Returns to recover as retail emerges from slump - Capital Economics
UK Commercial Property

Returns to recover as retail emerges from slump

UK Commercial Property Outlook
Written by Andrew Burrell
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A subdued economic outlook and continued contraction in retail are expected to weigh on all-property rents and returns this year. In the near-term, rising property yields will be the result of the ongoing correction in the retail sector this year, while a 25bps rise in UK interest rates in 2021 brings a modest increase in other sectors. Over the next five years, we think all-property rental value growth will improve slowly, but steadily, as economic growth recovers and vacancy remains low. As a result, all-property capital value growth will also see consistent improvement. Overall, returns will average 5.7% a year, which remains relatively soft compared with the 8.1% a year average over the last five years.

  • Overview – A subdued economic outlook and continued contraction in retail are expected to weigh on all-property rents and returns this year. In the near-term, rising property yields will be the result of the ongoing correction in the retail sector this year, while a 25bps rise in UK interest rates in 2021 brings a modest increase in other sectors. Over the next five years, we think all-property rental value growth will improve slowly, but steadily, as economic growth recovers and vacancy remains low. As a result, all-property capital value growth will also see consistent improvement. Overall, returns will average 5.7% a year, which remains relatively soft compared with the 8.1% a year average over the last five years.
  • Economic Backdrop – After the decisive election result and reduction in Brexit uncertainty, we think that the economy is close to a turning point. We expect GDP growth to edge down to 1.0% this year, but expect looser fiscal policy to support growth of around 1.8% y/y in 2021.
  • Investment Market – While there were signs of an upturn in H2 2019, we expect uncertainty to linger and result in subdued investment this year. Property yields will continue to rise this year and next, albeit at a slower rate, driven by retail in the short-term and rising interest rates further out.
  • Office Market – In the near term, we expect office rental value growth to hold up against a background of solid demand and tight supply. We think rents for Rest of UK offices will outperform London and Rest of South East offices.
  • 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 – While yields are expected to gradually rise next year, rising supply is expected to slow rental value growth, which, will cause capital value growth to slow and total returns to ease. Nonetheless, industrial will remain the top performing sector.
  • Leisure and Hotels – We expect an improvement in the leisure sector as real wage growth holds up this year and next, which should support consumer spending. However, hotel returns are forecast to slow in the near term as weak tourism weighs on demand.

