Returns to remain soft - Capital Economics
UK Commercial Property

Returns to remain soft

UK Commercial Property Outlook
Written by Andrew Burrell
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Regardless of the outcome of the election and Brexit, we expect all-property returns to be weak over coming years. Indeed, even if a deal is secured and economic growth picks up, we expect weakness in the retail sector to weigh on all-property rental values. In the near term, rising property yields in response to the bleak outlook for the retail sector and prolonged Brexit uncertainty are likely to weigh on capital values. If a deal is secured, we expect rising bond yields to put further upward pressure on property yields from next year. If a deal is not secured, we expect property yields to rise more quickly early next year, particularly if there is a no deal. However, lower interest rates and bond yields are likely to prevent property yields rising much higher over the following year or so.

  • Overview – Regardless of the outcome of the election and Brexit, we expect all-property returns to be weak over coming years. Indeed, even if a deal is secured and economic growth picks up, we expect weakness in the retail sector to weigh on all-property rental values. In the near term, rising property yields in response to the bleak outlook for the retail sector and prolonged Brexit uncertainty are likely to weigh on capital values. If a deal is secured, we expect rising bond yields to put further upward pressure on property yields from next year. If a deal is not secured, we expect property yields to rise more quickly early next year, particularly if there is a no deal. However, lower interest rates and bond yields are likely to prevent property yields rising much higher over the following year or so.
  • Economic Backdrop – With Brexit delayed and a general election ahead, we continue to present our forecasts in three scenarios (deal, no deal or repeated delay). A Conservative win would mean a combination of a harder Brexit and business friendly policies. A Labour win would mean a softer Brexit and business unfriendly policies. 
  • Investment Market – In the near term, we think that prolonged Brexit uncertainty will hold back investment and put upward pressure on property yields. Further ahead, we expect yields to continue to rise, particularly given weak retail rental value prospects. But how quickly they rise will depend on Brexit.
  • Office Market – A slowdown in employment growth is expected to weigh on office occupier markets. We expect Rest of UK offices to outperform as supply is tight and real rental values don’t look too high.
  • Retail Market – We expect retail rental values to fall for the next year or so. But, from 2022, we think that falls in vacancy, as floorspace declines but retail sales growth holds up, to support rental values.
  • Industrial Market – Slower rental value growth and higher yields are expected to cause industrial capital values to fall next year. But, given the shift in relative pricing in favour of industrial, yields are expected to rise less than in other sectors.
  • Leisure and Hotels – Hotel returns are expected to soften, as weak tourism flows weigh on demand for rooms and yields rise from historically low levels. The leisure sector is expected to outperform in the long term, supported by increasing real wages and changing consumer preferences towards experiences.

Main Forecasts

Table 1: All-Property Forecasts (Repeated Delays Scenario)*

 

2019 Q4

2020 Q1

2020 Q2

2020 Q3

2020 Q4

2021 Q4

2019-2023

2020-2023

ALL PROPERTY

Rental value growth, % y/y

-0.4

-0.5

-0.6

-0.3

-0.1

0.9

0.6

0.9

End qtr equiv. yield, %

5.7

5.8

5.9

5.9

6.0

6.0

5.9

5.9

Capital value growth, % y/y

-3.6

-3.8

-4.0

-4.2

-4.5

0.6

-0.7

0.0

Total return, % p.a

1.2

1.0

0.9

0.7

0.6

5.6

4.3

5.0

Source: Capital Economics

Table 2: All-Property Forecasts (January Deal Scenario)*

 

2019 Q4

2020 Q1

2020 Q2

2020 Q3

2020 Q4

2021 Q4

2019-2023

2020-2023

ALL PROPERTY

Rental value growth, % y/y

-0.4

-0.2

-0.1

0.2

0.8

1.5

1.1

1.5

End qtr equiv. yield, %

5.7

5.7

5.8

5.8

5.8

5.9

5.9

5.9

Capital value growth, % y/y

-3.6

-4.2

-4.6

-4.2

-1.8

0.0

-0.5

0.3

Total return, % p.a

1.2

0.8

0.5

0.9

3.3

5.2

4.8

5.8

Source: Capital Economics

Table 3: All-Property Forecasts (No Deal Scenario)*

 

2019 Q4

2020 Q1

2020 Q2

2020 Q3

2020 Q4

2021 Q4

2019-2023

2020-2023

ALL PROPERTY

Rental value growth, % y/y

-0.4

-0.8

-1.1

-1.3

-1.7

-0.6

-0.3

-0.3

End qtr equiv. yield, %

5.7

6.0

6.0

5.9

5.9

5.9

5.9

5.9

Capital value growth, % y/y

-3.6

-7.9

-8.9

-7.8

-5.7

0.1

-1.8

-1.3

Total return, % p.a

1.2

-2.8

-3.8

-2.8

-0.6

5.1

3.2

3.7

Source: Capital Economics

* We have chosen to illustrate the impact of different Brexit outcomes at the all-property level. At the sectoral level, we have shown our forecasts for the repeated delays scenario. However, in the near-term, a deal or no deal would have similar impacts on the sectors as the all-property average.


