Returns to weaken regardless of Brexit - Capital Economics
UK Commercial Property

Returns to weaken regardless of Brexit

UK Commercial Property Outlook
Written by Andrew Burrell
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Regardless of the Brexit outcome, we expect all-property returns to be squeezed as a result of weakness in the retail sector. However, as Brexit could dramatically alter the near-term outlook for the economy and UK commercial property, we are publishing three sets of all-property forecasts based on different Brexit outcomes. Under a no deal, returns could contract in the near-term, as property yields jump and rental values are hit. But, cuts to interest rates would prevent further rises. If a deal is secured, we expect higher interest rates to put upward pressure on yields and cause sharper falls in capital values from next year. If Brexit is repeatedly delayed, yields could increase a bit more in the near term but we would expect interest rates to rise by less. Nevertheless, under any Brexit scenario, the economy could be growing around 2% y/y by 2021, which would support a recovery in all-property rental values.

  • Overview – Regardless of the Brexit outcome, we expect all-property returns to be squeezed as a result of weakness in the retail sector. However, as Brexit could dramatically alter the near-term outlook for the economy and UK commercial property, we are publishing three sets of all-property forecasts based on different Brexit outcomes. Under a no deal, returns could contract in the near-term, as property yields jump and rental values are hit. But, cuts to interest rates would prevent further rises. If a deal is secured, we expect higher interest rates to put upward pressure on yields and cause sharper falls in capital values from next year. If Brexit is repeatedly delayed, yields could increase a bit more in the near term but we would expect interest rates to rise by less. Nevertheless, under any Brexit scenario, the economy could be growing around 2% y/y by 2021, which would support a recovery in all-property rental values.
  • Economic Backdrop – Underlying growth slowed over the first half of 2019, but we expect some recovery in Q3. Beyond this, much will depend on the outcome of Brexit. However, three economic trends will also be important: resilience of domestic demand, looser fiscal policy and above-target inflation.
  • Investment Market – Investment activity is likely to remain subdued whatever the Brexit outcome. Indeed, concerns about retail rental value prospects continue to push up retail yields. However, further ahead, Brexit is likely to determine when, and how quickly, yields rise in other sectors.
  • Office Market – A slowdown in employment growth is expected to weigh on office occupier markets. However, we expect regional office rental value growth to outperform Central London as supply pipelines appear more constrained.
  • Retail Market – Retail rental values are expected to fall further amid an oversupply of property. However, once this oversupply is reduced, solid rates of consumer spending growth should spark a recovery.
  • Industrial Market – Slower rental value growth and higher yields are expected to cause industrial capital values to fall, but, given the shift in relative pricing in favour of industrial, this will be by less than other traditional sectors.
  • Leisure and Hotels – With yields still near historically low levels, we think that they will continue to rise, weighing on hotel and leisure returns. However, in the longer term, the leisure sector is expected to outperform, supported by increasing real wages and changing consumer preferences towards experiences.

Main Forecasts

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

 

2019 Q3

2019 Q4

2020 Q1

2020 Q2

2020 Q3

2020 Q4

2021 Q4

2019-2023

ALL PROPERTY

Rental value growth, % y/y

-0.5

-0.7

-0.5

-0.3

-0.1

0.1

1.2

0.7

End qtr equiv. yield, %

5.6

5.7

5.8

5.8

5.9

5.9

6.0

6.0

Capital value growth, % y/y

-2.9

-4.5

-4.2

-3.9

-3.6

-3.3

-1.0

-1.3

Total return, % p.a

1.7

0.4

0.8

1.1

1.5

1.8

4.2

3.8

Source: Capital Economics

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

 

2019 Q3

2019 Q4

2020 Q1

2020 Q2

2020 Q3

2020 Q4

2021 Q4

2019-2023

ALL PROPERTY

Rental value growth, % y/y

-0.5

-0.7

-0.3

0.2

0.6

1.0

1.6

1.1

End qtr equiv. yield, %

5.6

5.6

5.6

5.7

5.8

5.9

6.0

6.0

Capital value growth, % y/y

-2.9

-2.5

-2.7

-3.4

-3.1

-4.2

-0.8

-0.8

Total return, % p.a

1.7

2.3

2.2

1.5

1.9

0.9

4.4

4.3

Source: Capital Economics

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

 