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

-0.3

1.2

1.6

1.7

1.7

1.2

1.5

End yr equiv. yield, %

5.6

5.7

5.8

5.8

5.8

5.7

5.7

5.8

Capital value growth, % y/y

-3.3

-1.9

0.3

1.2

2.0

2.0

0.7

1.4

Income return, % y/y

4.6

4.8

4.9

5.0

5.0

4.9

4.9

5.7

4.9

Total return, % p.a

1.2

2.9

5.2

6.2

7.0

7.0

5.7

6.3

OFFICE PROPERTY

Rental value growth, % y/y

1.5

1.5

1.5

1.7

1.9

2.0

1.7

1.8

End yr equiv. yield, %

5.6

5.6

5.7

5.8

5.7

5.7

5.7

5.7

Capital value growth, % y/y

0.3

0.8

-0.5

0.5

2.9

2.3

1.2

1.3

Income return, % y/y

4.1

4.1

4.2

4.3

4.3

4.3

4.2

4.3

Total return, % p.a

4.4

5.0

3.7

4.8

7.2

6.6

5.5

5.6

RETAIL PROPERTY

Rental value growth, % y/y

-4.9

-4.4

0.0

1.1

1.3

1.3

-0.1

0.9

End yr equiv. yield, %

6.1

6.3

6.3

6.3

6.2

6.2

6.2

6.2

Capital value growth, % y/y

-11.6

-7.8

0.3

1.4

2.0

2.0

-0.4

1.4

Income return, % y/y

5.3

5.7

5.8

5.8

5.8

5.8

5.8

5.8

Total return, % p.a

-6.8

-2.1

6.1

7.2

7.8

7.7

5.4

7.2

INDUSTRIAL PROPERTY

Rental value growth, % y/y

2.9

2.3

2.2

2.0

2.0

2.0

2.1

2.0

End yr equiv. yield, %

5.3

5.3

5.4

5.4

5.4

5.4

5.4

5.4

Capital value growth, % y/y

2.4

2.1

1.1

1.7

1.4

2.0

1.6

1.5

Income return, % y/y

4.4

4.4

4.5

4.6

4.6

4.6

4.6

4.6

Total return, % p.a

6.9

6.5

5.6

6.3

6.1

6.6

6.2

6.1

LEISURE PROPERTY

Rental value growth, % y/y

0.0

0.8

1.5

1.9

1.9

1.9

1.6

1.8

End yr equiv. yield, %

5.7

5.8

5.8

5.9

5.9

5.9

5.8

5.8

Capital value growth, % y/y

-1.6

-1.0

1.5

1.0

1.9

1.9

1.1

1.6

Income return

5.3

5.6

5.6

5.6

5.6

5.6

5.6

5.6

Total return, % p.a

3.6

4.6

7.1

6.6

7.5

7.5

6.7

7.2

HOTELS PROPERTY

Rental value growth, % y/y

1.8

1.0

1.1

1.0

1.0

1.0

1.0

1.0

End yr equiv. yield, %

4.5

4.6

4.6

4.6

4.6

4.6

4.6

4.6

Capital value growth, % y/y

1.8

-0.2

0.0

1.0

1.0

1.0

0.6

0.8

Income return

4.1

4.3

4.3

4.3

4.3

4.3

4.3

4.3

Total return, % p.a

6.0

4.0

4.3

5.3

5.3

5.3

4.9

5.1

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

1.0

1.8

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

1.06

1.38

0.52

0.84

1.07

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

1.19

1.28

0.82

1.00

1.25

CPI inflation, % y/y

2.7

2.5

1.8

1.6

1.7

$/£ (end-period)

1.35

1.28

1.33

1.35

1.40

Euro/£ (end-period)

1.13

1.11

1.18

1.29

1.33

Household spending, % y/y

2.3

1.6

1.4

1.4

1.6

Unemployment rate (ILO measure), %

4.4

4.1

3.9

3.9

3.8

Employment, % y/y

1

1.2

0.8

0.3

0.6

Average earnings, % y/y

2.3

2.9

3.5

3.0

3.3

Nationwide house prices, % y/y in Q4

3.2

0.6

1.5

1.9

2.0

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 2019 (%)

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)

empty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cell

Sources: MSCI, Capital Economics


Economic Backdrop

Economy at a turning point

  • Following the decisive election result and the subsequent reduction in uncertainty, we think that the economy has reached a turning point. Indeed, while GDP growth ground to a halt in Q4, timelier survey data are already indicating that there was a pick-up in GDP growth early in the year. The all-sector PMI jumped from 50.0 in December to 53.9 in January, consistent with quarterly GDP growth accelerating to 0.5% in Q1. (See Chart 9.) And other surveys have all been overwhelmingly positive too.
  • Admittedly, given the weak starting point the annual rate of GDP growth will probably edge down to 1.0% this year. (See Chart 10.) But further ahead, economic growth will accelerate to around 1.8% y/y in 2021, placing us above the consensus forecast.
  • We think that looser fiscal policy, rather than an increase in business investment will drive GDP growth higher. After all, as negotiations over future UK-EU relationship go down to the wire, the possibility of some form of “WTO no deal” will cause uncertainty to linger and keep a lid on any pick-up in investment. (See Chart 11.) But, as we explained in our UK Outlook, business investment should pick up next year as any remaining uncertainty fades.
  • Instead, looser fiscal policy will take the reins. We expect an increase in government spending equivalent to around 1% of GDP. However, the recent resignation of Sajid Javid as Chancellor and the promotion of Rishi Sunak provides a potential upside to GDP growth. Indeed, by raising the chances of a further relaxation of the fiscal rules, there could be room for an even larger boost to GDP growth over the next few years.
  • Even so, the labour market has peaked. Indeed, we think that employment growth will slow from the 1.0% y/y average in 2019 to 0.3% y/y this year before edging up to 0.6% y/y in 2021. (See Chart 12.) As a result, wage growth is set to slow slightly. But with the unemployment rate remaining around 3.8%, average pay growth should stay around 3% y/y over the forecast horizon, well above our predictions for inflation. (See Chart 13.)
  • With real wage growth remaining robust, the stagnation in consumer spending growth in Q4 was most likely a blip. While consumers have had the ability to spend, an unwillingness to spend has been a key constraint on growth. But with the prospect of higher taxes under a labour government and a no deal Brexit on 31st January now gone, we think that spending growth will rebound to 1.5% y/y this year and 2.0% in 2021.
  • Meanwhile, despite the fiscal injection, we doubt that inflation will rise above the Bank of England’s target of 2% in the near term. (See Chart 14.) As a result, we expect the Monetary Policy Committee (MPC) to keep rates on hold this year. Further ahead, though, and in contrast with the market consensus, we expect interest rates to rise rather than fall. (See Chart 15.) Indeed, the acceleration in GDP growth in 2021 will push the MPC to increase interest rates. But we only expect one 25bps hike from 0.75% to 1% in H1 2021.
  • With an improvement in the global backdrop, and domestic interest rates set to rise in 2021, we expect bond yields to increase over the next two years. Indeed, the 10-year gilt yield will rise from around 0.6% now to around 1.00% by the end of this year and to around 1.25% in 2021. (See Chart 16.)