Main Forecasts

Table 4: Key Commercial Property Forecasts (Year End, Repeated Delays Scenario)

 

2018

2019

2020

2021

2022

2023

2019-2023

2020-2023

ALL PROPERTY

Rental value growth, % y/y

0.5

-0.4

-0.1

0.9

1.3

1.4

0.6

0.9

End yr equiv. yield, %

5.5

5.7

6.0

6.0

5.9

5.9

5.9

5.9

Capital value growth, % y/y

1.4

-3.6

-4.5

0.6

1.7

2.1

-0.7

0.0

Income return, % y/y

4.6

4.7

5.0

5.1

5.1

5.0

5.0

5.0

Total return, % p.a

6.0

1.2

0.6

5.6

6.8

7.1

4.3

5.0

OFFICE PROPERTY

Rental value growth, % y/y

0.8

1.3

0.9

1.1

1.2

1.3

1.1

1.1

End yr equiv. yield, %

5.6

5.7

5.9

5.9

5.9

5.9

5.9

5.9

Capital value growth, % y/y

2.1

0.8

-3.5

0.2

1.5

1.6

0.1

0.0

Income return, % y/y

4.0

4.1

4.4

4.4

4.4

4.4

4.3

4.4

Total return, % p.a

6.2

4.8

0.89

4.6

5.9

6.0

4.5

4.4

RETAIL PROPERTY

Rental value growth, % y/y

-2.2

-4.8

-2.6

0.0

1.1

1.3

-1.0

0.0

End yr equiv. yield, %

5.7

6.1

6.5

6.5

6.4

6.3

6.4

6.4

Capital value growth, % y/y

-5.3

-11.7

-8.1

0.6

2.2

2.7

-2.9

-0.7

Income return, % y/y

5.1

5.5

5.9

5.9

5.8

5.8

5.8

5.9

Total return, % p.a

-0.5

-6.2

-2.2

6.5

8.0

8.5

2.9

5.2

INDUSTRIAL PROPERTY

Rental value growth, % y/y

4.6

2.8

1.9

1.6

1.6

1.6

1.9

1.7

End yr equiv. yield, %

5.3

5.3

5.5

5.5

5.5

5.5

5.5

5.5

Capital value growth, % y/y

11.4

1.8

-1.2

1.0

1.3

1.9

1.0

0.7

Income return, % y/y

4.5

4.4

4.5

4.6

4.7

4.7

4.6

4.6

Total return, % p.a

16.4

6.2

3.3

5.6

6.0

6.6

5.5

5.4

LEISURE PROPERTY

Rental value growth, % y/y

1.2

0.4

0.8

1.5

1.9

1.9

1.3

1.5

End yr equiv. yield, %

5.7

5.8

6.0

6.0

5.9

5.8

5.9

5.9

Capital value growth, % y/y

0.6

-1.4

-2.2

1.5

3.6

2.8

0.9

1.4

Income return

5.3

5.4

5.6

5.6

5.5

5.5

5.5

5.6

Total return, % p.a

5.9

4.0

3.4

7.1

9.2

8.3

6.4

7.0

HOTELS PROPERTY

Rental value growth, % y/y

1.2

1.8

1.0

1.1

1.0

1.0

1.2

1.0

End yr equiv. yield, %

4.3

4.5

4.7

4.8

4.8

4.8

4.7

4.8

Capital value growth, % y/y

4.8

-2.2

-3.7

-1.0

1.0

1.0

-1.0

-0.7

Income return

4.3

4.5

4.7

4.8

4.8

4.8

4.7

4.8

Total return, % p.a

9.2

2.2

1.0

3.8

5.8

5.8

3.7

4.1

Sources: MSCI, Capital Economics

Table 5: Key UK Economic Forecasts (Year Average, Repeated Delays Scenario)

 

2017

2018

2019f

2020f

2021f

GDP, % y/y

1.9

1.4

1.3

1.0

1.5

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

1.06

1.38

0.52

0.63

0.63

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

1.19

1.28

0.75

0.75

0.75

CPI inflation, % y/y

2.7

2.5

1.8

1.7

1.7

$/£ (end-period)

1.35

1.28

1.25

1.25

1.25

Euro/£ (end-period)

1.13

1.11

1.14

1.19

1.19

Household spending, % y/y

2.3

1.6

1.2

1.5

1.6

Unemployment rate (ILO measure), %

4.4

4.1

3.9

3.9

3.9

Employment, % y/y

1.0

1.2

1.2

0.6

0.5

Average earnings, % y/y

2.3

2.9

3.7

3.5

3.3

Nationwide house prices, % y/y in Q4

3.1

0.5

1.0

1.5

2.0

Sources: Refinitiv, Capital Economics


Sectoral Rankings

Chart 1: CE Forecasts for Rental Value Growth in 2019 (% y/y)

