Structural change hits rental growth - Capital Economics
UK Commercial Property

Structural change hits rental growth

UK Commercial Property Outlook
Written by Andrew Burrell
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The near-term outlook for most commercial property sectors is poor despite the early signs of economic recovery. Although transactions are set to pick-up post-lockdown, we think property yields will rise further as the rental outlook deteriorates. Between 2019-24, we expect all-property rental value growth will be at best flat. This reflects not only cyclical weakness, but also lasting structural change, such as more remote working and more online spending. Overall, all-property returns will average 4.3% a year, which is weak by historical standards and a downgrade on our previous view.

  • Overview – The near-term outlook for most commercial property sectors is poor despite the early signs of economic recovery. Although transactions are set to pick-up post-lockdown, we think property yields will rise further as the rental outlook deteriorates. Between 2019-24, we expect all-property rental value growth will be at best flat. This reflects not only cyclical weakness, but also lasting structural change, such as more remote working and more online spending. Overall, all-property returns will average 4.3% a year, which is weak by historical standards and a downgrade on our previous view.
  • Economic Backdrop – While activity is recovering from its deep trough, we do not think the economy will return to its pre-virus trend any time soon. In fact, with the threat of a second wave, the risks are skewed to the downside. We expect that weak demand will put downward pressure on inflation and that interest rates will remain at their current low levels for some time.
  • Investment Market – Despite signs of a pick-up in activity in late Q2, we think total investment will drop by about 30% this year and any recovery will be gradual thereafter. We expect further yield increases in the short term. Low interest rates provide the room for yield reductions over the medium term, but in the light of downgraded rental prospects, we expect these to be very modest.
  • Office Market – The near-term outlook for jobs is weak and this is expected to undermine rental growth in 2020-21. Thereafter, as more employees spend more time working from home, we expect weaker demand for office space. Over our five-year horizon, we think returns will average only around 4% per year, which is a downgrade on our previous expectations.
  • Retail Market – Even though shops have reopened, the outlook for retail remains poor and we expect capital values to decline by 20% this year. While we think there will be a slow recovery from next year, values will remain well below pre-virus levels, as the online shift continues to undermine rental growth.
  • Industrial Market – While other sectors saw marked declines in occupier demand in Q2, the increase in online sales during lockdown strengthened industrial demand. But with retailers struggling, we expect this will weigh on industrial vacancy and rental growth in 2020. Over the five-year forecast, we expect capital values to rise by 2% p.a. and that industrial property will outperform other traditional property sectors.
  • Leisure and Hotels – With incomes under pressure and tourist flows weak, we think the hospitality sector will continue to struggle, especially once government support is removed. As such, we expect marked declines in capital values this year and a slow recovery over the forecast period for both leisure and hotels.

Main Forecasts

Table 1: Key Commercial Property Forecasts (Year End)

 