Economic Backdrop

Chart 9: IHS Markit/CIPS Composite PMI & GDP

Chart 10: UK Real GDP

Chart 11: Business Investment & Uncertainty

Chart 12: UK Employment (%y/y)

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Chart 13: Average Weekly Earnings & Inflation

Chart 14: CPI Inflation (%)

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Chart 15: Expectations for Interest Rates (%)

Chart 16: 10-Year Government Bond Yields (%)

empty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cellempty cell

Sources: Refinitiv, IHS Markit, Bloomberg, Capital Economics


Investment Market

Yields expected to rise

  • After a weak start to 2019, there was a notable pick-up in investment activity in the second half of the year. (See Chart 17.) Nevertheless, investment totalled just around £50bn in 2019, down over 20% y/y on the previous 12 months. While there have been signs of a post-election bounce, we think that investment is unlikely to rebound this year as uncertainty related to trade negotiations will linger.
  • Indeed, although there was some improvement in investment enquiries in Q4, the net balance of RICS surveyors continued to report a decline in retail and office investment enquiries, though industrial requests were more positive. (See Chart 18.)
  • Commercial property is likely to remain fairly good value compared with other assets. Admittedly, there were mixed movements in valuation measures during Q4. The dividend yield for equities fell, slightly improving the spread against property. By contrast, there was a rise in bond yields relative to property yields. (See Chart 19).
  • Nonetheless, against a backdrop of weak investment and further retail restructuring, we expect property yields to rise again this year, albeit more slowly than in 2019. In turn, retail yields are expected rise most, by a further 20-25bps. Office and industrial yields are also predicted to edge up, but only marginally.
  • In 2021, a rise in short-term interest rates of 25bps to 1% is likely to put further upward pressure on bond yields. As a result, property yields will drift higher in both the office and industrial sectors. This upward movement is a mild correction and is expected to lift sector yields by around 20bps on average. By contrast, retail yields are expected to stabilise from next year, albeit at much higher levels than for office or industrial. (See Chart 20.)
  • Looking at yield movements from their recent lows across sectors, the severity of the retail correction becomes apparent, especially in shopping centres and retail warehousing. (See Chart 21.) In contrast to the 100bps plus shifts in retail, office yields are expected to rise in total by much less at 20-35bps and industrial yields at closer to 10bps.
  • Rising yields in 2020 will weigh on capital values, albeit a less steep contraction than last year’s forecast. (See Chart 22.) All-property capital values are expected to fall by 1.5% this year, a drop that is still largely the result of sharply declining capital values in retail.
  • In 2021, capital values are expected to be flat, while growth resumes in the following year at relatively modest rates. This reflects a combination of a steadily stronger rental contribution over time and declining negative yield impact as the retail sector bottoms out.
  • All-property total returns are expected to remain subdued in the near term. But, while we expect negative returns in the retail sector this year, returns in other sectors are enough to push the all-property figure slightly higher. In addition, as retail recovers from 2021 and the dip in the other sectors prove to be short-lived, total returns will improve steadily over the rest of the forecast. (Chart 23.)
  • Between 2020 and 2024, returns for industrial, leisure, Rest of UK offices and retail warehouses are expected to outperform the all-property average of 5.7% a year. By contrast, we think returns for West End offices, standard shops and shopping centres will be the lowest. (See Chart 24.)