Chart 2: CE Forecasts for Rental Value Growth in 2019 to 2023 (% y/y)

Chart 3: CE Forecasts for Capital Value Growth in 2019 (% y/y)

Chart 4: CE Forecasts for Capital Value Growth in 2019 to 2023 (% y/y)

Chart 5: Equivalent Yields, Q3 2019 (%)

Chart 6: Equivalent Yields, Q4 2023 (%)

Chart 7: CE Forecasts for Total Returns in 2019

(% p.a)

Chart 8: CE Forecasts for Total Returns in 2019 to 2023

(% p.a)

Sources: MSCI, Capital Economics


Economic Backdrop

Outlook shaped by Brexit and the election

  • While prolonged Brexit-related uncertainty has weighed on UK GDP growth, softer global growth means that the outlook for the UK economy has weakened. Unless a deal is secured, we see little upside to GDP growth and interest rates over the next few years.
  • Although the UK avoided a recession in Q3, the 0.3% q/q rise in GDP suggests that the economy failed to regain much momentum after Q2’s 0.2% q/q contraction. And we expect growth to remain weak in Q4, at 0.2% q/q. (See Chart 9.) This is consistent with the IHS Markit/CIPS PMIs, which suggest that there is little momentum in the economy. (See Chart 10.)
  • We continue to provide clients with three main Brexit scenarios: a deal by 31st January; repeated Brexit delays; and a no deal on the 31st January. However, the general election on 12th December will have important implications for the outcome of Brexit and the economy.
  • As noted in an UK Economics Update, a Conservative majority would mean more business friendly policies but a harder Brexit. In contrast, a Labour win would mean less business-friendly policies, but a softer Brexit.
  • While we try not to place too much weight on our probabilities, given the combination of possible election results and implications for Brexit, we think that there is a 45% chance of a delay, a 35% chance of a deal, a 15% chance of a no deal and a 5% chance of remain.
  • With the outlook for global growth weaker, we have revised down our forecasts for GDP growth in all three scenarios.
  • That said, the only scenario where we think a recession would occur is if there is a no deal exit. (See Chart 11.) In particular, we think that a slowdown in employment growth and lower real incomes would weigh heavily on consumer spending growth. (See Chart 12.)
  • However, we also expect that cuts to Bank Rate and fiscal stimulus would support GDP growth further out. (See Chart 13.) In turn, the recession would be relatively shallow and GDP growth would rebound to around 2% by 2021.
  • If Brexit is delayed again, continued uncertainty would deter household spending and business investment. (See Chart 14.) As a result, we predict GDP growth will slow to 1% y/y in 2020. In addition, we expect inflation to remain below target over the forecast horizon. (See Chart 15.) As such, we think that the Monetary Policy Committee will need to cut Bank Rate next year. We have pencilled in a 25bps cut from 0.75% to 0.5%.
  • In contrast, if a deal is struck and business confidence rebounds, we expect business investment to recover. In turn, we predict GDP to rise by 1.3% y/y in 2020 and 2.2% y/y in 2021. Moreover, we expect Bank Rate to be increased to 1.5% by end-2021 and 10-year gilt yields to rise over coming years. (See Chart 16.)

Economic Backdrop

Chart 9: UK GDP Growth

Chart 10: Activity PMIs

Chart 11: GDP in Different Brexit Outcomes (% y/y)

Chart 12: Consumer Spending (% y/y)

Chart 13: Bank Rate (%)

Chart 14: Business Investment (% y/y)

Chart 15: CPI Inflation (% y/y)

Chart 16: 10-Year Gilt Yields (%)

