COVID crash to decimate capital values this year - Capital Economics
UK Commercial Property

COVID crash to decimate capital values this year

UK Commercial Property Outlook
Written by Andrew Burrell
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The coronavirus outbreak has transformed the economic outlook and is expected to hit commercial property hard. In the near term, we expect transactions, which are already slowing, to collapse and property yields to spike, as uncertainty over future rental growth peaks. Assuming the path out of lockdown continues as set out by the government, there should be early signs of recovery by the summer, though the risks will remain skewed to the downside. Over the next five years, we think all-property rental value growth will resume slowly, as economic growth recovers. As a result, capital value growth will also see consistent improvement. Overall, all-property returns will average 5.2% a year, which is relatively weak compared with recent historic averages.

We are resending this publication due to an incorrect title in the previous message. We apologise for any inconvenience.

  • Overview – The coronavirus outbreak has transformed the economic outlook and is expected to hit commercial property hard. In the near term, we expect transactions, which are already slowing, to collapse and property yields to spike, as uncertainty over future rental growth peaks. Assuming the path out of lockdown continues as set out by the government, there should be early signs of recovery by the summer, though the risks will remain skewed to the downside. Over the next five years, we think all-property rental value growth will resume slowly, as economic growth recovers. As a result, capital value growth will also see consistent improvement. Overall, all-property returns will average 5.2% a year, which is relatively weak compared with recent historic averages.
  • Economic Backdrop – Even assuming measures are lifted by the summer, UK GDP is expected to record its worst contraction on record this year. And next year’s recovery is clouded in downside risks. Against this backdrop, we expect inflationary pressures to weaken and interest rates to stay close to their current lows.
  • Investment Market – There was evidence of weaker investment activity even before the lockdown and we expect transaction levels to collapse in Q2. Activity is expected to slowly rebuild into 2021, but we think that all-property yields will stand around 40bps higher than their pre-virus levels by year-end.
  • Office Market – Although office occupiers face less disruption than some other sectors near term, we expect a sharp fall in capital values during 2020. A slow revival after 2021 is led by tight regional markets, with rental growth in London undermined by its stronger supply pipeline.
  • Retail Market – We expect rents and capital values to fall sharply this year, but retail yields should stabilise after 2021. We think retail rental growth will pick up after 2021, as the stock starts to contract against a background of growing retail sales.
  • Industrial Market – We expect industrial occupier demand to hold up better than other sectors. But we still think that there will be significant knock-ons from the economic downturn. As such, we forecast a fall in capital values this year, though milder than elsewhere and the sector is also set to recover more quickly.
  • Leisure and Hotels – Coronavirus has hammered the hospitality industry, where we expect double-digit falls in capital values in 2020 and a slow recovery over the medium term. In our forecasts, the leisure sector is eventually supported by the recovery in domestic spending, but hotel returns remain subdued reflecting weak tourism.

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

-4.5

2.2

1.6

1.7

1.7

0.5

1.8

End yr equiv. yield, %

5.6

6.0

5.9

5.8

5.8

5.8

5.9

5.8

Capital value growth, % y/y

-3.3

-10.6

4.7

2.5

2.2

2.3

0.2

2.9

Income return, % y/y

4.6

5.1

5.0

5.0

5.0

5.0

5.0

5.0

Total return, % p.a

1.2

-5.5

9.6

7.5

7.2

7.3

5.2

7.9

OFFICE PROPERTY

               

Rental value growth, % y/y

1.5

-2.7

2.1

1.7

1.9

2.0

1.0

1.9

End yr equiv. yield, %

5.6

5.9

5.8

5.8

5.7

5.7

5.8

5.7

Capital value growth, % y/y

0.3

-7.8

2.8

2.6

2.5

2.4

0.5

2.6

Income return, % y/y

4.1

4.4

4.2

4.3

4.3

4.3

4.3

4.3

Total return, % p.a

4.4

-3.4

7.0

6.9

6.8

6.6

4.8

6.8

RETAIL PROPERTY

               

Rental value growth, % y/y

-4.9

-8.8

3.1

1.2

1.3

1.3

-0.4

1.8

End yr equiv. yield, %

6.1

6.7

6.5

6.4

6.3

6.2

6.4

6.3

Capital value growth, % y/y

-11.6

-17.4

7.5

2.8

2.4

2.2

-0.5

3.7

Income return, % y/y

5.3

6.1

6.0

5.9

5.8

5.8

5.9

5.9

Total return, % p.a

-6.8

-11.3

13.5

8.7

8.2

8.0

5.4

9.6

INDUSTRIAL PROPERTY

               