2019 Q3

2019 Q4

2020 Q1

2020 Q2

2020 Q3

2020 Q4

2021 Q4

2019-2023

ALL PROPERTY

Rental value growth, % y/y

-0.5

-0.7

-0.8

-1.0

-1.3

-1.2

-0.5

-0.2

End qtr equiv. yield, %

5.6

5.9

5.9

5.9

6.0

6.0

6.0

6.0

Capital value growth, % y/y

-2.5

-7.5

-7.9

-8.1

-7.9

-3.7

-0.2

-2.1

Total return, % p.a

1.7

-2.4

-2.8

-3.0

-2.7

1.5

5.0

3.1

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

-0.7

0.1

1.2

1.4

1.5

0.7

1.1

End yr equiv. yield, %

5.5

5.7

5.9

6.0

6.1

6.1

6.0

6.0

Capital value growth, % y/y

1.4

-4.5

-3.3

-1.0

0.9

1.4

-1.3

-0.5

Income return, % y/y

4.6

4.9

5.1

5.2

5.2

5.2

5.1

5.2

Total return, % p.a

6.0

0.4

1.8

4.2

6.1

6.6

3.8

4.7

OFFICE PROPERTY

Rental value growth, % y/y

0.8

0.7

1.1

1.4

1.6

1.6

1.3

1.4

End yr equiv. yield, %

5.6

5.7

6.0

6.1

6.1

6.1

6.0

6.1

Capital value growth, % y/y

2.1

-1.3

-2.7

-2.3

1.3

1.5

-0.7

-0.5

Income return, % y/y

4.0

4.3

4.5

4.7

4.7

4.7

4.6

4.6

Total return, % p.a

6.2

2.9

1.8

2.4

6.0

6.2

3.9

4.1

RETAIL PROPERTY

Rental value growth, % y/y

-2.2

-4.8

-2.2

0.6

1.1

1.3

-0.8

0.2

End yr equiv. yield, %

5.7

6.1

6.3

6.4

6.4

6.4

6.3

6.4

Capital value growth, % y/y

-5.3

-11.6

-5.8

-0.3

1.1

1.3

-3.1

-0.9

Income return, % y/y

5.1

5.9

6.1

6.2

6.2

6.2

6.1

6.2

Total return, % p.a

-0.5

-5.7

0.3

5.9

7.3

7.5

3.1

5.3

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

5.6

5.7

5.7

5.6

5.6

Capital value growth, % y/y

11.4

1.3

-1.0

-0.7

0.3

1.6

0.3

0.0

Income return, % y/y

4.5

4.5

4.7

4.8

4.9

4.9

4.8

4.8

Total return, % p.a

16.4

5.8

3.7

4.1

5.2

6.5

5.0

4.9

LEISURE PROPERTY

Rental value growth, % y/y

1.2

0.4

1.2

1.5

1.9

1.9

1.4

1.6

End yr equiv. yield, %

5.7

5.8

5.9

6.0

6.1

6.1

6.0

6.0

Capital value growth, % y/y

0.6

-1.4

-0.7

-0.5

1.1

1.1

-0.1

0.2

Income return

5.3

5.4

5.6

5.7

5.7

5.8

5.6

5.7

Total return, % p.a

5.9

4.0

4.9

5.1

6.8

6.8

5.5

5.9

HOTELS PROPERTY

Rental value growth, % y/y

1.2

1.7

1.2

1.1

1.0

1.0

1.2

1.1

End yr equiv. yield, %

4.3

4.5

4.7

4.8

4.9

4.9

4.7

4.8

Capital value growth, % y/y

4.8

-3.2

-2.1

-1.4

-0.5

0.2

-1.4

-0.9

Income return

4.3

4.5

4.7

4.8

4.9

4.9

4.8

4.8

Total return, % p.a

9.2

1.3

2.6

3.4

4.4

5.1

3.4

3.9

Sources: MSCI, Capital Economics

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

 

2017

2018

2019f

2020f

2021f

GDP, % y/y

1.8

1.4

1.4

1.5

2.0

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

1.06

1.38

0.80

1.10

1.50

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

1.19

1.28

1.00

1.25

1.75

CPI inflation, % y/y

2.7

2.5

1.9

2.2

2.3

$/£ (end-period)

1.35

1.28

1.25

1.30

1.35

Euro/£ (end-period)

1.13

1.11

1.19

1.13

1.17

Household spending, % y/y

2.2

1.8

1.9

1.5

2.0

Unemployment rate (ILO measure), %

4.4

4.1

3.9

4.0

4.0

Employment, % y/y

1.0

1.2

0.9

0.4

0.4

Average earnings, % y/y

2.3

2.9

3.7

3.6

3.5

Nationwide house prices, % y/y in Q4

3.0

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, Q2 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 dependent on Brexit outcome

