE or raise interest rates for many years. We expect 10-year gilt yields to stay low for the next couple of years at around 0.5%. (See Chart 15 again.)

Economic Backdrop

Chart 9: Real GDP (Q4 2019 = 100)

Chart 10: COVID-19 New Cases (000s)

Chart 11: GDP & Employment

Chart 12: ILO Unemployment Rate (%)

Chart 13: Household Spending & GDP (2019 Q4 = 100)

Chart 14: CPI Inflation (% y/y)

Chart 15: Bank Rate & Gilt Yields (%)

Chart 16: BoE Stock of Gilt Purchases & Stock of Gilts in Issue (£bn)

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


Investment Market

Property yields to edge higher in 2021

  • Despite the easing of the UK’s virus restrictions, investment volumes did not recover as much as expected in Q3. (See Chart 17.) Preliminary data suggest total purchases were around £6.4bn in Q3, better than Q2, but still less half the pre-COVID-19 averages. With a second wave confirmed, the UK back in lockdown and an Brexit uncertainties ahead, the current quarter could be worse. Our recent Update indicates that activity could now fall as much as 40% y/y on weak 2019 levels this year.
  • Any recovery in 2021 is expected to be slow. There was an improvement in the balance of surveyors reporting rising enquiries in Q3, but it remained more negative than at any time since the GFC. (See Chart 18.) With no certainty about the emergence from the current lockdown and a vaccine still months away, the weakness is likely to persist well into next year. We expect year-on-year improvements on an exceptionally weak 2020, but this still will leave activity well adrift of its pre-2019 norms.
  • All-property yields were stable in Q3, which was a surprise. (See Chart 19.) As expected, retail, hotels and leisure saw further rises. But there were falls in industrials, supermarkets and regional offices. With the new lockdown and an uncertain Brexit looming, we forecast another rise in yields in Q4, albeit less pronounced than seen in the spring.
  • Property valuations stabilised in Q3, following a marked improvement in Q2. (See Chart 20 and here.) While there was a small reduction in equity dividends, gilt yields were unchanged and so spreads were broadly stable. Apart from industrial, all sectors now look either under or fairly valued. But with rents under pressure and activity subdued, we think further upward movement in property yields is likely in 2021.
  • The economy is expected to stumble into 2021 with sentiment fragile and uncertainty about the virus and Brexit. As a result, we expect that yields will edge higher over the next six months or so. In large part, this reflects the ongoing malaise in property rents, with further declines expected in retail and offices next year. Only as economic fortunes begin to turn later next year are property yields forecast to stabilise.
  • But, as we noted last quarter, only modest yields reversals are now likely after next year. (See Chart 21.) This is despite UK interest rates stalling at record lows. Although rental growth returns in most segments after 2022, for office and retail in particular any expansion is far more sluggish than in the past thanks to structural change. We think this will keep all-property yields well above their pre-virus lows until the end of the forecast.
  • Admittedly, UK yields have kept a sizeable premium over continental European assets since 2016. The removal of Brexit uncertainty could then allow a convergence, especially if the UK economy outperforms. But while conceding this downside risk, we feel other influences will prevent yields falling faster.
  • We now expect a 9% y/y decline on all-property capital values this year, but with a further 2% fall in 2021. (See Chart 22.) As the pandemic passes, a subdued revival is forecast, though annual growth remains sub-2% p.a.
  • We expect the first negative annual property returns since 2009 this year. (Chart 23.) The recovery brings a rebound in 2021, with returns averaging around 6-7% p.a. in 2022-24. Sector fortunes are coloured by 2020 outturns. So retail, leisure and hotels fare the worst over a five-year horizon, 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: Total Investment and RICS Sentiment

Chart 19: Equivalent Yields (q/q, bps)

Chart 20: CE Valuation Score

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

Chart 22: All-Property Capital Value Growth (% y/y)

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Chart 23: Total Returns (% p.a)