Rental value growth, % y/y

2.9

-1.2

1.3

2.0

2.0

2.0

1.2

1.8

End yr equiv. yield, %

5.3

5.5

5.4

5.4

5.4

5.4

5.4

5.4

Capital value growth, % y/y

2.4

-4.1

2.9

1.8

1.4

2.0

0.8

2.0

Income return, % y/y

4.4

4.5

4.5

4.6

4.6

4.6

4.6

4.6

Total return, % p.a

6.9

0.5

7.3

6.4

6.1

6.6

5.4

6.6

LEISURE PROPERTY

               

Rental value growth, % y/y

0.0

-5.0

2.0

1.9

1.9

1.9

0.5

1.9

End yr equiv. yield, %

5.7

6.5

6.2

6.1

6.0

5.9

6.1

6.1

Capital value growth, % y/y

-1.6

-16.7

6.9

3.6

3.6

3.6

0.2

4.4

Income return

5.3

6.3

6.0

5.9

5.8

5.7

5.9

5.8

Total return, % p.a

3.6

-10.4

12.9

9.4

9.4

9.3

6.1

10.3

HOTELS PROPERTY

               

Rental value growth, % y/y

1.8

-3.4

2.0

1.0

1.0

1.0

0.3

1.3

End yr equiv. yield, %

4.5

5.0

4.9

4.8

4.7

4.7

4.8

4.8

Capital value growth, % y/y

1.8

-13.2

4.1

3.1

3.1

3.1

0.1

3.4

Income return

4.1

4.7

4.6

4.5

4.4

4.4

4.6

4.5

Total return, % p.a

6.0

-8.4

8.7

7.6

7.6

7.6

4.6

7.9

Sources: MSCI, Capital Economics

Table 2: Key UK Economic Forecasts (Year Average)

 

2017

2018

2019

2020f

2021f

GDP, % y/y

1.9

1.4

1.4

-12

10

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

1.32

1.38

0.81

0.12

0.13

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

1.19

1.38

0.67

0.25

0.25

CPI inflation, % y/y

2.7

2.5

1.8

1.0

1.0

$/£ (end-period)

1.35

1.28

1.33

1.25

1.30

Euro/£ (end-period)

1.13

1.11

1.18

1.14

1.24

Household spending, % y/y

2.3

1.6

1.1

-21.0

12

Unemployment rate (ILO measure), %

4.4

4.1

3.8

7.0

5.7

Employment, % y/y

1.0

1.2

1.1

-3.0

1.5

Average earnings, % y/y

2.3

2.9

3.5

-0.2

2.0

Nationwide house prices, % y/y in Q4

3.2

0.6

1.5

-4.0

4.0

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)

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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)
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Sources: MSCI, Capital Economics


Economic Backdrop

Shape of recovery key to outlook

  • Following the collapse in economic activity, indicators are beginning to reveal the extent of the destruction caused by the lockdown and social distancing measures. Q1 GDP confirmed one of the greatest quarterly hits to the economy on record. Furthermore, business surveys suggest the data will only get worse in Q2, when we have pencilled in a -23% q/q drop in GDP. (See Chart 9.)
  • Despite the government’s road map outlining the easing of restrictions, normal economic activity is still a distant reality. There is evidence that the stringency of lockdowns has a direct impact on economic performance and that the quicker that the restrictions are eased, the faster the recovery will be. (See Chart 10.)
  • As a result, we must consider the length of the lockdown when assessing the outlook. Our central forecast assumes a three-month period of stringent measures before a bounce back in activity during the second half of 2020 and into 2021. In the case of more prolonged restrictions, we expect each additional month of lockdown to reduce GDP growth in 2020 by about 1.5 percentage points. (See Chart 11.) In the most extreme case of a year’s restrictions, a more prolonged recovery leaves GDP well below pre-virus levels, due to scarring effects.
  • The shape of the recovery is another important uncertainty. Our central forecast assumes a “long tick” shape, whereby activity will recover quickly as restrictions are eased, but increases in insolvencies and unemployment will become a constraint on growth and imply some loss in output. (See Chart 12.) As an estimate, we assign a 50% probability to this outcome.
  • There are a range of scenarios around our central view. The upside limit is a best-case scenario would see a “V” shaped recovery whereby activity is recovered swiftly and fully. On the other hand, a worst-case scenario would see an “L” shaped recovery. This is possible if the virus cannot be contained, choking activity over a long period, with little recovery.
  • In all scenarios, there will be a significant hit to the labour market, though government action will in part mitigate this. The recent extension of the furlough scheme will not prevent an increase in unemployment. However, it will prevent average earnings and employment falling as far as the slump in hours worked. (See Chart 13.)
  • We expect the unemployment rate to peak at 8.5% in our central scenario, and, although the descent from this peak is fairly rapid, there is no return to pre-virus lows. (See Chart 14.) A “V” shaped recovery would see a return to a pre-recession rate from a lower peak, whereas an “L” shaped recovery would imply the unemployment rate remains elevated over the forecast.
  • Inflation rates are expected to decelerate over the rest of 2020. We expect upward pressure from rising food prices to be more than offset by the collapse of oil prices and its impact on the price of fuel and energy. (See Chart 15.) As a result, we expect inflation to remain below 1% y/y for much of 2020, edging up slightly into next year.
  • Bank of England Governor Bailey’s first months in the job have focused on emergency monetary easing. We expect the base rate to remain at 0.10% following recent cuts from 0.75%, with more quantitative easing potentially in the pipeline. As a result, we expect 10-year gilt yields to remain near their historical lows. (See Chart 16.)