  • Underlying economic growth in the UK has slowed in 2019. Indeed, after growing by 0.5% q/q in Q1, growth fell by 0.2% q/q in Q2 as the boost to the economy before the initial Brexit deadline faded. (See Chart 9.) Nevertheless, we expect some recovery in GDP growth in Q3. As such, we think the UK will avoid a technical recession (two consecutive quarters of negative growth).
  • Going forward, the outlook for economic growth depends on the outcome of Brexit. We have three plausible forecast scenarios: a deal in October, repeated Brexit delays and no deal. Each have different implications for the economy. (See Chart 10.) As such, they have different implications for our all-property forecasts as shown in Tables 1, 2 and 3.
  • As noted in an Economics Update, with the election of Boris Johnson as Prime Minister, the chances of a no deal have risen. (See Chart 11.) But, there is still an above-50% chance that either Brexit is repeatedly delayed or a deal is secured.
  • Under a no deal, there are a wide range of possibilities for GDP growth depending on the state of preparations, tariffs, the government’s policy response and UK/EU relations. On balance, it seems likely that GDP growth would contract in the near term. However, we think that interest rate cuts and looser fiscal policy would help GDP rebound more quickly than is widely expected.
  • In contrast, if a deal is secured, GDP growth could increase from about 1.4% y/y this year to around 2.2% y/y in 2021. Indeed, we think that reduced uncertainty would lead firms to restart stalled investment plans. (See Chart 12.) Meanwhile, if Brexit is delayed repeatedly until at least the end of 2021, we would expect firms to look through near-term uncertainty, resulting in GDP growth rising to 2% by 2021.
  • Regardless of the Brexit outcome, there are three economic trends that are likely to have an important bearing on the economy. First, we think that the softness in the global economy will be more of a drag on the UK than many expect. In turn, domestic demand will lead economic growth.
  • In particular, the consumer sector is expected to be a main driver. That said, we expect employment growth to slow further, which will weigh on real incomes. But with real wages expected to grow at stronger rates than in the last few years, we don’t think that real income growth will slump. (See Chart 13.)
  • Second, fiscal policy will probably be loosened in all scenarios. After a no deal, that would play an important role in supporting the economy. In the other Brexit scenarios, it would provide an extra boost to GDP growth.
  • Third, as businesses pass through previous increases in wages into their prices, inflation is likely to exceed the 2% target for the next two years. (See Chart 14.) That would especially be the case after a no deal, as the boost to import prices from a weaker pound could lift inflation above 3%.
  • Looser fiscal policy and higher inflation also point to higher interest rates and bond yields. (See Chart 15 and 16.) Nevertheless, even if there is a deal or Brexit is delayed, the softer global backdrop would mean rates aren’t hiked before mid-2020. And if there were to be a no deal, rates would be cut initially to 0.25%, although we expect that these moves would be reversed from 2021.

Economic Backdrop

Chart 9: UK GDP Growth

Chart 10: GDP in Different Brexit Outcomes (%y/y)

Chart 11: Brexit Scenarios Probabilities (%, 8th August)

Chart 12: Business Investment (% y/y)

Chart 13: Real Household Incomes & Spending (% y/y, Repeated Delays Scenario)

Chart 14: CPI Inflation (% y/y)

Chart 15: Bank Rate (%)

Chart 16: 10-Year Gilt Yields (%)