Chart 24: Total Returns by Sector (% p.a., 2020-24)

Sources: Property Archive, LSH, RICS, Refinitiv, MSCI, Capital Economics


Office Market

Rents to fall again next year

  • Office rents have held up better than anticipated this year, but we think further falls are to come. The renewed UK lockdown has weakened the short-term economic outlook and we think this will delay the recovery in office rents. (See our Update.) The extension of the furlough scheme will delay job losses, but we ultimately expect employment to fall sharply next year. (See Chart 25.) While office-type sectors are unlikely to see such a sharp decline (as many have been able to work remotely), they will not be unaffected.
  • Admittedly, progress on a vaccine could significantly improve the outlook, but we think the impact on occupier demand may be limited. After all, we anticipate more remote working will cause a major demand shift in the office sector over the next half decade or more. (See our Focus and also our London Update.) As such, we have further downgraded our office rental expectations.
  • In Central London, take-up remained weak in Q3. But within this total, fortunes diverged across the capital. According to Knight Frank, City leasing activity increased by around 20% q/q and the West End fell by the same proportion. (See Chart 26.)
  • At the same time, availability in Central London increased by 10% q/q in Q3, as significant tenant-released space was returned to the market. This was unsurprising given occupiers have stated that they intend to use less office space in the long term. (See Chart 27.)
  • The rise was most notable in the West End, where vacancy increased to 6.1% from 4.9% in Q2, supporting our downbeat near-term view of rents. (See Chart 28.) Overall, Central London vacancy increased to 6.7% from 6.1% over the same period. However, this increase is still much smaller than at the height of the GFC slump.
  • A large development pipeline implies further increases in Central London vacancy. Indeed, at 9.4m. sq. ft., almost twice as much space is expected to complete this year as last. (See Chart 29.) While we think some of this will now be pushed into next year and most of the rest has been pre-let, there is still a sizeable chunk of speculative space on stream. This is a concern at a time when occupier demand is weak and there is likely to be a further release of second-hand space.
  • In the first three quarters of 2020, City rents fell by 0.4%, while West End rents declined by 1.2%. Though London rents have not fallen quite as far as we expected yet, we think they may have further to fall. Our view is consistent with the latest RICS commercial survey, which showed a net balance of 76% of surveyors anticipate that London office rents will fall over the next 12 months.
  • We have pencilled in rental declines of around 1% in the City and 1.5% in the West End in 2020. Next year, Central London rents are expected to see further declines and the return to growth thereafter is sluggish.
  • Looking ahead, with the Brexit deadline nearing and relations between the UK and EU still uneasy, a no deal threat remains. Though we think that a deal remains most likely and the potential impact of no deal is less of a concern than a year ago, Brexit presents a risk to property markets. (See our Update.) Moreover, with a higher exposure to the international investors than elsewhere, we think that there is a bigger downside in London markets.

Office Market

Chart 25: UK Employment (mn)

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

Chart 27: Intentions of Long-term Use of Workplace by OfficeBased Companies (%)

Chart 28: City and West End Vacancy Rate (%)

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Chart 29: London Office Development Pipeline (M Sq. Ft.)

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 (M. Sq. Ft.)

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Sources: MSCI, Institute of Directors, RICS, Knight Frank, Avison Young, Capital Economics