Economic Backdrop

Chart 9: IHS Markit/CIPS Composite PMI & GDP

Chart 10: GDP & Lockdown Restrictions

Chart 11: GDP Lockdown Scenarios (100 = 2016)

Chart 12: GDP Recovery Scenarios (100 = Q4 2019)

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Chart 13: Total Hours Worked, Employment & Average Earnings (% q/q)

Chart 14: Unemployment Rate in Different Recoveries (%)

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Chart 15: Contributions to CPI Inflation (ppts)

Chart 16: Bank Rate & 10-Year Gilt Yield (%)

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Sources: Refinitiv, IHS Markit, Oxford University, ONS, Capital Economics


Investment Market

COVID crisis forces yields up

  • Investment activity has been subdued in early 2020, as the bounce from a decisive Conservative election victory in December dissipated. (See Chart 17.) Preliminary data suggest investment transactions of around £12.5bn in Q1, which was below the levels recorded in 2019 H2, but still above the lows of year ago. There was also a deterioration in the net balance of RICS surveyors reporting an, albeit fairly modest, decline in investment enquiries in Q1. (See Chart 18.)
  • But Q1 only covered the start of the COVID lockdown and things are expected to get much worse with the market effectively closed in April and May. In our view, activity will drop by about 30% this year. (See Update.) And this assumes a recovery after Q2, which would be jeopardised if there were a renewed outbreak or the lockdown was eased more slowly.
  • The spread of the virus brought dramatic turbulence on financial markets, which has had an impact on property valuation measures. The equities dividend yield rose sharply in Q1 after markets crashed in March, leaving property more overvalued against shares. By contrast, as bond yields hit historic lows, the spread to property yields rose to new highs suggesting rising investor caution. (See Chart 19).
  • Meanwhile, the upward pressure on yields intensified in all sectors in Q1. And as the crisis worsens in Q2, we expect further rises in all sectors, with retail faring worst. But once the lockdown eases and transactions revive, this initial rise will gradually unwind. But we expect yields will still be around 40bps higher by the end of 2020 than pre-crisis. (See Chart 20.) Thereafter, even with UK interest rates at record lows, the decline in property yields will slow and they will remain slightly above their 2019 levels at the end of the forecast period.
  • Higher yields in 2020 will weigh heavily on capital values, which we expect to decline by just over 10% y/y on the all-property measure. (See Chart 21.) This would be the steepest annual decline since 2008. But this trough is expected to be less deep and the recovery swifter than the last crash, with values up by 6% next year. Thereafter, modest rental growth and slow yield reductions mean a more subdued growth profile.
  • The coronavirus crisis has clearly accelerated the pace of structural decline in retail (See Chart 22.) Values in the sector were already expected to fall this year, but the cumulative decline since 2019 is now expected to be close to 30% – not as bad as in 2007-08, but not far off. And this is not offset by the sector’s slightly stronger bounce after 2021. By contrast, while still seeing notable falls this year, both offices and industrial see less cumulative impact, most of which is regained in the recovery.
  • We expect the decline in capital values to push all-property annual returns into negative territory for the first time since 2009 this year. (Chart 23.) The post-COVID recovery brings a double-digit rebound in 2021, as the UK economy returns to normal. Thereafter, total returns of around 7% p.a. are reasserted for the rest of the forecast.
  • The onset of coronavirus has slightly shifted sector relativities in our five-year total returns forecasts. Over the period, the top returning sectors now reflect a combination of higher income returns and a better rental growth outlook. This means that some retail subsectors are present, notably retail parks and shopping centres, along with leisure, industrial and regional office outperformance. (See Chart 24.) By contrast, lower yielding London offices, hotels and shops languish.