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: Change in Equivalent Yield

(Peak to Trough, Bps)

Chart 22: Contribution to Capital Value Growth (%)

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Chart 23: Total Returns (% p.a)

Chart 24: Total Returns by Sector

(% p.a. average 2020-24)

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


Office Market

Central London rental growth to hold up

  • Office rental value growth was 1.5% y/y in Q4, up from 1.3% y/y in the previous quarter. Admittedly, the latest figures show some signs of a slowdown in UK office-based employment growth. (See Chart 25.) Despite this, against a background of solid demand and tight supply, we think that office rental value growth will hold up this year and next.
  • There have already been signs of a slowdown in the London occupier market. According to Knight Frank, despite agents reporting a 25% increase in active requirements, take-up in the City fell by almost 30% in 2019. As a result, total Central London take-up was down by 20% over the same period. (See Chart 26.)
  • At the same time, the vacancy rate in Central London rose from 5.5% at the start of the year to 5.7% in Q4. However, this is still well below the recent peak of 7.3% seen in 2017. Given the tightness of occupier markets, rental value growth has probably been more subdued than expected over the last two years. (See Chart 27.)
  • With the space under construction in Central London expected to increase to 8m sq. ft. this year, further upward pressure on vacancy rates is expected in the near-term. (See Chart 28.) But it is worth noting that just over half of the space under construction in Central London this year has already been pre-let.
  • Despite this somewhat mixed occupier outlook, we have upgraded our view for Central London rental value growth. In large part this reflects stronger than expected rental outturns in the last year. In particular, in the City of London office rental growth rose by a punchy 1.7% y/y in Q4.
  • As discussed in our recent Update, there was also a marked improvement in London employment growth over the first nine months of 2019. Although we still expect a slowdown over the next two years, jobs growth is expected be higher than our previous estimates for the capital, boosting occupier demand.
  • As such, we have made modest upward revisions to our office rental growth forecasts, which we think will average an 1.5% and 1.3% a year in the City and West End respectively in 2020-21. Longer term, historically high real rental levels in these markets are expected to limit any further acceleration, though annual growth rates do edge up gradually towards 2% by the end of the forecast.
  • In most of the regional cities, there was also a slowdown of take-up in city centres. (See Chart 29.) Bristol and Manchester were the main exceptions. In fact, Bristol was the only city with take-up well above its five-year average at the end of 2019. However, this figure was lifted by BT’s pre-lease in the Assembly scheme, which accounted for around 30% of total take-up during 2019.
  • In Rest of UK office markets, rents grew by 1.9% y/y in Q4, up from 1.5% y/y. We think that rental growth will be supported by tight supply in the regions. On average, there is less than one year’s worth of supply based on annual take-up over the past five years. (See Chart 30.) In particular, supply in Rest of the South East, Liverpool and Edinburgh looks especially tight on this comparison.

Office Market

Chart 25: Total and Office-Based Employment Growth

Chart 26: Central London Office Take-Up and London Office-Based Employment Growth

Chart 27: Central London Vacancy Rate and Rental Value Growth

Chart 28: Central London Office Space Under Construction (M Sq. Ft.)

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Chart 29: City Centre Office Take-Up (000s Sq. Ft.)

Chart 30: Years of Supply in the Regions

(Based on 5-Yr Avg. Take-Up)

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Chart 31: Rest of South East Real Office Rental Values and Historical Trend

Chart 32: Office Rental Value Growth (% y/y)

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Sources: MSCI, ONS, Colliers, Knight Frank, Avison Young, RICS, Capital Economics