2019

2020

2021

2022

2023

2024

2020-24

2021-24

ALL PROPERTY

Rental value growth, % y/y

-0.6

-4.1

0.4

1.3

1.3

1.3

0.0

1.1

End yr equiv. yield, %

5.6

6.1

6.0

6.0

6.0

5.9

6.0

6.0

Capital value growth, % y/y

-3.3

-10.3

0.8

2.0

1.7

1.9

-0.8

1.6

Income return, % y/y

4.6

5.1

5.1

5.2

5.1

5.1

5.1

5.1

Total return, % p.a

1.2

-5.2

5.9

7.2

6.8

7.0

4.3

6.7

OFFICE PROPERTY

Rental value growth, % y/y

1.5

-1.9

0.6

1.0

1.0

0.8

0.3

0.9

End yr equiv. yield, %

5.6

5.8

5.8

5.7

5.7

5.7

5.8

5.7

Capital value growth, % y/y

0.3

-6.0

0.2

1.9

1.4

1.2

-0.3

1.2

Income return, % y/y

4.1

4.3

4.3

4.3

4.3

4.3

4.3

4.3

Total return, % p.a

4.4

-1.7

4.5

6.3

5.7

5.5

4.0

5.5

RETAIL PROPERTY

Rental value growth, % y/y

-4.9

-9.6

-0.3

0.9

0.9

0.9

-1.4

0.6

End yr equiv. yield, %

6.1

6.8

6.8

6.8

6.8

6.8

6.8

6.8

Capital value growth, % y/y

-11.6

-19.0

-0.3

1.6

0.9

1.4

-3.1

0.9

Income return, % y/y

5.3

6.0

6.2

6.3

6.3

6.3

6.2

6.3

Total return, % p.a

-6.8

-12.9

5.9

7.8

7.3

7.7

3.2

7.2

INDUSTRIAL PROPERTY

Rental value growth, % y/y

2.9

0.8

1.3

2.0

2.1

2.3

1.7

1.9

End yr equiv. yield, %

5.3

5.5

5.4

5.3

5.3

5.3

5.4

5.3

Capital value growth, % y/y

2.4

-2.1

2.6

2.9

2.9

3.1

1.9

2.9

Income return, % y/y

4.4

4.6

4.5

4.6

4.5

4.5

4.5

4.5

Total return, % p.a

6.9

2.4

7.1

7.5

7.5

7.6

6.4

7.4

LEISURE PROPERTY

Rental value growth, % y/y

0.0

-9.5

-0.5

0.5

1.0

1.0

-1.5

0.5

End yr equiv. yield, %

5.7

6.8

6.8

6.7

6.7

6.7

6.7

6.7

Capital value growth, % y/y

-1.6

-24.2

0.2

1.2

1.0

1.0

-4.1

0.9

Income return

5.3

6.5

6.4

6.4

6.4

6.4

6.4

6.4

Total return, % p.a

3.6

-17.7

6.7

7.6

7.4

7.4

2.3

7.3

HOTELS PROPERTY

Rental value growth, % y/y

1.8

-2.0

0.5

0.9

1.0

1.0

0.3

0.9

End yr equiv. yield, %

4.5

5.0

5.0

4.9

4.9

4.9

4.9

4.9

Capital value growth, % y/y

1.8

-11.9

1.5

1.9

2.0

2.0

-0.9

1.9

Income return

4.1

4.7

4.7

4.6

4.6

4.6

4.6

4.6

Total return, % p.a

6.0

-7.2

6.2

6.6

6.6

6.6

3.8

6.5

Sources: MSCI, Capital Economics

Table 2: Key UK Economic Forecasts (Year Average)

 

2017

2018

2019

2020f

2021f

GDP, % y/y

1.9

1.4

1.5

-11

9.5

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

1.32

1.38

0.54

0.05

0.05

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

1.19

1.38

0.74

0.15

0.15

CPI inflation, % y/y

2.7

2.5

1.8

1.0

1.4

$/£ (end-period)

1.35

1.28

1.33

1.35

1.35

Euro/£ (end-period)

1.13

1.11

1.18

1.13

1.13

Household spending, % y/y

2.3

1.6

1.0

-17.4

14

Unemployment rate (ILO measure), %

4.4

4.1

3.8

4.8

6.6

Employment, % y/y

1.0

1.2

1.1

-1.0

-0.8

Average earnings, % y/y

2.3

2.9

3.5

-0.7

2.0

Nationwide house prices, % y/y in Q4

3.2

0.5

1.4

-3.3

4.0

Sources: Refinitiv, Capital Economics


Sectoral Rankings

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

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

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

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

Chart 5: Equivalent Yields, Q4 2020 (%)

Chart 6: Equivalent Yields, Q4 2024 (%)