Investment Market

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

Chart 18: RICS Surveyors Reporting a Rise in Investment Enquiries (% Net Balance)

Chart 19: All-Property Net Initial Yields Less 10-Year Gilts and Equity Yields (Bps)

Chart 20: Net Initial Yields (%)

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Chart 21: Contributions to Capital Value Growth (%)

Chart 22: Cumulative Capital Value Growth (%)

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Chart 23: Total Returns (% p.a)

Chart 24: Total Returns by Sector

(% p.a. average 2020-24)

 

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


Office Market

Central London rents to see sharpest fall

  • Our forecast for a steep decline in UK employment implies a sharp fall in office occupier demand this year. (See Chart 25.) But we expect office-based employment will hold up better, as occupiers have faced less disruption than other sectors, with more employees able to work from home. (See Chart 26.) Of course, this might lead to problems for demand further down the line, if firms find their workers are equally productive away from the office and that more flexible working helps to retain talent. We will be exploring the long-term outlook for office space further in a Focus.
  • Leasing activity is already showing signs of slowing in some markets. In fact, there was a marked slowdown in take-up in London in Q1. (See Chart 27.) According to Knight Frank, the West End saw a fall of 50% y/y in take-up to its lowest quarterly level since 2009. And while City take-up also fell, it declined by just 10%.
  • But the Central London vacancy rate was stable in Q1 at 5.7%. (See Chart 28.) This rate would have to rise significantly to reach the level seen in the recent peak in 2017, let alone the 10.9% reached in 2009. However, the size of the development pipeline for the next couple of years points to vacancy rising substantially.
  • Indeed, at 6.6m sq. ft., there is a record-high amount of space under construction in Central London, which is largely concentrated in the City. (See Chart 29.) This figure is 35% higher than a year ago. Admittedly, 60% of that space has been pre-let or is under offer, but firms moving to that space are still likely to be releasing other space onto the market at a time when demand is weak.
  • Serviced offices present an additional risk, albeit one that may not immediately appear in the vacancy estimates. The disruption from COVID-19 has adversely affected providers. Due to the flexibility of their leases and concerns around hot desking, operators have come under increasing pressure. Knight Frank noted that serviced offices accounted for 6% of London office stock in Q1. WeWork, which appears to face elevated company-level risks, accounts for a quarter of this, with some London submarkets such as Paddington, Canary Wharf and the City especially exposed. (See Chart 30.)
  • As a result, we think rental value growth will turn negative in Central London this year. We expect rents in both the City and West End will decline by around 3% in 2020. While this is a bigger revision to our City forecasts than in the West End, this in part reflects the City’s larger supply pipeline and greater exposure to serviced offices. Thereafter, we expect an improvement in economic activity will boost employment, which will support occupier demand and rents longer term. (See Table 3.)
  • By contrast, there was a rise in regional take-up in Q1. Admittedly, it was a mixed picture for the regions as Leeds and Cardiff saw declines, while Birmingham saw a notable boost. But overall, regional city take-up was 20% up on the year before. (See Chart 27 again.)
  • Rest of UK office rental growth of 1.9% y/y in Q1 was unchanged from Q4. Although we expect rents to decline by 1.8% this year, we think Rest of UK rents will hold up better than London and Rest of South East. We expect regional rents will be supported by a more limited supply pipeline. On average, based on annual take-up over the past five years, there is less than a year of new supply under construction. (See Chart 31.) On this basis, the pipeline looks particularly tight in markets such as Liverpool and Edinburgh.

Office Market

Chart 25: UK Employment Growth (% y/y)

Chart 26: Most likely to work from home (%)

Chart 27: City Centre Office Take-Up (000s Sq. Ft.)

Chart 28: Central London Vacancy Rate (%)

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Chart 29: Central London Office Space Under Construction (M Sq. Ft.)

Chart 30: WeWork Impact on London Vacancy Rates

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

Chart 32: RICS Surveyors Expecting Rising Office Rental Values (% Net Balance)

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Sources: MSCI, YouGov, RICS, Knight Frank, CBRE, Avison Young, CE

 