Office Market

Rest of UK to outperform

  • Supply constraints in the Rest of South East office market are expected to maintain rental growth at around 1.3% y/y this year and next. This still slightly lags our London City and Rest of UK office forecasts. This is in part because we think that there is limited scope for Rest of South East rents to accelerate, given real rental values are well above their historical trend. (See Chart 31.)
  • Over the next five years, we forecast rental value growth of 1.7% a year for all-offices. We expect that Rest of UK rental growth will outperform the UK average at 2.2% a year, while Rest of South East rents are expected to languish, rising at just 1.4% a year. (See Chart 32.)
  • The improved outlook for rents is consistent with the latest RICS commercial survey, where expectations of office rental growth for London and Rest of UK picked up markedly in Q4. (See Chart 33.)
  • There were some signs of a Boris Bounce in the office yield data for Q4 2019. Avison Young reported that City prime yields fell by 25bps in the final quarter of the year. Yields in the West End were flat, but at 3.5%, remained at very low levels. These changes were mirrored in average London office net initial yields in the MSCI data for Q4 in London and the South East, albeit the falls were more modest.
  • The outlook for yields in 2020 is finely balanced. We don’t expect the recent falls in London yields to be sustained against a background of mediocre rental growth and subdued demand. And as investors seem to have priced in uncertainty for this year, there is unlikely to be significant upward pressure elsewhere in the near term.
  • But an expected rise in UK interest rates during 2021 will put upward pressure on bond yields, which we expect to push up office yields next year and beyond. Compared with recent movements in the retail sector, however, this is a fairly mild shift, taking yields up on average 20bps across office sectors by 2021. (See Chart 34.)
  • This year, we predict that capital values for offices will grow by 1.9% y/y, up from just 0.3% y/y in 2019. Next year, we are more pessimistic. We think that office capital values will decline by 0.5% y/y as rental growth stabilises and yields pick-up in response to a rise in interest rates. (See Chart 35.)
  • The fall in values during 2021 is driven by rising yields in the markets of Central London. By contrast, in Rest of UK offices, the falls are expected to be partially offset by solid rental growth and so capital values hold up better.
  • Overall, returns in regional office offices are expected to exceed those in London. Between 2020 and 2024, we forecast average returns in Rest of UK and Rest of South East of 6.7% and 5.6% a year respectively. (See Chart 36.) By contrast, total returns in City and West End offices average 5.4% and 4.5% a year over the forecast, below the all-property average.

Office Market

Chart 33: RICS Surveyors Expecting Rising Office Rental Values (% Net Balance)

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 31% of office stock by value