Office Market

No recovery in capital values before 2022

  • In the regional market, there was some improvement in occupier activity in Q3. According to Avison Young, regional office take-up increased by 70% q/q to 1.3m. sq. ft. in Q3. (See Chart 30.) Take-up was boosted by a 280,000 sq. ft. pre-let deal to Baillie Gifford in Edinburgh. However, the level of activity in the regions remains very low by recent standards.
  • That said, Rest of UK rents have been more resilient than we anticipated. In fact, from the start of the year to Q3, rents have risen slightly and we think they will end this year and next year broadly flat. Rents are expected to hold up better in the regions in part because of their tighter supply pipeline. After all, there is less than a year’s worth of new supply in most regional cities based on annual take-up over the past five years. (See Chart 31.)
  • Meanwhile, take-up in the South East market has remained weak. (See Chart 32.) At around 550,000 sq. ft. in Q3, this was down almost 10% q/q on Q2, which was one of the worst quarters on record. Despite this, the vacancy rate fell slightly from 6.9% to 6.8% and remains below the highs of 9.5% seen in 2011. (See Chart 33.) This at least should help limit rental falls in the South East.
  • Nevertheless, between Q1 and Q3 2020, Rest of South East rents fell by 0.3%. By the end of this year, we think rental falls could be close to 1% y/y. Beyond this, our expectations are that Rest of South East rents will only start to recover slowly after 2022.
  • Over the forecast horizon, we expect office rental growth in the Rest of UK to outperform Rest of South East. We have pencilled in rental growth of 0.5% a year for regional cities over the next five years. By contrast, we think Rest of South East rents will essentially be flat. (See Chart 34.)
  • By the end of this year, we forecast office yields will be about 25bps higher than their end-2019 level. (See Chart 35.) And with pressure on rents likely to continue next year, a further small increase in yields is expected. But we think that the gradual rental recovery will stabilise yields after 2022, paving the way for a gentle decline further out. Nonetheless, the rental outlook is anaemic. We think this is likely to keep office yields well above their 2019 levels over the next five years.
  • We have revised up our forecasts for office capital values this year. We now think that they will fall by only 4% in 2020, instead of the 6% we were previously expecting. Next year, with rents still falling and yields inching up, a further fall is in prospect, albeit relatively mild.
  • We don’t think that all-office capital values will start to recover until after 2021 and that any upturn will be subdued. In fact, we expect capital values will, on average, be flat at best over the forecast horizon. Within this, a better rental outlook for the Rest of UK will mean values fall less than in Central London and Rest of South East offices. (See Chart 36.)
  • We expect office returns will be close to 1% this year, a marked deterioration on recent years. Between 2020 and 2024, we expect all-office returns to average just 4% p.a.. In context, this would be notably weaker than the 8% p.a. seen in the last five years. At a sub-sector level, we think that Rest of UK will outperform, while Central London returns are expected to be below par.

Office Market

Chart 33: Rest of South East Vacancy Rate and Office Rents

Chart 34: Office Rental Value Growth (% y/y)

Chart 35: Office Equivalent Yields (%)

Chart 36: Office Property Forecasts

(% y/y, 2020-24, Annual Average)

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Sources: MSCI, Capital Economics


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

 