Sources: Refinitiv, Capital Economics

Investment Market

Investment activity unlikely to rebound

  • Following a soft start to the year, investment activity was weak in Q2, totalling just £8.8bn. (See Chart 17.) We think that weakness will continue this year as investors act cautiously amid Brexit uncertainty. But beyond this, regardless of Brexit, we expect that investment will remain subdued. (See our recent Update.)
  • A key reason for this is that, under any Brexit outcome, we think that retail yields will need to increase further to entice buyers to the market given the sector’s bleak rental value prospects. Indeed, pricing concerns have already pushed up retail equivalent yields relative to other sectors. (See Chart 18.)
  • In addition, even though we expect the economy to be growing by around 2% y/y in 2021, supporting some pick up in all-property rental values, falls in retail rental values are likely to weigh heavily on the all-property average. (See Chart 19.)
  • Brexit is likely to impact when, and how quickly, yields rise. Under a no deal, we expect yields to jump as a result of the initial economic disruption. But further out, cuts to interest rates would prevent further rises. If a deal is secured and Bank Rate is hiked in 2020 and 2021, as valuations are already stretched in many sectors, we expect a further rise in yields next year. If Brexit is repeatedly delayed, yields could increase a bit more in the near term. But if the delay is long enough and yields have risen sufficiently, investors could look through the uncertainty.
  • That said, with 10-year gilt yields at their lowest levels since after the 2016 EU referendum, property already looks favourably priced. However, as discussed in our Focus, we think that the spread between property and bond yields shouldn’t narrow back to its pre-crisis average level.
  • As such, as interest rates rise, property would start to look overvalued more quickly. Nevertheless, even if property yields are unchanged there appears to be room to absorb the increase in bond yields to 2.25% by 2023 that we expect under our repeated delays scenario without causing a spike in property yields. (See Chart 20.)
  • We also expect there to be differences in how much yields rise by sector. Aside from the retail sector, where we expect yields to continue to rise, Central London offices and South East industrial property appear most susceptible to rising bond yields as their respective yield spreads are low relative to history. (See Chart 21.)
  • However, because we think that the trend towards online spending has shifted relative pricing in favour of industrial property, we do not expect industrial yields to increase as much as in other sectors. The upshot is that, over the next five years we think that Central London office yields will increase the most. (See Chart 22.)
  • Given our forecast of higher yields and falls in retail rents, all-property capital values could decline until 2021. We have pencilled in a cumulative decline in capital values of between 7% and 11% depending on the Brexit outcome. (See Chart 23.)
  • The bigger picture is that all-property returns will be squeezed, regardless of the Brexit outcome. (See Chart 24.) But all-property returns could go negative under a no deal.

Investment Market

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

Chart 18: Change in Equivalent Yields since 2018 Q4

Chart 19: GDP and All-Property Rental Value Growth Scenarios (% y/y)

Chart 20: All-Property Net Initial Yields Less 10-Year Gilts (Bps, Repeated Delays Scenario)

Chart 21: Property Net Initial Yields Less 10-Year Gilts by Sector (Bps)

Chart 22: Change in Equivalent Yields between 2019 Q2 to 2023 Q4 (Bps, Repeated Delays Scenario)

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

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

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

Office Market

Regional rental value growth to outpace Central London

  • We expect a slowdown in employment growth to weigh on occupier markets in Central London and the regions this year, regardless of the outcome of Brexit. However, we think that the tighter supply pipeline in regional markets will see rental value growth outpace that in Central London.
  • In Central London, office rental value growth improved in Q2 despite prolonged Brexit uncertainty, growing by 0.9% y/y compared with 0.6% y/y in Q1. However, we expect rental value growth to slow to around 0.5% y/y by year-end.
  • This reflects our view that employment growth peaked earlier in the year and we expect occupier demand to soften in H2. There have already been some signs of slowdown, with Central London office take-up in H1 this year around 18% lower than the same period of 2018. (See Chart 25.)
  • Admittedly, the relationship between London office-based jobs and Central London office take-up has diverged recently. However, we think that some of the factors that may have caused this divergence, such as the rapid increase in flexible office take-up and firms hiring more workers ahead of the initial Brexit deadline, will wane.
  • However, we do not expect rental value growth to fall. Indeed, for now current rates of take-up have continued to erode availability. In fact, Knight Frank data for Q2 show that the vacancy rate fell to 5.1% in the West End and to 4.9% in the City, well below their previous peaks of 8.3% and 7.3% respectively. Based on historical relationships, this would actually be consistent with rental value growth accelerating. (See Chart 26.)
  • That said, with a decent amount of supply still expected to come to market over the next three years, we think that an acceleration is unlikely. Indeed, the amount of space under construction in the West End and the City remains above its 15-year average, albeit down sharply from its 2017 peak in the City. (See Chart 27.)
  • In the regional office markets, rental value growth slowed slightly in Q2 to 1% y/y. However, regional office-take up in Q2 was mixed, falling in the Rest of South East but increasing overall in the big nine cities in the Rest of UK. (See Chart 28.) Within the Rest of UK, the increase in take-up was mostly driven by Manchester and Birmingham.
  • In the Rest of UK, the slowdown in rental value growth in Q2 mainly reflected softer growth in the South and North West. (See Chart 29.)
  • With office-based employment in the Rest of UK barely growing, we think rental value growth could slow further. (See Chart 30.) In turn, we have revised down the forecast for Rest of UK rental value growth this year to 1.3% y/y.
  • Even so, we continue to expect that office rental value growth in the regional markets will outpace Central London this year. This is consistent with RICS surveyors’ office rental expectations. (See Chart 31.) That said, RICS surveyors are slightly less pessimistic on London rental values than in recent years.