Rental value growth

1.5

1.5

1.5

1.7

1.9

2.0

Rental value growth

1.2

1.3

1.3

1.5

1.8

2.0

End yr equiv. yield, %

5.6

5.6

5.7

5.8

5.7

5.7

End yr equiv. yield, %

6.3

6.3

6.4

6.6

6.5

6.5

Capital value growth

0.3

2.1

-0.5

0.5

2.5

2.3

Capital value growth

-0.1

0.8

-0.5

-0.2

3.4

2.0

Income return

4.1

4.1

4.2

4.3

4.3

4.3

Income return

4.3

4.4

4.5

4.6

4.5

4.5

Total return, % p.a

4.4

6.2

3.7

4.8

6.8

6.6

Total return, % p.a

4.3

5.2

4.0

4.4

7.9

6.5

London City 11% of office stock by value

Rest of UK 23% of office stock by value

Rental value growth

1.7

1.5

1.5

1.7

1.7

1.8

Rental value growth

1.9

2.1

2.1

2.2

2.2

2.3

End yr equiv. yield, %

5.4

5.4

5.5

5.6

5.5

5.5

End yr equiv. yield, %

6.4

6.4

6.5

6.6

6.6

6.5

Capital value growth

0.7

0.6

-1.1

1.5

2.7

1.8

Capital value growth

0.4

1.7

0.7

-0.3

2.2

3.9

Income return

4.0

4.1

4.3

4.4

4.3

4.3

Income return

4.8

4.9

5.0

5.2

5.2

5.1

Total return, % p.a

4.7

4.7

3.2

5.9

7.0

6.1

Total return, % p.a

5.2

6.6

5.8

4.9

7.4

9.0

London West End 35% of office stock by value

Rental value growth

1.3

1.2

1.3

1.5

1.8

1.8

End yr equiv. yield, %

4.4

4.4

4.5

4.6

4.5

4.5

Capital value growth

0.5

0.4

-1.2

1.3

2.9

2.9

Income return

3.4

3.3

3.4

3.5

3.4

3.4

Total return, % p.a

3.8

3.7

2.3

4.8

6.4

5.2

Sources: MSCI, Capital Economics


Retail Market

No respite for retail rents before 2022

  • Retail rental values fell by 4.9% y/y in Q4 2019. Moreover, the quarterly drop was the worst since the current downturn began almost two years ago, at minus 2% q/q. In context, this was as bad as the most severe decline in the last recession. Overall, nominal rents have now fallen about 16% from their peak and in real terms they are about 25% below their long-term trend. (See Chart 37.)
  • There is tentative evidence from the RICS commercial property survey that rental expectations may be bottoming out. This is consistent with our expectations. A slight deceleration in the rate of retail rental declines is expected this year and we expect levels to stabilise during 2021. (See Chart 38.)
  • As discussed in our recent Focus, we think that rental values could start to rise again as early as 2022. This reflects a combination of limited development and change of use reducing the supply overhang, against a background of solid retail sales growth. (See Chart 39.) Nonetheless, in the near-term, risks to rents remain skewed to the downside.
  • In-store retail sales growth slowed through last year, from 2.6% y/y in Q1 to record a slight quarterly fall in Q4. In the past, this would be consistent with at worst a slowdown in rents. Some of the weakness in spending likely reflected Brexit-related uncertainty, as well as poor Christmas trading. With the election over and real wage growth forecast to hold up, we expect retail sales growth to pick up in 2020. (See Chart 40.)
  • While all sub-sectors have suffered in the recent upheaval, performance has not been even. Last year, standard shops were most resilient, albeit rents still fell by 4.5% y/y. Shopping centres are expected to see the most severe falls again in 2020, followed by retail warehouses. This is consistent with the pattern of increases in vacancy over the past two years in these sub-sectors.
  • This view also appears to mirror investor sentiment. During 2019, shopping centre and retail warehouse initial yields each rose by around 70bps, compared with just 20bps for shops.
  • Given the dire rental backdrop in the near term, we think that all-retail yields will rise further. As a result, the sector is expected to remain the highest yielding over the forecast horizon. This compares to the pre-2017 period, where it was typically the lowest. (See Chart 41.)
  • This year, the pace of retail yield rises is expected to moderate, as the rental correction starts to ease. For all-retail, the initial yield increase is a further 25bps, roughly half the shift in 2019, with largest sectoral move of roughly 30bps for shopping centres. As such, retail capital vales will continue to fall sharply, dropping a further 7.8% in 2020.
  • Not surprisingly, retail returns lag other sectors in the near term, but make up ground at the end of the forecast, averaging 5.4% a year between 2020 and 2024. Within the all-retail total, only retail warehouses are expected to outperform the all-property average over the next five years. (See Chart 42.)

Retail Market

Chart 37: Real Retail Rental Values Relative to Trend

Chart 38: Retail Floorspace (Bn Sq. Ft.)

Chart 39: Retail Rental Values and Rental Expectations

Chart 40: Retail Rental Values and Retail Sales

Chart 41: Equivalent Yields (%)

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

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Sources: MSCI, Refinitiv, VOA, 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