2019

2020

2021

2022

2023

2024

2019

2020

2021

2022

2023

2024

All Office

Rest of South East 30% of office stock by value

Rental value growth

1.5

-0.9

-0.5

0.0

0.7

0.9

Rental value growth

1.2

-1.0

-0.5

0.0

0.5

0.5

End yr equiv. yield, %

5.6

5.7

5.7

5.7

5.6

5.6

End yr equiv. yield, %

6.3

6.6

6.6

6.5

6.4

6.4

Capital value growth

0.3

-3.6

-1.1

0.5

2.3

0.9

Capital value growth

-0.1

-4.8

-0.5

0.8

2.1

0.5

Income return

4.1

4.3

4.2

4.3

4.2

4.2

Income return

4.3

4.6

4.5

4.6

4.5

4.5

Total return, % p.a

4.4

0.7

3.1

4.8

6.5

5.1

Total return, % p.a

4.3

-0.2

4.0

5.4

6.6

5.0

London City 11% of office stock by value

Rest of UK 24% of office stock by value

Rental value growth

1.7

-1.0

-0.5

0.5

1.0

1.0

Rental value growth

1.9

0.0

0.0

0.5

1.0

1.0

End yr equiv. yield, %

5.4

5.4

5.5

5.5

5.4

5.4

End yr equiv. yield, %

6.4

6.6

6.6

6.6

6.5

6.5

Capital value growth

0.7

-1.0

-2.3

-0.4

2.9

1.0

Capital value growth

0.4

-2.1

-2.1

0.5

1.8

1.0

Income return

4.0

4.1

4.2

4.3

4.2

4.2

Income return

4.8

5.0

5.0

5.1

5.1

5.1

Total return, % p.a

4.7

3.1

1.8

3.9

7.1

5.2

Total return, % p.a

5.2

3.0

3.0

5.6

6.9

6.1

London West End 34% of office stock by value

Rental value growth

1.3

-1.5

-1.0

-0.5

0.5

1.0

End yr equiv. yield, %

4.4

4.6

4.6

4.5

4.4

4.4

Capital value growth

0.5

-4.6

-0.6

0.6

2.8

2.8

Income return

3.4

3.5

3.4

3.4

3.3

3.3

Total return, % p.a

3.8

-1.1

2.9

4.0

6.1

4.3

Sources: MSCI, Capital Economics


Retail Market

Lockdown prolongs the pain for retailers

  • The announcement of another month of UK-wide lockdown at the end of October brought renewed gloom for retailers. The closure of non-essential stores came at the worst time, in the run-up to Christmas trading. Nonetheless, even before, there was evidence that footfall had faded after late summer, perhaps linked to rising virus cases and tighter local restrictions. But the full lockdown brought a far more marked deterioration, taking activity from 70-80% of normal to under 40%, the weakest since July. (See Chart 37.)
  • There was another steep decline in retail rents during Q3, though outside of shopping centres it was not quite as bad as the Q2 figure. (See Chart 38.) Even given the re-opening of high streets in June, this was probably a better outturn than expected, with evidence on late and non-payment of rents showing little improvement since the spring. But we expect more pain ahead. Indeed, the latest RICS survey of rental expectations for the sector recorded a further deterioration in Q3.
  • A rapid rebound in sales has provided some support for physical stores. The rise in retail sales in October pushed them 6.8% above their pre-virus level. (See Chart 39.) But the biggest contribution to this growth was online demand, while lockdown will inevitably lead to a relapse in store sales as shops close again. And even if current restrictions are short-lived, consumer spending is expected to stutter over the next six months, as the furlough scheme ends and unemployment rises.
  • Our recent Global Focus highlighted UK retail as highly exposed to the impact of online post-COVID-19. This reflected not only our expectation of accelerated non-store purchases after the virus, but also a legacy of over-capacity and a CVA process that will hasten any rental correction. Our analysis concluded that a return to rental growth over the next five years looks unlikely. (See Chart 40.)
  • As a result of this research, we have further downgraded our rental outlook for retail. Admittedly, near-term pressure should ease from next year, as trading returns to normal. And vaccine developments could even bring upside. But after a rental fall of almost 10% y/y this year, a further 5-6% decline is in prospect in 2021. (See Chart 40 again.) And while this is the worst of the drop, aggregate rents continue to edge down for a further two years before stabilising. This would imply a decline of one third in nominal rents since their peak in 2017, a correction of unparalleled severity.
  • With a dismal rental outlook and economic headwinds, we think retail yields have further to rise in the next 12 months. And after this, it also looks unlikely that recent rises will be reversed during any post-COVID upturn. While yields do stabilise once rents bottom out, we see limited scope for compression, despite persistently low bond yields. (See Chart 41.) This leaves retail yields 100bps above their 2017 lows, making retail the highest yielding major commercial sector by some margin.
  • After declining by almost a fifth this year, retail capital values are expected to drop by a further 5% y/y in 2021. Within this, shopping centre values are hardest hit, down a combined 36% this year and next. The contrast of this severe adjustment with other property sectors is stark and any clawback in retail capital values in the final years of the forecast is modest.
  • Retail returns are expected to slump in 2020, though they average about 6% p.a. in the final years of the forecast. This reflects better income returns, given poor capital value prospects. (See Chart 42.) Retail warehousing is the strongest performer, while shopping centre returns fall on average over the 5-year period.