Office Market

Chart 25: Central London Office Take-Up and London Office-Based Employment Growth

Chart 26: Central London Vacancy Rate and Rental Value Growth

Chart 27: Central London Office Space Under Construction (M Sq. Ft.)

Chart 28: Regional Office Take-Up (000s Sq. Ft.)

Chart 29: Rest of UK Rental Value Growth (% y/y)

Chart 30: Office-Based Employment Growth

(Four-Quarter Average, % y/y)

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

Chart 32: Q2 2019 Office Rental Values (% Difference from Trend)

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

Office Market

Central London yields most susceptible to increase

  • Our expectation for regional outperformance reflects our view that supply conditions in the regional markets are tight, with less than one years’ worth of supply based on average annual take-up over the past five years. The exceptions are Birmingham, Manchester and Glasgow. However, even these cities have less than 1.5 years’ worth of supply.
  • Further ahead, we think that Rest of UK rental values have more scope to grow than Central London. However, rental value growth in the Rest of South East may be more constrained. Admittedly, nominal rental values in the Rest of South East don’t necessarily look too high relative to history. But, in real terms, they look more stretched relative to their historic real trend than in the West End. (See Chart 32 on previous page.)
  • As such, over the next five years, we forecast average rental value growth of 1.6% per year in the Rest of UK and 1.3% per year in the Rest of South East. This compares to just above 1% per year in the City of London and the West End. (See Chart 33.)
  • Given that we expect property yields to rise regardless of Brexit, the impact of slightly stronger office rental value growth on capital values is expected to be largely offset over the next few years.
  • There have already been signs that shifts in investor sentiment have affected office yields in the City of London, with equivalent yields around 13bps higher since Q3 last year. Notably, this has meant that the ‘London premium,’ which saw Central London yields compress faster than in the regions for most of the past 10 years, has now been eroded. (See Chart 34.) Even so, Savills report that prime City office yields declined in July to 4%, from 4.25% in June, citing that there remains decent demand for prime assets.
  • Nevertheless, as discussed earlier, both City of London and West End office yields look likely to rise as a result of increases in short-term interest rates. In contrast, Rest of UK office yields appear least susceptible given their higher starting point and the more positive outlook for rental value growth. In turn, we have pencilled in a 40bps increase in yields over the next five years in the Rest of UK and more than a 60bps increase in Central London.
  • However, because interest rates and bond yields are expected to remain low relative to history in any Brexit outcome, we do not expect office yields to return back to their pre-crisis averages. (See Chart 35.)
  • 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 5.4% per year in the Rest of UK over the next five years. (See Chart 36.) Returns in the Rest of South East are likely to be a bit lower, at around 4.5% per year.
  • Given Central London rental value growth is expected to be subdued and yields look likely to rise by more than in regional office markets, total returns are forecast to be less than the all-office average.

Office Market

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

Chart 34: Central London Yields Less Regional Office Yields (Difference from Long-Run Average, Bps)

Chart 35: Office Equivalent Yields (%, Repeated Delays Scenario)