Office Market

Working from home poses downside risk

  • Meanwhile, Rest of South East rental growth slowed slightly to 1.1% y/y in Q1 from 1.2% y/y in the previous quarter. While the supply pipeline is tight in the South East, real rental values are well above their historical trend and we expect rents to fall by 3% in 2020.
  • Our expectation of a weak outlook for office rents is consistent with the latest RICS commercial survey. Indeed, there was a sharper fall in the net balance of surveyors that expect a decline in rental expectations for Central London offices than the Rest of UK in Q1. (See Chart 32.)
  • With working from home at all-time highs, this has increased speculation around the long-term outlook for office demand. While we have noted this as a downside risk to our rental forecast, we expect the most important driver of office occupier demand will be the impact of the disruption from COVID-19 on employment over the coming years. (See our Update.)
  • Overall, we forecast all-offices rental value growth to average 1% per year over the next five years. Within this, we think that Central London will see the slowest growth in large part because the supply pipeline is stronger. In contrast tighter conditions in regional markets are expected to bring somewhat stronger growth from 2021. (See Chart 33.)
  • With all-offices yields flat in Q1, we forecast that a rise in the risk premium for property and a decline in rental expectations will cause yields to rise by around 30bps this year. (See Chart 34.) For comparison, the increase we have pencilled in for office yields is less than the rise in retail, but more than the rise in industrial.
  • Thereafter, an improvement in economic prospects should ease investor caution. Even with interest rates at low levels and with bond yields expected to remain low, there is likely to be a pickup in investor appetite as the economy recovers. We expect a return to rental growth during 2021, which will help stabilise office yields.
  • We think capital values for offices will fall by almost 8% in 2020. While we expect declining office rents to have an impact on capital values, we think the effects of the rise in yields will be greater. In fact, this is already apparent in the MSCI monthly series, which showed that yield movement had the most significant impact on office capital values in April, while rents were flat.
  • The decline in capital values this year will be seen across all office markets. However, a better outlook for rents in Rest of UK offices will mean capital values will fall less severely than in Central London and Rest of South East offices.
  • In 2021, as the economy returns to growth, we forecast that all-office capital values will pick up from their lows. We forecast that capital values will rise by almost 3% y/y as rents return to modest growth and yields stabilise. (See Chart 35.)
  • Returns for offices are likely to turn negative this year before picking up over the medium term. Between 2020 and 2024, we forecast that returns will average 5% a year for all-offices, with returns in Rest of UK expected to outperform, both City and West End lag at under 5% a year. (See Chart 36.)

Office Market

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

Chart 34: Office Equivalent Yields (%)

Chart 35: Contribution to Office Capital Value Growth (%-pts)

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

-2.7

2.1

1.7

1.9

2.0

Rental value growth

1.2

-3.0

2.0

1.5

1.8

2.0

End yr equiv. yield, %

5.6

5.9

5.8

5.8

5.7

5.7

End yr equiv. yield, %

6.3

6.6

6.5

6.6

6.5

6.5

Capital value growth

0.3

-7.8

2.8

2.6

2.5

2.4

Capital value growth

-0.1

-7.4

3.6

0.7

3.4

2.0

Income return

4.1

4.4

4.2

4.3

4.3

4.3

Income return

4.3

4.6

4.4

4.6

4.5

4.5

Total return, % p.a

4.4

-3.4

7.0

6.9

6.8

6.6

Total return, % p.a

4.3

-2.7

8.0

5.4

7.9

6.5

   

London City 11% of office stock by value

Rest of UK 24% of office stock by value

Rental value growth

1.7

-3.3

2.0

1.7

1.7

1.8

Rental value growth

1.9

-1.8

2.3

2.2

2.2

2.3

End yr equiv. yield, %

5.4

5.7

5.6

5.6

5.5

5.5

End yr equiv. yield, %

6.4

6.7

6.6

6.6

6.6

6.5

Capital value growth

0.7

-8.4

3.8

1.7

2.7

1.8

Capital value growth

0.4

-6.0

-0.6

3.7

2.2

3.9

Income return

4.0

4.4

4.3

4.4

4.3

4.3

Income return

4.8

5.2

5.1

5.2

5.2

5.1

Total return, % p.a

4.7

-4.0

8.1

6.1

7.0

6.1

Total return, % p.a

5.2

-0.8

4.5

8.9

7.4

9.0

   

London West End 34% of office stock by value

Rental value growth

1.3

-2.8

2.0

1.5

1.8

1.8

End yr equiv. yield, %

4.4

4.7

4.6

4.5

4.5

4.5

Capital value growth

0.5

-9.1

4.2

3.8

1.8

1.8

Income return

3.4

3.6

3.4

3.4

3.4

3.4

Total return, % p.a

3.8

-5.5

7.6

7.2

5.2

5.2

 