Sources: Refinitiv, IHS Markit, Capital Economics


Investment Market

Yields to rise in near term, even if Bank Rate cut

  • After a subdued first half of the year, there was some pick-up in investment activity in Q3. (See Chart 17.) That said, compared to Q3 last year, the value of deals completed was almost 30% lower. With Brexit further delayed, we expect investors to remain cautious. Indeed, there have been no signs of an improvement in investment enquiries. (See Chart 18).
  • As such, we expect property yields to continue to edge up in the near term. This is even though property looks favourably priced compared to bonds, with 10-year gilt yields near historically low levels. (See Chart 19). However, property continues to look expensive compared to equity dividend yields.
  • Further ahead, regardless of the outcome of Brexit, we expect that weak retail rental prospects will hold back investment and put further upward pressure on property yields.
  • Indeed, as discussed in a recent Focus, we think that falls in retail rental values will weigh heavily on the all-property average over the next couple of years. (See Chart 20).
  • However, the outcome of Brexit is likely to determine how quickly property yields rise. (See our Update.) If a deal is done by 31st January, we expect increases in Bank Rate and bond yields to contribute to further increases in property yields next year. That said, the wide bond to property yield spread means that the rise would be gradual.
  • If a deal is not agreed, we think that property yields would increase more quickly in the near term, particularly if there is a no deal on 31st January. However, lower interest rates and bond yields than in our deal scenario would prevent property yields from rising much further over the following year or so.
  • By sector, we expect Central London office and standard shop yields to increase the most. After all, the spread between the current level of net initial yield and the 10-year bond yield is much lower than its 10-year average for each of these sectors. (See Chart 21). This suggests that they are most susceptible to yield rises.
  • Admittedly, the past 10 years is an arbitrary comparison. But we think that it captures most of the structural change towards online spending in recent years, which has shifted relative pricing in favour of industrial property, at the expense of retail.
  • As such, including the rise in equivalent yields already experienced since the end of 2018, shopping centre and retail warehouses are likely to increase the most over this cyclical downturn. (See Chart 22).
  • With yield rises offsetting rental value growth, we expect all-property capital values to fall until 2021. How much they fall depends on the Brexit outcome. We have pencilled in cumulative falls in capital values of 5%, 7% and 9% under a deal, repeated delay or no deal respectively. (See Chart 23.)
  • The upshot is that all-property returns are likely to remain soft for the next couple of years, even if a Brexit deal is done. (See Chart 24.) Although not the most probable outcome, if there was a no deal Brexit, all-property returns are likely to go negative temporarily.
  • Within the all-property average, we expect Rest of UK industrial and office property to outperform, with returns averaging almost 7% a year between 2019 and 2023. In contrast, average returns for shopping centres and shops are likely to be lower at around 2%.

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: GDP and All-Property Rental Value Growth Scenarios (% y/y)

Chart 21: Net Initial Less 10-Yr Gilt Yields by Sector

(Difference from 10-Yr Average, Bps)

Chart 22: Change in Equivalent Yields (Bps)

Chart 23: Cumulative Change in All-Property Capital Values (%, 2019 to 2021)

Chart 24: Total Returns Scenarios (Year End, % p.a)

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


Office Market

Office rental value growth to slow in 2020

  • Office rental value growth picked up to 1.3% y/y in Q3, from 1.1% in Q2. We think that rental value growth will hold up in Q4. But, next year, we expect a slowdown in employment growth to weigh on occupier demand and rental values.
  • At 1.5% y/y, the pace of rental value growth in Central London in Q3 was faster than in the regions. It was also much stronger than expected earlier in the year by the IPF Consensus. However, there are early signs that occupier demand is softening, which will weigh on rental values. Indeed, take-up in the third quarter was 15% lower than in Q3 last year. (See Chart 25.)
  • In the regions, take-up was also generally lower in Q3 compared to the year earlier. The exceptions were Liverpool and Glasgow, where take-up was also well above its five-year average. That said, take-up in Glasgow was boosted by the 272,800 sq. ft. pre-sale of One Central by JP Morgan Chase, which accounted for almost 80% of total city centre take-up.
  • Even so, the recent strength of take-up in Glasgow is consistent with the fact that the pace of decline in Scottish rental values has slowed. This was an important driver of the improvement in Rest of UK rental value growth. (See Chart 26.)
  • However, deeper cracks are starting to appear in the labour market, which are expected to weigh on office occupier demand. In the three months to September, 58,000 jobs were lost. This compares to an increase of 114,000 in the three months to June. In addition, employment growth slowed to 0.9% y/y, down from 1.5% y/y at the start of the year.
  • Admittedly, office-based employment grew by 2.6% y/y in Q2, the strongest pace in three years. But, as discussed in an Update, recent weakness in economy activity and falling job vacancies suggest that office-based employment growth has peaked. (See Chart 27.) As such, we expect office rental value growth to slow next year.
  • However, unless there is a no deal Brexit, we don’t expect office rental values to fall. In Central London, this reflects that current rates of rental value growth appear low given the tightness in the market. (See Chart 28.) As such, we think that there is some room for the market to absorb softer occupier demand. In fact, as we mentioned here, this could pose upside risk to our forecasts.
  • That said, the Central London vacancy rate ticked up slightly in Q3, suggesting that some of the tightness in the market is waning. Further, the rapid pace of expansion of flexible office providers also appears to be slowing.
  • In addition, with space under construction expected to increase to 8m sq. ft. next year, we think that the vacancy rate will continue to rise. (See Chart 29.) This is expected to prevent rental value growth accelerating, even if a deal is secured.
  • In the regions, we expect tight supply to support rental values, even as occupier demand reduces. Indeed, on average, there is less than one year’s worth of supply based on average annual take-up over the past five years. (See Chart 30.) Supply conditions in Liverpool, Edinburgh and Bristol look particularly tight.

Office Market

Chart 25: City Centre Office Take-Up (000s Sq. Ft.)