Retail Market

Chart 37: Retail Footfall Index

Chart 38: Retail Rental Value Growth (% q/q)

Chart 39: Retail Sales Volumes (February 2020 = 100)

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

Chart 41: Retail Yields by Subsector (%)

Chart 42: Retail Property Forecasts (% y/y, 2020-24)

Sources: MSCI, Springboard, Refinitiv, Capital Economics

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

 

2019

2020

2021

2022

2023

2024

2019

2020

2021

2022

2023

2024

All Retail

Shopping Centres 23% of retail stock by value

Rental value growth

-4.9

-9.6

-5.6

-0.9

-0.2

0.0

Rental value growth

-5.7

-14.0

-8.0

-2.0

-1.0

0.0

End yr equiv. yield, %

6.1

6.7

6.7

6.7

6.6

6.6

End yr equiv. yield, %

7.3

8.9

8.8

8.8

8.7

8.6

Capital value growth

-11.6

-18.4

-5.1

-0.3

0.3

1.0

Capital value growth

-17.7

-29.4

-7.0

-1.4

-0.4

1.2

Income return

5.3

5.4

6.2

6.3

6.3

6.3

Income return

5.4

5.1

6.5

6.8

7.0

7.0

Total return, % p.a

-6.8

-12.9

1.1

6.0

6.7

7.3

Total return, % p.a

-13.2

-24.3

-0.5

5.3

6.6

8.2

Retail Warehouses – 47% of retail stock by value

Standard Shops – 31% of retail stock by value

Rental value growth

-5.6

-8.5

-5.0

-1.0

0.0

0.0

Rental value growth

-4.6

-10.5

-5.0

0.0

0.0

0.0

End yr equiv. yield, %

6.8

7.7

7.7

7.6

7.6

7.5

End yr equiv. yield, %

5.0

5.6

5.5

5.5

5.5

5.4

Capital value growth

-14.5

-18.2

-5.0

-0.3

0.7

1.0

Capital value growth

-9.2

-19.1

-4.1

0.5

0.4

0.9

Income return

6.0

6.5

7.0

7.0

7.0

6.9

Income return

4.4

4.3

4.9

4.9

4.9

4.8

Total return, % p.a

-9.3

-11.7

2.0

6.7

7.7

7.9

Total return, % p.a

-5.2

-14.8

0.8

5.5

5.3

5.8

Sources: MSCI, Capital Economics


Industrial Market

Rental growth to pick up pace after next year

  • With online sales elevated, the industrial occupier market strengthened in Q3. Indeed, Amazon accounted for around a third of leased space, as quarterly take-up reached another record high. According to CBRE, at 13.3m sq. ft. in Q3, take-up was almost double the level of a year ago. (See Chart 43.) Availability also fell 12% to 25.2m sq. ft. in Q3.
  • In turn, quarterly rental growth picked up to 0.4% in Q3, from 0.2% in Q2. However, this was not enough to prevent industrial rental growth continuing its slowdown on an annual basis seen since Q2 2018.
  • And although RICS surveyors’ expectations for rents improved following Q2’s slump, a smaller net balance expects rental rises than a year ago. (See Chart 44.)
  • We have pencilled in 1.5% y/y growth at year-end, down from 2.9% y/y in 2019. But this would still mean industrial is the only commercial sector to record rental growth this year.
  • Given that we don’t expect online demand to maintain its current high levels next year, we expect some upward pressure on vacancy. After all, some retailers are likely to go bankrupt following a tough Christmas, which would lead to a rise in second-hand warehouse space. As a result, we don’t expect to see rental growth accelerating in 2021. (See Chart 45.)
  • Between 2022 and 2024, we think the economic recovery and accelerated online demand and will support industrial rental growth. Indeed, we think rental growth will average around 2% p.a. over the next four years. This would be notably weaker than the 4.2% p.a. seen over the last five years, though significantly stronger than any of the other commercial sectors. But, a faster acceleration in online sales poses an upside risk to our forecasts. (See our Focus.)
  • We think rents in the Rest of South East will continue to outperform those in the Rest of UK. (See Chart 46.) Indeed, the rise in speculative space under construction this year has mostly been in the regions in the regions outside of the South East.
  • Meanwhile, strong occupier demand in the South East is expected to keep vacancy low. Over the forecast horizon, we think rental growth will average just over 2% p.a. in the Rest of South East compared with 1% p.a. in the Rest of UK. (See Chart 46.)
  • A 4bps fall in industrial yields in Q3 reversed some of the rises seen in the first half of the year. But yields were still up by 10bps. We now think industrial yields will stay flat during Q4 and into 2021. (See Chart 47.) Further ahead, as rental growth accelerates, we expect industrial yields will fall, slowly but steadily. As a result, industrial is the only sector to reverse its pandemic yield rises by the end of the forecast.
  • Despite continued rental growth, this rise in yields mean we expect capital values to hold broadly steady this year. But this is followed by a recovery in values next year of about 1.5%.
  • Over the forecast horizon, we think capital values will increase by around 2% p.a., supporting average total returns of 7% p.a. (See Chart 48.) This means that industrial property will continue to outperform other traditional commercial sectors.

Industrial Market

Chart 43: Industrial Take-Up and Availability

Chart 44: RICS Surveyors’ Industrial Rental Expectations (% Net Balance)

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

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

Chart 47: Industrial Equivalent Yields (%)

Chart 48: Ind. Forecasts (% y/y, 2020-24, Annual Avg.)

Sources: CBRE, MSCI, RICS, Capital Economics

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

 