Sources: MSCI, Capital Economics


Retail Market

Retail repricing intensifies with lockdown

  • Retail rental values continued to decline in Q1, taking the annual growth rate to -6.7% y/y, from -4.9% y/y in late-2019. At minus 1.8% q/q, the drop was as bad as the most severe decline in the last recession. This puts real rents around 17% below their peak. (See Chart 37.) And we expect more pain to follow. Tentative evidence from the RICS survey that rental expectations were bottoming out in late 2019 was dispelled in Q1. (See Chart 38.)
  • The outlook has worsened dramatically since March when non-essential UK stores were forced to close as the country locked down. Evidence from landlords suggests that even though this hit late in the quarter, it adversely affected rent collection. (See Chart 39 and our Update.) Rental payments were later across all sectors, but the proportion paid was particularly low in retail according to a Property Week survey. And some occupiers are withholding payments, trying to negotiate concessions with landlords.
  • With most stores likely to be closed at least until the end of May, we expect retail demand to collapse in Q2. In-store retail sales volumes fell by 5.1% m/m during March and then by an unprecedented 18% m/m in April. Admittedly, the relationship between rents and retail sales has broken down in recent years. But against this bleak backdrop, a further acceleration in the contraction in retail rents seems inevitable.
  • But the pressure on rents will ease later in the year, as lockdown measures are lifted and trade resumes. Nonetheless, we expect rents to fall by almost 9% y/y during 2020, more than twice as sharp as our pre-virus forecast.
  • As conditions return to normal over the next 12 months or so, we expect retail rents to return to growth in line with the rebound in UK GDP, rising by 3.1% in 2021 and then averaging just over 1% p.a. over the forecast horizon.
  • While all sub-sectors have suffered in the upheaval, performance has not been even. Shopping centres are expected to see the most severe falls in 2020, followed by retail warehouses and standard shops. (See Chart 40.) And the rental recovery from 2021 is also expected to be slower in shopping centres and retail warehouses.
  • Given the dire retail rental backdrop, we think all-retail yields will rise even further. As with rents, we expect the retail sector to be hardest hit in Q2. Although some of this increase is expected to unwind by end-2020, retail yields will still be 50-60bps above their pre-virus levels. (See Chart 41.) Gradual reductions continue over the medium term, but retail is expected to remain comfortably the highest yielding sector.
  • We expect the decline in retail capital values to accelerate in 2020, with a 17% fall, even worse than last year. Cumulatively, this is still milder than the post-GFC crash (except for shopping centres where the decline began much earlier). But the fall in retail values dwarfs other sectors this time. There is a slow recovery from this year, though values remain below their pre-virus levels at the end of the horizon.
  • Retail returns are sharply negative in 2020 and strongly underperform other sectors. But ground is regained over the longer term, with returns averaging 5.4% a year between 2020 and 2024, which is above the all-property average. This largely reflects the higher income returns as rental prospects remain weak. (See Chart 42.)

Retail Market

Chart 37: Real Retail Rental Values Relative to Trend (%)

Chart 38: Retail Rental Values and Rental Expectations

Chart 39: Rents Paid Within a Week of Due Date (%)

Chart 40: Retail Rental Values by Subsector (% y/y)

Chart 41: Net Initial Yields (%)

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

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Sources: MSCI, Refinitiv, Property Week, RICS, 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

-8.8

3.1

1.2

1.3

1.3

Rental value growth

-5.7

-9.5

3.5

0.5

0.5

0.5

End yr equiv. yield, %

6.1

6.7

6.5

6.4

6.3

6.2

End yr equiv. yield, %

7.3

8.3

8.0

7.8

7.7

7.5

Capital value growth

-11.6

-17.4

7.5

2.8

2.4

2.2

Capital value growth

-17.7

-20.3

7.4

3.1

2.5

2.5

Income return

5.3

6.1

6.0

5.9

5.8

5.8

Income return

5.4

6.6

6.5

6.3

6.2

6.0

Total return, % p.a

-6.8

-11.3

13.5

8.7

8.2

8.0

Total return, % p.a

-13.2

-13.7

13.9

9.4

8.6

8.5

   

Retail Warehouses – 47% of retail stock by value

Standard Shops – 31% of retail stock by value

Rental value growth

-5.6

-9.0

3.0

1.2

1.4

1.4

Rental value growth

-4.6

-8.0

3.0

1.8

1.8

1.8

End yr equiv. yield, %

6.8

7.5

7.2

7.1

7.0

7.0

End yr equiv. yield, %

5.0

5.5

5.3

5.2

5.2

5.2

Capital value growth

-14.5

-17.0

7.3

2.6

2.8

2.4

Capital value growth

-9.2

-16.0

7.9

2.8

1.8

1.8

Income return

6.0

6.8

6.6

6.5

6.4

6.4

Income return

4.4

4.9

4.7

4.6

4.6

4.6

Total return, % p.a

-9.3

-10.2

13.9

9.2

9.3

8.9

Total return, % p.a

-5.2

-11.1

12.6

7.4

6.4

6.4

 