Chart 26: Rest of UK Rental Value Growth (% y/y)

Chart 27: Office-Based Vacancies (000s)

Chart 28: Central London Vacancy Rate and Rental Value Growth

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

Chart 30: Years of Supply in the Regions (Based on 5-Yr Avg. Take-Up)

Chart 31: RICS Surveyors Expecting Rising Office Rental Values (% Net Bal)

Chart 32: Rest of South East Real Office Rental Values and Historical Trend

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

Office Market

Rest of UK to outperform

  • We expect tighter supply to contribute to stronger rental value growth in the regions than in Central London over the coming years.
  • Admittedly, the net balance of RICS surveyors in Q3 expecting rental values to rise outside of London dropped to just 2%, the lowest since after the 2016 EU referendum. (See Chart 31 on the previous page.) But the decline was not broad-based, and the balance remained stronger than for London.
  • This is consistent with the fact that real rental values for Central London offices look high relative to their historical trends, particularly in the City of London. This suggests that rental values have less scope to rise.
  • In contrast, real rental values for Rest of UK offices are in line with their historical trend. However, the same cannot be said for the Rest of the South East. (See Chart 32 on the previous page.) As such, within the regions, we expect Rest of UK rental value growth to be stronger, averaging 1.6% a year over the next five years.
  • As a result, between 2020 and 2023, we only expect average rental value growth in the Rest of UK to be stronger than current rates. (See Chart 33.)
  • However, in the near term, we expect the impact of further increases in office yields to offset positive rates of rental value growth on capital values, even in the Rest of UK.
  • Investors have already started pricing in a weaker outlook for City offices, with yields rising by more than 10bps over the past year. But, so far, other office yields have been relatively unaffected.
  • However, given West End equivalent yields are both low relative to their history and compared to other sectors, we think that they look most susceptible to yield increases in the coming year or so. We have pencilled in increases in equivalent yields of around 40bps in both the City and West End. (See Chart 34.)
  • Although we expect Central London office yields to increase the most over coming years, we do not expect them to return to their previous highs. This reflects that the equilibrium interest rate has fallen over time, which, all else equal, suggests that bond and property yields will also be lower than in the past.
  • However, with Rest of South East and Rest of UK equivalent yields more than 100bps higher than yields in the City of London, we think that the rise in yields there will be more moderate.
  • In turn, we expect office capital values to fall over the rest of this year and next. (See Chart 35.) However, in 2021, we forecast capital value growth to turn positive. Indeed, we expect the improving outlook for economic growth and office occupier demand to support a pick-up in rental value growth and office yields to stabilise.
  • The bigger picture is that returns for the Rest of UK office market are likely to outperform other office sectors. We forecast average returns of 6.6% a year in the Rest of UK between 2019 and 2023. (See Chart 36.) Returns in the Rest of South East are likely to be a bit lower, averaging around 4.8% a year.

Office Market

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

Chart 34: Office Equivalent Yields (%, Repeated Delays Scenario)

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

Chart 36: Office Property Forecasts (% y/y, 2019-23, Annual Average, Repeated Delays Scenario)

Sources: MSCI, Capital Economics

Table 6: CE Office Sector Forecasts (% y/y, Year-End, Repeated Delays Scenario)

 