2019

2020

2021

2022

2023

2024

2019

2020

2021

2022

2023

2024

All Industrial

Rest of UK Industrial 35% of industrial stock by value

Rental value growth

2.9

1.5

1.5

2.0

2.1

2.3

Rental value growth

1.6

0.8

0.8

1.0

1.1

1.3

End yr equiv. yield, %

5.3

5.4

5.4

5.3

5.2

5.1

End yr equiv. yield, %

6.0

6.1

6.1

6.0

5.9

5.8

Capital value growth

2.4

-0.1

1.4

2.9

3.9

4.3

Capital value growth

0.5

-1.2

1.0

1.8

3.6

3.0

Income return

4.4

4.5

4.5

4.6

4.5

4.4

Income return

5.1

5.2

5.2

5.3

5.2

5.1

Total return, % p.a

6.9

4.3

5.9

7.5

8.4

8.7

Total return, % p.a

5.6

4.0

6.1

7.2

8.8

8.1

South East Industrial 65% of industrial stock by value

Rental value growth

3.8

1.8

1.8

2.6

2.7

2.8

End yr equiv. yield, %

4.9

5.0

5.0

5.0

4.9

4.8

Capital value growth

3.5

0.5

1.6

3.4

4.1

4.9

Income return

4.0

4.1

4.1

4.2

4.1

4.0

Total return, % p.a

7.6

4.5

5.7

7.6

8.2

9.0

Sources: MSCI, Capital Economics


Leisure and Hotels

Second lockdown delays hospitality recovery

  • With the UK in a second national lockdown, most hotel and leisure operators have been forced to close. Even before this, social distancing reduced capacity and meant that the hospitality sector was hit hard. Further ahead, we expect the weak economic outlook to weigh on returns.
  • The performance of the leisure sector will depend heavily on the resilience of household consumption. (See Chart 49.) Once the furlough scheme ends next March, we expect employment to fall sharply and this will hit spending. Our view is that household consumption will not return to its pre-virus level until 2023, which will weigh on the leisure sector.
  • Admittedly, the sector was temporarily boosted by government support, as the number of diners at UK restaurants surged above pre-virus levels in August. (See Chart 50.) This was largely driven by the Eat Out to Help Out discount scheme and the VAT cut for the tourism and hospitality sectors. The VAT cut has been extended until the end of March next year. This will provide some relief to occupiers. Nonetheless, this is unlikely to offset the impact of the second lockdown, especially given the uncertainty about when restrictions will be eased.
  • With occupiers struggling, rents have fallen by 5.4% in the year to Q3. As economic sentiment and household spending remain below pre-virus levels, we expect rental growth to decline further by year end and into 2021. This will sustain the upward pressure on equivalent yields, which rose by 11bps q/q to 6.8% in Q3.
  • This rise in yields led capital values to fall by 16.4% between Q1 and Q3. (See Chart 51.) We think capital values are likely to fall significantly further this year and next.