Sources: MSCI, Capital Economics


Industrial Market

Industrial sector not immune

  • While industrial is likely to outperform the other sectors, we expect that occupier demand will take a hit this year. This is despite social distancing accelerating the shift to online spending in recent months. In fact, with retail at the forefront of the disruption and retailers accounting for almost 40% of logistics take-up, we expect there will be significant knock-on effects for the industrial sector. (See Chart 43.)
  • Industrial rental growth has been slowing since 2018. Therefore, even though the virus lockdown only began late in Q1, it came as no surprise that the latest MSCI quarterly data show that industrial rental growth slowed from 2.9% y/y in Q4 2019 to 2.7% y/y in Q1 2020.
  • Nevertheless, the occupier market appears to have held up well in Q1. CBRE reported that take-up reached 6.2m sq. ft., 40% up on the previous year. (See Chart 44.) With non-essential stores closing and consumers stockpiling in March, there was a boost to take-up and future requirements from the food sector. But, as most of these are expected to be fulfilled soon, this is unlikely to boost take-up much beyond the current quarter. More importantly, with economic activity likely to slump in Q2, we expect this will lead to a sharp reduction in take-up through this year.
  • Over the past year, industrial vacancy has been broadly stable. Positively for landlords, it’s likely to have tightened recently, with tenants taking back space that they were previously marketing in response to an increase in inventories and short-term demand. What’s more, the volume of speculative stock under construction has fallen by 60% over the last year, which means that we don’t expect new supply to boost vacancy too significantly over the coming quarters. (See Chart 45.)
  • But, with demand weakening and vacancy likely to rise, we expect rents will decline by 1.2% y/y in 2020. As economic activity picks up again next year and occupier demand improves, we think rents will grow by 1.3% y/y in 2021. (See Chart 46.) Despite this short-term disruption, we expect growth will average 1.2% a year over the next five years. This would be weak by recent standards but would represent outperformance of the other sectors.
  • We think rents in the Rest of South East will outperform Rest of UK, as supply is restricted by high and rising land values. (See our Update.) Over a five-year horizon, we think that rental growth will average 1.7% a year in the Rest of South East, compared with 0.4% a year in the Rest of UK.
  • Meanwhile, industrial yields were stable in Q1. But on the back of a reduction in rental growth expectations and a rise in the risk premium for property, we forecast that yields will rise by around 20bps this year. (See Chart 47.) This is still modest compared to the adjustment we expect in other sectors. The rise is partially unwound in 2021, after which as uncertainty over cashflows eases and rental growth picks up, we think industrial yields will stabilise.
  • In turn, we expect that capital values will decline by 4.1% in 2020, which would be the sharpest drop in values since the 26% y/y fall in 2008. By the end of 2021, we think that a return to rental growth and renewed downward pressure on yields will support capital value growth of 2.9% y/y.
  • Over the next five years, a slowdown in capital value growth is likely to weigh on industrial returns. (See Chart 48.) As such, we forecast returns will average 5.4% a year, below the 6.8% average in the previous five years.

Industrial Market

Chart 43: Share of Industrial Take-Up in 2019 (%)

Chart 44: Industrial Take-Up (M. Sq. Ft.)

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

Chart 46: Industrial Floorspace Under Construction (M. Sq. Ft.)

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Chart 47: Industrial Net Initial Yields (%)

Chart 48: Industrial Property Forecasts (% y/y, 2020-24, Annual Average)

 

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

-1.2

1.3

2.0

2.0

2.0

Rental value growth

1.6

-2.0

0.8

1.0

1.0

1.0

End yr equiv. yield, %

5.3

5.5

5.4

5.4

5.4

5.4

End yr equiv. yield, %

6.0

6.2

6.0

6.0

6.1

6.1

Capital value growth

2.4

-4.1

2.9

1.8

1.4

2.0

Capital value growth

0.5

-4.9

2.8

1.0

0.5

1.0

Income return

4.4

4.5

4.5

4.6

4.6

4.6

Income return

5.1

5.3

5.1

5.3

5.4

5.4

Total return, % p.a

6.9

0.5

7.3

6.4

6.1

6.6

Total return, % p.a

5.6

0.4

7.9

6.3

5.9

6.4

   

South East Industrial 65% of industrial stock by value

Rental value growth

3.8

-0.8

1.5

2.6

2.5

2.5

End yr equiv. yield, %

4.9

5.1

5.0

5.0

5.1

5.1

Capital value growth

3.5

-3.7

2.9

2.2

1.9

2.5

Income return

4.0

4.1

4.1

4.2

4.3

4.3

Total return, % p.a

7.6

0.5

7.0

6.4

6.2

6.8

 