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

0.7

1.1

1.4

1.6

1.6

Rental value growth

1.2

0.7

1.0

1.5

1.6

1.6

End yr equiv. yield, %

5.6

5.7

6.0

6.1

6.1

6.1

End yr equiv. yield, %

6.3

6.4

6.6

6.8

6.8

6.8

Capital value growth

2.1

-1.3

-2.7

-2.3

1.3

1.5

Capital value growth

2.0

-0.8

-2.1

-0.9

1.0

1.6

Income return

4.0

4.3

4.5

4.7

4.7

4.7

Income return

4.4

4.5

4.7

4.9

4.9

4.9

Total return, % p.a

6.2

2.9

1.8

2.4

6.0

6.2

Total return, % p.a

6.5

3.7

2.6

4.0

5.9

6.5

London City 12% of office stock by value

Rest of UK 23% of office stock by value

Rental value growth

1.4

0.5

0.8

1.2

1.5

1.6

Rental value growth

0.8

1.3

1.6

1.7

1.8

1.8

End yr equiv. yield, %

5.2

5.5

5.7

6.0

6.0

6.0

End yr equiv. yield, %

6.7

6.7

7.0

7.0

7.0

7.0

Capital value growth

3.1

-3.8

-3.4

-3.0

1.5

1.6

Capital value growth

3.0

1.4

-1.5

-1.5

1.4

1.4

Income return

3.7

4.0

4.2

4.5

4.5

4.5

Income return

4.9

5.0

5.2

5.2

5.3

5.3

Total return, % p.a

6.9

0.2

0.8

1.5

6.0

6.1

Total return, % p.a

8.0

6.4

3.7

3.7

6.6

6.6

London West End 34% of office stock by value

Rental value growth

-0.1

0.5

0.9

1.3

1.6

1.6

End yr equiv. yield, %

4.4

4.6

4.8

5.1

5.1

5.1

Capital value growth

1.3

-2.8

-3.7

-3.7

1.6

1.6

Income return

3.3

3.7

3.9

4.1

4.1

4.1

Total return, % p.a

4.6

0.9

0.2

0.4

5.7

5.7

Sources: MSCI, Capital Economics

Retail Market

Short-term pain, long-term gain

  • The retail sector remains oversupplied, driven by changing consumer preferences away from bricks and mortar retail and towards online. In turn, retail rental values likely have further to fall. However, further ahead, as this oversupply eases, we expect solid rates of consumer spending growth to spark a recovery in rental value growth.
  • In Q2, retail rental values fell by 3.8% y/y, the largest annual drop since 2010 Q1, with rents declining on an annual basis in all markets, including Central London. Looking ahead, we think things could get worse before they get better. This reflects our view that the oversupply of retail property will continue to outweigh demand. Indeed, data from the Valuations Office Agency shows that, although there has been some slowdown in the growth of new retail floorspace, it remains high compared to the past. (See Chart 37.)
  • This oversupply partly explains why the relationship between retail sales and rental value growth has broken down. In addition, the widespread use of CVAs has allowed retail rental values to adjust more quickly. Even so, the 3.3% y/y rise in in-store retail sales in Q2 would still have only been consistent with retail rental values stalling over the next 12 months. (See Chart 38.)
  • That said, there have been some signs that a trough in retail rental values may not be far away. For one, there has been a stabilisation in the net balance of surveyors who expect retail rental values to fall. (See Chart 39.) This has generally provided a good read on retail rental value growth about one year ahead.
  • In addition, vacancy rates for Rest of London and Rest of UK shops and in-town shopping centres fell in Q2 compared to Q1. But, retail vacancy rates remain well above their rates one year ago.
  • As such, in the near-term, we expect retail rents to fall a bit further. Given retail accounts for almost 40% of the MSCI universe, this will weigh heavily on the all-property average, regardless of the outcome of Brexit.
  • But further ahead, we expect retail rental value growth to recover. This is consistent for our forecast for consumer spending to hold up at around its current pace of a bit below 2% y/y. (See Chart 40.) Even under a no deal we think that consumer spending could recover to 2% y/y by 2021 as the economy bounces back. However, we expect consumer spending growth to remain below its pre-crisis average of 3.5% y/y. Therefore, we do not expect retail rental value growth to return to its pre-crisis average rates.
  • The outlook for shopping centre rental values is the most negative. In Q2, shopping centre rental values fell by 5% y/y. In addition, with persistent vacancy the highest among shopping centres, it appears that it will be more difficult to re-let shopping centre space.
  • Given this bleak rental value growth outlook, we think higher retail yields will be required to entice investors. As such, on top of the 30bps increase in retail equivalent yields experienced since 2018 Q1, we have pencilled in a further 60bps rise, most of which we expect to happen by end-2021. (See Chart 41.)
  • On balance, over the next five years, we expect retail capital value growth to average between minus 2.6% per year for retail warehouses and minus 4.2% per year for shopping centres. (See Chart 42.)

Retail Market

Chart 37: Floorspace of Retail Properties (March Years)

Chart 38: Retail Rental Values and Retail Sales (% y/y)

Chart 39: Retail Rental Values and Rental Expectations

Chart 40: Retail Rental Values and Consumer Spending (% y/y)

Chart 41: Retail 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 Centres23% of retail stock by value