  • Over the forecast horizon, we think leisure rental and capital values will average around minus 1% p.a. and minus 3% p.a.. (See Chart 52.) Retail is the only sector we expect to perform worse over this period.
  • In the hotels sector, occupancy has fallen back since its brief and partial recovery in July and August. (See Chart 53.) This reflected an easing of travel restrictions and a surge in “staycations” in the summer months. Since, hotel occupancy has suffered as virus restrictions have tightened. And with the UK in lockdown and restrictions likely to remain in place into early next year at least, headwinds remain for the sector.
  • The hotels sector has also experienced declines in rental and capital values. However, hotels have been hit less severely than leisure. Since the start of the year, rental values have fallen by 0.8% and equivalent yields have risen by 29bps to 4.8%. As such, capital values have fallen by 6.4%. Against a weak backdrop for demand, we expect little improvement in capital values next year. (See Chart 54.)
  • Looking further ahead, uncertainty around travel restrictions combined with weak global growth will weigh on both leisure and business travel. This will dampen any recovery in hotels. Admittedly, a vaccine could lead to a significant improvement in the outlook for tourism, but until there is more clarity around the roll-out, this remains an upside risk to our forecasts.
  • Over the next five years, we expect average annual total returns of 3.9%. This is notably worse than in the recent past, when hotel returns averaged 7.5% p.a..

Leisure and Hotels

Chart 49: Household Spending & Leisure Rental Value Growth

Chart 50: Number of Restaurant Diners (% y/y)

Chart 51: Contribution to Leisure Capital Value Growth (% y/y)

Chart 52: Leisure Property Forecasts (% y/y)

Chart 53: Hotel Occupancy Rate (%)

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

Sources: Refinitiv, OpenTable, MSCI, Capital Economics, STR

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

2019

2020

2021

2022

2023

2024

 

2019

2020

2021

2022

2023

2024

All Leisure

All Hotels

Rental value growth

0.0

-8.0

-1.5

0.0

1.0

2.0

Rental value growth

1.8

-2.0

0.0

0.5

0.7

0.7

End yr equiv. yield, %

5.7

6.8

6.8

6.6

6.5

6.4

End yr equiv. yield, %

4.5

4.8

4.8

4.8

4.7

4.7

Capital value growth

-1.6

-22.9

-1.5

2.4

3.2

3.6

Capital value growth

1.8

-8.2

0.0

1.6

1.8

1.8

Income return

5.3

6.5

6.5

6.3

6.2

6.1

Income return

4.1

4.5

4.5

4.5

4.4

4.4

Total return, % p.a

3.6

-16.4

5.0

8.7

9.3

9.7

Total return, % p.a

6.0

-3.7

4.5

6.0

6.2

6.2

Sources: MSCI, Capital Economics


Andrew Burrell, Chief Property Economist, andrew.burrell@capitaleconomics.com
Prohad Khan, Property Economist, prohad.khan@capitaleconomics.com
Sam Hall, Assistant Property Economist, sam.hall@capitaleconomics.com