Sources: MSCI, Capital Economics


Leisure and Hotels

COVID provides huge setback for hospitality industry

  • Hopes that the leisure sector could see a recovery in 2020 have been crushed by the virus. The outbreak has effectively closed the leisure industry down since late March. (See Chart 49.) In addition, with social distancing expected to be in force for an extended period, there are big questions over the sector’s medium-term prospects.
  • It was not a big surprise then that MSCI figures from Q1 showed a 6.2% y/y slump in leisure capital values. (See Chart 50.) As rents only declined slightly, most of the damage was done by a 25bp rise in yields. A further sharp deterioration in fortunes is expected in Q2 and, by end-2020, capital values are expected to be 16% lower than their pre-virus levels, as rental growth falls by 5% y/y and equivalent yields rise by 70bps.
  • The sector is likely to see the benefits of relaxed lockdown restrictions later than other commercial sectors and there remain concerns about how quickly it can return to normal. Even if public confidence returns, social distancing measures are likely to remain in place, which will greatly reduce capacity. As a result, we forecast the recovery in 2021 will be slower than other sectors, with the risks skewed to the downside until a vaccine is available.
  • However, we think that the leisure sector will improve longer term. While the virus will leave economic scars, real wage and consumer spending growth are expected to recover from 2021. Admittedly, some subsectors will struggle more, particularly those reliant on tourism or mass gatherings. But with demand for leisure rising with incomes, we expect leisure to outperform eventually. Indeed, we expect total returns to average 6.1% between 2020-2024 compared with 5.2% at the all-property level. (See Chart 51.)
  • We highlighted the risks of COVID to hotels last quarter when the outbreak was confined to China. Since then international travel has slowed almost to a halt and hotel operators have seen revenues evaporate. (See Chart 52.) This has led to concerns about rent payments and occupiers like Travelodge have pushed landlords hard for concessions.
  • The short-term impact of COVID lockdowns is expected to be severe. UK hotel capital value growth had been slowing since early 2018, as yields stabilised. In Q1, there was an abrupt turnaround as yields jumped 15bps, with a 2% q/q fall in capital values. (See Chart 53.) Much worse is expected to follow in Q2 and, though this is likely to be the low point, hotels will be slower than other sectors to revive. In 2020, we expect a double-digit contraction in capital values as yields rise by 50bps above their pre-virus lows.
  • Further out, as with leisure, the outlook remains clouded with uncertainty. International travel is likely to be one of the last areas to return to normal once the virus spread is controlled. Domestic use should revive more quickly – indeed CBRE recently reported that the UK industry was better placed because of its greater reliance on domestic spending. But this shock is unlike previous cyclical downturns and the recovery is expected to be very slow.
  • Annual hotel returns are expected to fall to minus 8% in 2020, by far the worst outturn since 2008. A recovery is expected from 2021. But even so, returns are only set to average around 4.7% per annum between 2020 and 2024, which is low compared with other commercial property sectors. (See Chart 54.)

Leisure and Hotels

Chart 49: UK Restaurant Visits (% y/y)

Chart 50: Contribution to Leisure Capital Value Growth (% y/y)

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

Chart 52: Weekly Flight Ticket Sales (% y/y)

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Chart 53: Contribution to Hotels Capital Value Growth (% y/y)

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

 

Sources: ONS, Statista, Refinitiv, MSCI, Capital Economics

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

-5.0

2.0

1.9

1.9

1.9

 

Rental value growth

1.8

-3.4

2.0

1.0

1.0

1.0

End yr equiv. yield, %

5.7

6.5

6.2

6.1

6.0

5.9

 

End yr equiv. yield, %

4.5

5.0

4.9

4.8

4.7

4.7

Capital value growth

-1.6

-16.7

6.9

3.6

3.6

3.6

 

Capital value growth

1.8

-13.2

4.1

3.1

3.1

3.1

Income return

5.3

6.3

6.0

5.9

5.8

5.7

 

Income return

4.1

4.7

4.6

4.5

4.4

4.4

Total return, % p.a

3.6

-10.4

12.9

9.4

9.4

9.3

 

Total return, % p.a

6.0

-8.4

8.7

7.6

7.6

7.6

Sources: MSCI, Capital Economics


Andrew Burrell, Chief Property Economist, andrew.burrell@capitaleconomics.com
Prohad Khan, Property Economist, prohad.khan@capitaleconomics.com
James Yeatman, Research Assistant, james.yeatman@capitaleconomics.com