Rental value growth

-2.2

-4.8

-2.2

0.6

1.1

1.3

Rental value growth

-2.6

-6.5

-3.5

0.0

0.0

0.5

End yr equiv. yield, %

5.7

6.1

6.3

6.4

6.4

6.4

End yr equiv. yield, %

6.5

7.1

7.3

7.4

7.4

7.4

Capital value growth

-5.3

-11.6

-5.8

-0.3

1.1

1.3

Capital value growth

-9.5

-14.6

-6.4

-0.7

0.0

0.5

Income return

5.1

5.9

6.1

6.2

6.2

6.2

Income return

4.9

5.5

5.7

5.7

5.7

5.7

Total return, % p.a

-0.5

-5.7

0.3

5.9

7.3

7.5

Total return, % p.a

-5.0

-9.1

-0.7

5.0

5.7

6.2

Retail Warehouses – 46% of retail stock by value

Standard Shops – 30% of retail stock by value

Rental value growth

-2.4

-4.5

-2.0

0.7

1.2

1.4

Rental value growth

-1.9

-4.0

-1.5

1.0

1.8

1.8

End yr equiv. yield, %

6.1

6.6

6.8

6.8

6.8

6.8

End yr equiv. yield, %

4.8

5.2

5.5

5.6

5.6

5.6

Capital value growth

-6.5

-11.0

-5.0

0.4

1.2

1.4

Capital value growth

-3.0

-10.4

-6.6

-1.0

1.8

1.8

Income return

5.6

6.3

6.5

6.5

6.5

6.5

Income return

4.3

4.7

5.0

5.1

5.1

5.1

Total return, % p.a

-1.2

-4.7

1.4

6.9

7.7

7.9

Total return, % p.a

1.1

-5.7

-1.6

4.1

6.9

6.9

Sources: MSCI, Capital Economics

Industrial Market

Industrial yields likely past their trough

  • Slower rental value growth and rises in industrial yields are expected to cause capital values to fall over the coming years. However, given the structural shift in consumer preferences towards online spending, which has generated new demand for industrial property, we don’t expect capital values to fall as much as in other traditional sectors.
  • Admittedly, as a proxy for logistics demand, logistics traffic volumes suggest that industrial demand has softened since 2018. (See Update.) However, industrial rental values have not slowed to the same extent, reflecting the shortage of supply. (See Chart 43.)
  • Indeed, in Q2, a net balance of 9% of RICS surveyors reported falling industrial availability, compared to 6% in Q1. And reports continue to suggest that there is a lack of appropriate supply, particularly well-located space for distribution purposes.
  • Nevertheless, we still expect rental value growth to slow as industrial supply is increasing. Savills data for H1 2019 show that industrial take-up totalled around 16m sq. ft. while available supply was more than double this. Higher levels of supply were particularly prevalent in the West Midlands and North West. (See Chart 44.)
  • This is consistent with the view of RICS surveyors, whose results in Q2 suggest that industrial rental value growth could slow to around 2% y/y over the next 12 months. (See Chart 45.)
  • In addition, real rental values in the Rest of South East appear particularly stretched, suggesting that there is little cope for the pace of rental value growth to increase. (See Chart 46.)
  • Over the next five years, we have pencilled in average rental value growth of 2% per year in the Rest of South East and 1.8% per year in the Rest of UK, a bit below the respective historical averages.
  • Unlike the retail and office sectors, industrial yields were broadly stable in Q2. However, they have not been immune to recent shifts in investor sentiment and, at the all-industrial level, were around 2bps higher than the end of last year. (See Chart 47.) This is in line with our view that industrial yields have been pushed too low, partly reflecting overly optimistic expectations about future rental value growth.
  • We expect industrial equivalent yields to increase a bit more over the coming years. However, given that we think that there has been a relative pricing shift in favour of industrial property, we forecast around 40bps of increase in industrial equivalent yields, compared to around 55bps in all-property equivalent yields.
  • Our forecast of positive rates of rental value growth will provide some offset to the impact of higher yields on capital value growth. (See Chart 48.)
  • Nevertheless, we expect industrial total returns to slow from the 10.3% y/y recorded in Q2 to an average of 5% per year over the next five years. Even so, industrial property will continue to outperform the traditional property sectors.

Industrial Market

Chart 43: Logistics Traffic and Rental Values (% y/y)

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: Change in Industrial Equivalent Yields (Bps)

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

Sources: ONS, MSCI, Savills, 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