2018

2019

2020

2021

2022

2023

2018

2019

2020

2021

2022

2023

All Office

Rest of South East 31% of office stock by value

Rental value growth

0.8

1.3

0.9

1.1

1.2

1.3

Rental value growth

1.2

1.2

0.9

1.1

1.2

1.3

End yr equiv. yield, %

5.6

5.7

5.9

5.9

5.9

5.9

End yr equiv. yield, %

6.3

6.4

6.7

6.6

6.6

6.6

Capital value growth

2.1

0.8

-3.5

0.2

1.5

1.6

Capital value growth

2.0

-0.3

-3.0

1.4

1.7

1.3

Income return

4.0

4.1

4.4

4.4

4.4

4.4

Income return

4.4

4.4

4.7

4.7

4.7

4.7

Total return, % p.a

6.2

4.8

0.9

4.6

5.9

6.0

Total return, % p.a

6.5

4.1

1.7

6.1

6.4

6.0

London City 11% of office stock by value

Rest of UK 23% of office stock by value

Rental value growth

1.4

1.0

0.5

0.7

0.9

1.0

Rental value growth

0.8

1.7

1.2

1.6

1.7

1.7

End yr equiv. yield, %

5.2

5.4

5.8

5.7

5.7

5.7

End yr equiv. yield, %

6.7

6.6

6.8

6.8

6.8

6.7

Capital value growth

3.1

-1.9

-5.8

1.1

1.3

1.4

Capital value growth

3.0

3.5

0.3

-1.1

2.5

2.8

Income return

3.7

3.7

4.2

4.2

4.2

4.2

Income return

4.9

4.8

5.0

5.0

5.0

5.0

Total return, % p.a

6.9

1.7

-1.5

5.3

5.4

5.5

Total return, % p.a

8.0

8.3

5.3

3.9

7.5

7.8

London West End 35% of office stock by value

Rental value growth

-0.1

1.3

0.7

0.8

0.9

1.2

End yr equiv. yield, %

4.4

4.5

4.8

4.8

4.8

4.8

Capital value growth

1.3

0.8

-5.7

-0.2

0.9

1.2

Income return

3.3

3.4

3.7

3.8

3.8

3.8

Total return, % p.a

4.6

4.3

-1.9

3.5

4.7

5.0

Sources: MSCI, Capital Economics


Retail Market

Rents to rise in 2022

  • Retail rental values fell by 4.2% y/y in Q3, the 6th consecutive quarterly fall on this basis. We think that rental value declines are likely to worsen in the near term, even if a Brexit deal is secured.
  • For one, a simple extrapolation suggests that, if the same pace of store closures seen so far this year continues, a further 300 retail stores could close by the end of the year. With almost 40% of the market over-rented, if they are re-let, it is likely to be at lower rents.
  • Further, even though the use of Company Voluntary Agreements (CVAs) appears to have peaked, the ongoing impacts are likely to continue to be felt in the market. (See our Update). Mothercare is a recent example. They had already entered a CVA which resulted in 55 store closures. But in early November they fell into administration, with all 79 remaining stores to close.
  • And the downturn is shifting from the regions into London, with rental value growth slowing from more than 2% y/y a year ago to minus 0.4% y/y and minus 0.1% y/y in Q3 in the City and West End respectively.
  • This is consistent with the Q3 RICS Commercial Market survey which showed that surveyors do not expect any improvement in retail rents over the next year. (See Chart 37.)
  • That said, as discussed in our Focus, we think that rental values could rise as early as 2022 as the retail oversupply starts to reduce while retail sales growth is expected to be solid, allowing vacancy to decline.
  • Indeed, if we are right that floorspace productivity will be higher than its historical average, our calculations suggest that retail floorspace could start to decline in 2022. (See Chart 38.)
  • Admittedly, in-store retail sales growth has softened this year, from 2.6% y/y in Q1 to 0.7% y/y in Q3. Based on past form, this would be consistent with some weakness in rents. But given real wage growth is forecast to hold up at a bit below 2%, we expect retail sales growth to pick up. (See Chart 39.) That said, if there were a no deal Brexit, there would be a greater risk that rental values would not recover within the forecast horizon.
  • The retail sub-sectors are not expected to perform equally. In particular, shopping centre and retail warehouse rental values are expected to fall the most. This is consistent with the fact that vacancy has increased by more over the past two years in these two sub-sectors. (See Chart 40.)
  • This view also appears to be shared by investors. Indeed, over 2019, shopping centre and retail warehouse equivalent yields have risen by around 30bps, compared to just 14bps for shops.
  • Given the bleak rental prospects, in the near term, we think that all-retail yields will rise by more than office and industrial yields. As a result, the sector is expected to be the highest yielding over the forecast horizon. This compares to history, where it was the lowest. (See Chart 41.)
  • As such, between 2019 and 2023, retail returns are expected to lag other sectors, averaging just 2.9% per year. Within the all-retail total, although capital values are also expected to fall sharply, retail warehouses are expected to outperform on average over the next five years. (See Chart 42.)

Retail Market

Chart 37: Retail Rental Values and Rental Expectations

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

Chart 39: Retail Rental Values and Consumer Spending (% y/y, Repeated Delays Scenario)

Chart 40: Change in Vacant Retail Units

(%, 2017 Q3 to 2019 Q3)

Chart 41: Equivalent Yields

(%, Repeated Delays Scenario)

Chart 42: Retail Property Forecasts (% y/y, 2019-23, Annual Average, Repeated Delays Scenario)

Sources: MSCI, Refinitiv, VOA, RICS, Capital Economics

Table 7: CE Retail Sector Forecasts (% y/y, Year-End, Repeated Delays Scenario)

 