-4.4

0.0

1.1

1.3

1.3

Rental value growth

-5.7

-5.0

0.0

0.0

0.5

0.5

End yr equiv. yield, %

6.1

6.3

6.3

6.3

6.2

6.2

End yr equiv. yield, %

7.3

7.6

7.6

7.6

7.5

7.4

Capital value growth

-11.6

-7.8

0.3

1.4

2.0

2.0

Capital value growth

-17.7

-8.6

0.0

0.0

1.8

1.9

Income return

5.3

5.7

5.8

5.8

5.8

5.8

Income return

5.4

5.9

6.0

6.1

6.0

5.9

Total return, % p.a

-6.8

-2.1

6.1

7.2

7.8

7.7

Total return, % p.a

-13.2

-2.7

6.0

6.1

7.9

7.8

Retail Warehouses – 47% of retail stock by value

Standard Shops – 31% of retail stock by value

Rental value growth

-5.6

-4.5

0.0

1.2

1.4

1.4

Rental value growth

-4.6

-3.7

0.0

1.8

1.8

1.8

End yr equiv. yield, %

6.8

7.1

7.0

7.0

7.0

6.9

End yr equiv. yield, %

5.0

5.3

5.3

5.2

5.2

5.2

Capital value growth

-14.5

-7.4

0.7

1.2

2.1

2.1

Capital value growth

-9.2

-7.9

0.0

2.8

1.8

1.8

Income return

6.0

6.3

6.4

6.5

6.5

6.5

Income return

4.4

4.7

4.7

4.6

4.6

4.6

Total return, % p.a

-9.3

-1.0

7.1

7.7

8.7

8.6

Total return, % p.a

-5.2

-3.2

4.7

7.4

6.4

6.4

Sources: MSCI, Capital Economics


Industrial Market

Slower rental growth to weigh on returns

  • We still expect industrial property to outperform the other sectors as demand is supported by growing e-commerce. But a rise in supply will cause industrial rental growth to slow over the coming years. Combined with a rise in yields, albeit marginal, this will mean that capital value growth will slow over the next two years.
  • The latest MSCI quarterly data show that rental growth slowed to 2.9% y/y in Q4, from 3.3% y/y in the previous quarter. And we think that growth will slow further. Indeed, industrial rental values still seem stretched compared to their historical trend. (See Chart 43.) This suggests that rental growth will continue to slow.
  • Furthermore, there are signs of weakness in the occupier market. Despite the proportion of internet sales rising as a percentage of total sales last year, JLL data show that grade A logistics take-up fell in 2019 by 12% y/y to 19.9 million sq. ft. (See Chart 44.)
  • Industrial supply rose by around 15% last year, which meant that vacancy rates increased from 8% to 9% in 2019. (See Chart 45.) As reported by Savills, there is also currently around 7m sq. ft. under construction this year and this will put further upward pressure on vacancy.
  • We think a weaker economic outlook this year will slow rental growth, though surveyors remain optimistic. The latest RICS commercial survey in Q4 showed that the net balance of 31% expect a rise in industrial rents, up from 19% in the previous quarter.
  • We forecast that industrial rental value growth will slow to 2.3% y/y this year and ease further during 2021. Over a five-year horizon, growth averages a touch over 2% y/y, which is a marked slowdown on the recent past, but means that industrial rents will continue to grow faster than other sectors.
  • There remain wide differences in subsector performance. Over the next five years, we predict that rental value growth will average 2.7% a year in the Rest of South East, compared with 1% a year in the Rest of UK. (See Chart 46.) More restricted supply in the Rest of South East market is the most important factor.
  • Meanwhile, industrial yields stalled last year and are expected to remain flat in 2020. A rise of 25bps in UK policy rates next year is likely to increase the upward pressure, though the rise in industrial yields is forecast to be more modest than in other sectors at around 10bps. (See Chart 47.)
  • As such, we forecast that capital value growth will slow to 2.1% y/y and 1.1% y/y in 2020 and 2021 respectively. Stronger rental value growth in the Rest of South East sub-market is expected to support stronger growth there, though the Rest of UK also escapes outright falls in values unlike most other UK property sectors.
  • The slowdown in capital value growth is expected to weigh on industrial returns. Overall, we think they will average 6.2% a year over the next five years, which remains below the averages of the recent past. Nevertheless, industrial property will still outperform other traditional sectors. In turn, we predict that returns for Rest of the South East and Rest of the UK will average around 6.3% and 6% p.a respectively over the next five years. (See Chart 48.)

Industrial Market

Chart 43: Industrial Rental Values and Historical Trend

Chart 44: Grade A Logistics Take-Up (M. Sq. Ft.)

Chart 45: Industrial Supply (M Sq. Ft.)

Chart 46: Regional Industrial Rental Forecasts (% y/y)

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Chart 47: Industrial Net Initial Yields (%)