1.9

1.8

1.7

1.7

1.7

End yr equiv. yield, %

5.3

5.3

5.5

5.6

5.7

5.7

End yr equiv. yield, %

5.9

6.0

6.1

6.2

6.3

6.3

Capital value growth

11.4

1.3

-1.0

-0.7

0.3

1.6

Capital value growth

7.2

0.4

0.0

-0.1

0.1

1.7

Income return

4.5

4.5

4.7

4.8

4.9

4.9

Income return

5.2

5.2

5.3

5.4

5.5

5.5

Total return, % p.a

16.4

5.8

3.7

4.1

5.2

6.5

Total return, % p.a

12.8

5.6

5.3

5.3

5.6

7.2

South East Industrial 65% of industrial stock by value

Rental value growth

5.7

3.3

2.0

1.6

1.5

1.5

End yr equiv. yield, %

4.9

5.0

5.2

5.3

5.4

5.4

Capital value growth

13.9

1.7

-1.5

-1.1

0.4

1.5

Income return

4.1

4.2

4.4

4.5

4.6

4.6

Total return, % p.a

18.5

5.9

2.8

3.4

4.9

6.1

Sources: MSCI, Capital Economics

Leisure and Hotels

Alternative sectors hit by yield rises

  • With yields in the leisure and the hotel sectors still near historically low levels, we think that the recent yield increases will continue as investors act cautiously amid Brexit-related uncertainty. Combined with softer rental value growth, we expect returns in both sectors to weaken this year.
  • Indeed, leisure capital values fell in Q2 for the second consecutive quarter, as equivalent yields rose by 7bps from their historic low of 5.5% in Q1. (See Chart 49.)
  • In addition, leisure rental value growth slowed to 1% y/y, a two-year low. In general, demand for leisure has benefited from changing consumer preferences towards experiences. But certain types of leisure, such as food and beverage, have been struggling. Indeed, a number of restaurant chains have entered into CVAs. In turn, we think that leisure rental value growth will slow a bit further.
  • However, we think that 2019 will mark the bottom for leisure rental value growth. For one, leisure vacancy rates held steady at 11.3% in Q2, albeit up from 8.2% a year ago. And our forecast that real earnings will continue to grow at solid rates of above 1% y/y, would be consistent with a pick-up in leisure rental value growth further ahead. (See Chart 50.) In turn, we expect capital value declines will be small compared to other property sectors, with the exception of industrial.
  • Combined with strong income returns, over the next five years, we expect the leisure sector to outperform, with total returns averaging 5.5% per year, compared to the all-property average of 3.8% per year. (See Chart 51.)
  • Hotel capital value growth was 3.1% y/y in Q2, down from a recent peak at the start of last year of 9.2% y/y. This has reflected an increase in hotel equivalent yields. However, given that hotel yields are some of the lowest after West End offices, we expect further rises this year, causing hotel capital values to fall.
  • The outlook for hotel demand is uncertain, with the impact of Brexit likely to have a large bearing. Nevertheless, it seems unlikely that tourism numbers would be affected long term. Indeed, despite positive and negative periods, tourism numbers have continued on an upward trend. (See Chart 52.) Even in the event of a no deal Brexit, the agreement that there will be short-term visa-free travel between the UK and EU should support numbers.
  • And even though we expect world GDP growth to soften a bit further, regardless of Brexit, there still appears to be scope for a further recovery in visitor numbers. (See Chart 53.) What’s more, with solid UK real wage growth expected to continue, domestic demand for hotel stays is also likely to hold up.
  • Nevertheless, hotel supply is expected to increase this year. In fact, CBRE note that supply in London is expected to increase by 4.8% and by 4.3% in the regions. In turn, we expect some downward pressure on hotel rental value growth. Around half of all new rooms are set to be three or four star – in contrast to the recent dominance of budget hotels as a share of new openings.
  • On balance, we forecast hotel returns to weaken from 7.4% y/y in Q2 to 1.3% y/y by year end, before improving gradually over the forecast horizon. (See Chart 54.)

Leisure and Hotels

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

Chart 50: Real Earnings and Leisure Rental Values (% y/y, Repeated Delays Scenario)

Chart 51: Leisure Property Forecasts (% y/y, Repeated Delays Scenario)

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

Chart 53: World GDP and UK Visitor Numbers (% 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

1.2

1.5

1.9

1.9

Rental value growth

1.2

1.7

1.2

1.1

1.0

1.0

End yr equiv. yield, %

5.7

5.8

5.9

6.0

6.1

6.1

End yr equiv. yield, %

4.3

4.5

4.7

4.8

4.9

4.9

Capital value growth

0.6

-1.4

-0.7

-0.5

1.1

1.1

Capital value growth

4.8

-3.2

-2.1

-1.4

-0.5

0.2

Income return

5.3

5.4

5.6

5.7

5.7

5.8

Income return

4.3

4.5

4.7

4.8

4.9

4.9

Total return, % p.a

5.9

4.0

4.9

5.1

6.8

6.8

Total return, % p.a

9.2

1.3

2.6

3.4

4.4

5.1

Sources: MSCI, Capital Economics


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

Written by
Amy Wood Property Economist
amy.wood@capitaleconomics.com +44 (0)20 7808 4994