2018

2019

2020

2021

2022

2023

2018

2019

2020

2021

2022

2023

All Retail

Shopping Centres 23% of retail stock by value

Rental value growth

-2.2

-4.8

-2.6

0.0

1.1

1.3

Rental value growth

-2.6

-6.0

-3.0

0.0

0.0

0.5

End yr equiv. yield, %

5.7

6.1

6.5

6.5

6.4

6.3

End yr equiv. yield, %

6.5

7.1

7.5

7.4

7.4

7.3

Capital value growth

-5.3

-11.7

-8.1

0.6

2.2

2.7

Capital value growth

-9.5

-14.4

-7.6

0.4

0.5

1.9

Income return

5.1

5.5

5.9

5.9

5.8

5.8

Income return

4.9

5.5

5.8

5.9

6.0

5.9

Total return, % p.a

-0.5

-6.2

-2.2

6.5

8.0

8.5

Total return, % p.a

-5.0

-8.9

-1.7

6.3

6.5

7.8

Retail Warehouses – 47% of retail stock by value

Standard Shops – 31% of retail stock by value

Rental value growth

-2.4

-4.8

-2.5

0.0

1.2

1.4

Rental value growth

-1.9

-4.0

-2.5

0.0

1.8

1.8

End yr equiv. yield, %

6.1

6.7

7.1

7.0

6.9

6.8

End yr equiv. yield, %

4.8

5.1

5.5

5.4

5.4

5.3

Capital value growth

-6.5

-12.7

-7.3

0.7

2.7

2.9

Capital value growth

-3.0

-8.2

-9.7

0.6

2.6

2.9

Income return

5.6

6.3

6.6

6.6

6.5

6.4

Income return

4.3

4.5

4.9

4.9

4.8

4.8

Total return, % p.a

-1.2

-6.5

-0.7

7.3

9.1

9.3

Total return, % p.a

1.1

-3.7

-4.8

5.4

7.4

7.7

Sources: MSCI, Capital Economics


Industrial Market

Rental value growth to slow as supply increases

  • Although the outlook for demand is stable, the increasing supply of industrial space is expected to cause rental value growth to slow over the coming years. Combined with increases in yields, we expect capital values to fall next year. However, given the structural shift in consumer preferences towards online spending and urbanisation, which has generated new demand for industrial property, we don’t expect capital values to fall as much as in other traditional sectors.
  • According to JLL, grade A logistics take-up in Q3 increased by 8.9% q/q to around 6.6 million sq. ft.. (See Chart 43.) And even excluding the 2.9m sq. ft. leased to Jaguar Land Rover, take-up was still slightly higher than in Q3 2018. Although UK GDP growth is expected to weaken, we think that demand for industrial space will remain buoyant, as the share of retail sales made online continues to increase.
  • Even though the outlook for demand is solid, we think that increases in industrial supply will put upward pressure on vacancy rates. Indeed, supply of grade A logistics space has steadily increased since 2016 and, at the end of Q3 2019, was 29% above the 10-year average. (See Chart 44.)
  • Further, a net balance of 3% of RICS surveyors reported falling industrial availability in Q3, down from 9% in Q2. That said, fewer RICS surveyors reported an increase in developments under construction in Q3, which could suggest that new supply is reaching a peak.
  • We predict rental value growth to slow from its Q3 pace of 3.3% y/y to 2.8% y/y in Q4. This is consistent with RICS surveyors’ rental expectations, which have been falling for over a year. (See Chart 45.)
  • We expect rental value growth to slow the most in the Rest of South East. Indeed, real rental values in the Rest of South East appear particularly stretched, suggesting that there is limited scope for the pace of rental value growth to increase. (See Chart 46.)
  • Over the next five years, we forecast rental value growth to average 2% a year in the Rest of South East and 1.7% a year in the Rest of UK, below their respective five-year averages.
  • Lower expectations for rental value growth are likely to put upward pressure on yields. Industrial equivalent yields have already increased by 5bps over the past year. And we anticipate a further 24bps rise by the end of 2022. (See Chart 47.) This reflects our view that industrial yields have reduced too far, partly due to overly optimistic expectations of investors about future rental value growth.
  • However, given we think that there has been a relative pricing shift in favour of industrial property, this upward shift is less than the 42bps increase in equivalent yields that we forecast on average across all sectors.
  • In turn, we expect industrial total returns to average 5.5% a year over the next five years. (See Chart 48.) This is a sharp slowdown from returns of over 20% just over a year ago. Even so, industrial property will continue to outperform the other traditional property sectors.

Industrial Market

Chart 43: Logistics Take-Up and Vacancy)

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

Chart 45: Industrial Rental Value Growth and RICS Rental Expectations

Chart 46: Industrial Rental Values (% Above/Below Historical Trend)

Chart 47: Industrial Equivalent Yields (%)

Chart 48: Industrial Property Forecasts (% y/y, 2019-23, Annual Average, Repeated Delays Scenario)

Sources: JLL, MSCI, RICS, Capital Economics

Table 8: CE Industrial Sector Forecasts (% y/y, Year-End, Repeated Delays Scenario)

 