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

Sources: JLL, 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

2.3

2.2

2.0

2.0

2.0

Rental value growth

1.6

1.1

1.0

1.0

1.0

1.0

End yr equiv. yield, %

5.3

5.3

5.4

5.4

5.4

5.4

End yr equiv. yield, %

6.0

6.0

6.0

6.0

6.1

6.1

Capital value growth

2.4

2.1

1.1

1.7

1.4

2.0

Capital value growth

0.5

0.7

0.7

0.7

0.5

1.0

Income return

4.4

4.4

4.5

4.6

4.6

4.6

Income return

5.1

5.1

5.2

5.3

5.4

5.4

Total return, % p.a

6.9

6.5

5.6

6.3

6.1

6.6

Total return, % p.a

5.6

5.9

5.9

6.0

5.9

6.4

South East Industrial 65% of industrial stock by value

Rental value growth

3.8

2.9

2.8

2.6

2.5

2.5

End yr equiv. yield, %

4.9

4.9

5.0

5.0

5.1

5.1

Capital value growth

3.5

2.8

1.4

2.2

1.9

2.5

Income return

4.0

4.0

4.1

4.2

4.3

4.3

Total return, % p.a

7.6

6.8

5.5

6.4

6.2

6.8

Sources: MSCI, Capital Economics


Leisure and Hotels

Brighter outlook for leisure, hotel sector still gloomy

  • The leisure sector probably reached a low point in 2019, and we expect to see some improvement in capital value growth and rental growth over the next couple of years. Meanwhile, we think that total returns will decline further in the hotel sector this year.
  • In the leisure sector, the 20bps rise in equivalent yields over 2019 drove a decline in capital values. (See Chart 49.) But, at minus 1.6% y/y in Q4, the rate of decline was unchanged from Q3.
  • Meanwhile, despite fairly robust real wage growth, rental growth ground to a halt in Q4. It is perhaps not too surprising given that both consumer and business confidence were weak last year. In fact, based on past form, rental growth appears to have held up better than expected. (See Chart 50.)
  • However, we think that the leisure sector will improve this year. After all, sentiment appears to have bounced back following the decisive election result in December. And, with real wage growth holding up this year and next, the sector will receive support from fairly robust consumer spending.
  • Admittedly, some leisure types have struggled, such as the food and beverage sector where several restaurant chains have entered CVAs. And we expect that these sub-sectors will remain fragile. But with demand for other types of leisure trending upwards, we expect weakness in these sectors to be offset by improvements elsewhere.
  • All told, over the longer term we expect the leisure sector to outperform the all-property total. Indeed, we expect total returns to average 6.7% between 2020-2024 compared to 5.7%. (See Chart 51.)
  • Hotel capital value growth also continued its downward trend at the end of last year, dropping from 2.6% y/y in Q3 to 1.8% y/y in Q4. As with the leisure sector, the rise in equivalent yields was behind the fall in capital values.
  • But tourist volumes have also weighed the sector. Granted, the number of foreign visitors rose above trend in Q3 (the latest data). But the data are volatile. And in any case, given the weakness in the euro-zone, we don’t expect to see a significant rise in tourist volumes over the next year or so. Indeed, our tourist demand indicator suggests tourist volumes will remain fairly flat. (See Chart 52.)
  • Admittedly, the coronavirus outbreak has added a downside risk to our forecast for the hotel sector. But visitors from China only account for around 2% of total visits to the UK. (See Chart 53.) So as long as the decline is temporary, we doubt it will have any meaningful impact. And in any case, with consumer spending set to be fairly strong over the coming year, domestic tourism will probably hold up.
  • What’s more, given that the supply pipeline looks solid, even if demand did rise, it’s unlikely to push up rents and capital values. Indeed, the government estimated in a recent policy paper that a further 130,000 rooms will be available by 2025 – an increase of around 14% on 2018.
  • Hotel returns are expected to fall to around 4% in 2020. Granted, we expect to see some improvement in total returns further ahead. But even so, returns are only set to average around 4.9% per annum between 2020 and 2024. (See Chart 54.)

Leisure and Hotels

Chart 49: Contribution to Leisure Capital Value Growth (% y/y)

Chart 50: UK Economic Sentiment & Leisure Rental Value Growth

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

Chart 52: Tourist Demand Indicator & UK Capital Values (% y/y)

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Chart 53: Visits to the UK (% of Total)

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

Sources: ONS, 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

0.8

1.5

1.9

1.9

1.9

Rental value growth

1.8

1.0

1.1

1.0

1.0

1.0

End yr equiv. yield, %

5.7

5.8

5.8

5.9

5.9

5.9

End yr equiv. yield, %

4.5

4.6

4.6

4.6

4.6

4.6

Capital value growth

-1.6

-1.0

1.5

1.0

1.9

1.9

Capital value growth

1.8

-0.2

0.0

1.0

1.0

1.0

Income return

5.3

5.6

5.6

5.6

5.6

5.6

Income return

4.1

4.3

4.3

4.3

4.3

4.3

Total return, % p.a

3.6

4.6

7.1

6.6

7.5

7.5

Total return, % p.a

6.0

4.0

4.3

5.3

5.3

5.3

Sources: MSCI, Capital Economics


Andrew Burrell, Chief Property Economist, +44 20 7811 3909, andrew.burrell@capitaleconomics.com
Prohad Khan, Property Economist, +44 20 7808 4075, prohad.khan@capitaleconomics.com
Gabriella Dickens, Assistant Economist, +44 20 3974 7421, gabriella.dickens@capitaleconomics.com