2018

2019

2020

2021

2022

2023

2018

2019

2020

2021

2022

2023

All Industrial

Rest of UK Industrial 35% of industrial stock by value

Rental value growth

4.6

2.8

1.9

1.6

1.6

1.6

Rental value growth

2.9

1.8

1.6

1.7

1.8

1.8

End yr equiv. yield, %

5.3

5.3

5.5

5.5

5.5

5.51

End yr equiv. yield, %

5.9

6.0

6.1

6.1

6.1

6.00

Capital value growth

11.4

1.8

-1.2

1.0

1.3

1.9

Capital value growth

7.2

0.3

-0.4

1.7

2.6

2.6

Income return

4.5

4.4

4.5

4.6

4.7

4.7

Income return

5.2

5.1

5.2

5.2

5.3

5.2

Total return, % p.a

16.4

6.2

3.3

5.6

6.0

6.6

Total return, % p.a

12.8

5.4

4.8

6.9

7.9

7.9

South East Industrial 65% of industrial stock by value

Rental value growth

5.7

3.4

2.1

1.6

1.5

1.5

End yr equiv. yield, %

4.9

5.0

5.2

5.2

5.3

5.25

Capital value growth

13.9

2.6

-1.7

0.6

0.5

1.5

Income return

4.1

4.0

4.2

4.3

4.4

4.4

Total return, % p.a

18.5

6.6

2.5

4.9

5.0

5.9

Sources: MSCI, Capital Economics


Leisure and Hotels

Bleak near-term outlook for alternative sectors

  • With yields expected to rise in the leisure and hotel sectors, total returns look set to continue their downward trend this year and next. Further ahead, hotel returns are expected to be soft. But the outlook for leisure is more positive.
  • Leisure capital value growth fell to minus 1.6% y/y in Q3, from minus 0.8% y/y in Q2. That was driven by a 10bps rise in equivalent yields. (See Chart 49.) Meanwhile, leisure rental value growth continued to weaken, despite stronger real wage growth. Indeed, rental growth was unchanged at the two-year low of 1% y/y in Q3, while average pay growth rose to 1.8% y/y, from 1.4% y/y in Q2.
  • We think that ongoing Brexit uncertainty is partly to blame. While consumers have the ability to spend, weaker economic sentiment appears to have caused households to postpone consumption. So rental growth will probably slow further until this improves. (See Chart 50.) And changing consumer preferences are also keeping a lid on rents. Indeed, certain types of leisure have struggled, such as food & beverage. In turn, MSCI leisure vacancy rates rose to 12.4% in Q3, compared to 8.2% in Q3 2018.
  • That said, the fundamentals are supportive of rents going forward. We expect real wage growth to remain strong at around 1% a year over the longer term. This would be consistent with a pick-up in rental value growth further ahead, especially if Brexit-related uncertainty eases.
  • Over the longer term, we expect the leisure sector to outperform, with total returns averaging 6.4% a year between 2019 and 2023, compared to the all-property average of 4.3% a year. (See Chart 51.)
  • Hotel capital value growth edged down from 3.1% y/y in Q2 to a six-year low of 2.6% y/y in Q3. We think a couple of factors are behind the fall. First, equivalent yields have risen by around 24bp since the end of last year. And second, a fall in the number of foreign visitors has weighed on demand for hotel rooms. (See Chart 52.)
  • Looking ahead, our tourist demand indicator suggests that the prospects for a sustained pick-up in demand are limited. (See Chart 53.) In particular, as we argued in our recent Update, weak growth in the euro-zone over the next year or so will keep a lid on any rise in tourist flows, since the region accounts for over 70% of foreign visitors to the UK.
  • Admittedly, domestic demand will probably hold up better since real wage growth looks set to remain fairly robust in the UK. But consumption data shows that households have curtailed spending in the recent past. And, importantly, spending on hotels has fallen to an even greater extent.
  • Even if demand did pick-up, we doubt it would have any meaningful impact on rents and capital values as the hotel supply pipeline looks solid. Indeed, the government estimated in a recent policy paper that a further 130,000 rooms will be available by 2025, that’s an increase of around 14% on 2018.
  • Hotel returns are expected to fall to around 2.2% in 2019 then to around 1% in 2020. Granted, we expect to see some improvement in total returns further ahead. But even so, returns are only set to average around 3.7% between 2019 and 2023. That’s below the outturn for 2018 of 9.2% and the all-property average in the forecast. (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, Repeated Delays Scenario)

Chart 52: UK Visitor Numbers and Trend (000s)

Chart 53: Tourist Demand Indicator & UK Capital Values (% y/y)

Chart 54: Hotel Property Forecasts (% y/y, Repeated Delays Scenario)

Sources: ONS, Refinitiv, MSCI, Capital Economics

Table 9: CE Leisure and Hotel Sector Forecasts (% y/y, Year-End, Repeated Delays Scenario)

2018

2019

2020

2021

2022

2023

 

2018

2019

2020

2021

2022

2023

All Leisure

All Hotels

Rental value growth

1.2

0.4

0.8

1.5

1.9

1.9

Rental value growth

1.2

1.8

1.0

1.1

1.0

1.0

End yr equiv. yield, %

5.7

5.8

6.0

6.0

5.9

5.8

End yr equiv. yield, %

4.3

4.5

4.7

4.8

4.8

4.8

Capital value growth

0.6

-1.4

-2.2

1.5

3.6

2.8

Capital value growth

4.8

-2.2

-3.7

-1.0

1.0

1.0

Income return

5.3

5.4

5.6

5.6

5.5

5.5

Income return

4.3

4.5

4.7

4.8

4.8

4.8

Total return, % p.a

5.9

4.0

3.4

7.1

9.2

8.3

Total return, % p.a

9.2

2.2

1.0

3.8

5.8

5.8

Sources: MSCI, Capital Economics


Andrew Burrell, Chief Property Economist, +44 20 7811 3909, andrew.burrell@capitaleconomics.com
Amy Wood, Property Economist, +4420 7808 4994, amy.wood@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