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

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

Sources: MSCI, Capital Economics


Economic Backdrop

Second wave threatens the recovery

  • The 20.4% q/q contraction in GDP in Q2 was the largest quarterly fall on record and confirmed that the coronavirus crisis has led the economy into a deep recession. More timely data show that activity has since rebounded, as the economy has reopened following the national lockdown. We expect the recovery in GDP to continue during the rest of 2020 and into 2021, but we think the economy will remain below its pre-virus trend for some time. (See Chart 9.)
  • A key factor behind the slump in GDP was the collapse in consumer spending during the national lockdown. This said, retail spending has rebounded with sales volumes just below their pre-virus level by June. (See Chart 10.) But non-retail consumption is likely to recover far more slowly and weigh down the recovery in overall consumer spending. Low confidence, with uncertainty surrounding Brexit and a second wave of the virus, will also curb consumers’ willingness to spend.
  • The biggest threat to the recovery of GDP and our forecasts is a second wave of the virus. Depending on the extent of a second outbreak, the recovery could slow, stall or reverse. In the worst-case scenario, the recovery could become “W” shaped, leaving GDP even lower than our central forecast at the end of 2022. (See Chart 11.)
  • In the labour market, the success of the furlough scheme has prevented a deeper slump in employment. A rise in inactivity has also helped to keep the unemployment rate low with workers dropping out of the labour force rather than searching for jobs in lockdown. However, we expect unemployment to rise once the furlough scheme ends in October. We think the rate will peak at 7% in 2021 as firms make redundancies and inactive workers gradually return to the labour force. (See Chart 12.)
  • Meanwhile, weak demand will keep inflation low for the rest of the year. In fact, we expect a brief spell of deflation later in 2020, since the temporary VAT cut for the hospitality and tourism sectors and the Eat Out to Help Out scheme will put downwards pressure on consumer prices. We expect prices to pick up again once these policies come to an end, but we think inflation will stay below the Bank of England’s 2.0% target at least until the end of 2022. (See Chart 13.)
  • Support for the hospitality industry and the labour market contributed to the £192bn (8.7% of 2019 GDP) of direct government help which has been provided in response to the crisis. The adverse impact of the pandemic on public finances will cause the budget deficit to surge from 2.6% of GDP in 2019/20 to almost 20% in 2020/21. As a result, we expect that the debt to GDP ratio will climb from 80% in 2019 to above 105% in 2020. (See Chart 14.)
  • The Bank of England announced no additional policy measures at its August’s meeting, but we think they will have to loosen policy further yet. The abundance of spare capacity in the economy will help keep inflation below target. But we are still pencilling in another £100bn of quantitative easing later this year with more to come in 2021. (See Chart 15.)
  • But we doubt that the Bank will cut interest rates into negative territory for further stimulus. Nor do we think the MPC will raise rates for at least five years yet. As a result, we expect 10-year gilt yields to remain at a very low level in line with the Bank rate. (See Chart 16.)

Economic Backdrop

Chart 9: GDP (Q4 2019 = 100)

Chart 10: Retail Sales Volumes (2016 = 100)

Chart 11: GDP Scenarios (Q4 2019 = 100)

Chart 12: ILO Unemployment Rate (%)

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Chart 13: CPI Inflation (% y/y)

Chart 14: Public Sector Net Debt (% of GDP)

Chart 15: Forecasts for the Stock of QE Purchases (£bn)

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

Sources: Refinitiv, ONS, Bloomberg, Capital Economics


Investment Market

Rental downgrades reduce room for yield falls post-pandemic

  • As expected, the UK’s lockdown resulted in exceptionally weak investment activity in Q2. (See Chart 17.) Preliminary data suggest total purchases were around £3.6bn, which was the weakest quarter on record and down around 60% y/y. There were more encouraging signs in the most recent figures (for June), when a sharp bounce indicated that May will be the low point of the current downturn.
  • But any recovery in investment is expected to be gradual. Indeed, sentiment remains fragile. There was a sharp deterioration in the balance of RICS surveyors reporting rising investment enquiries in Q2 across all sectors. (See Chart 18.) Even if activity returns to close to its pre-virus levels by the end of the year, as we expect, total investment will drop by about 30% in 2020. And this is only likely if there is no second wave outbreak or further lockdowns and if a hard Brexit is avoided at year-end.
  • After a turbulent spring, financial markets stabilised over the summer. The equity dividend yield declined further in Q3 in line with a continued stock market recovery. Nonetheless, the yield spread remains below its pre-virus levels, so property looks relatively expensive. (See Chart 19.) In contrast, as bond yields have continued to dip to new lows, the spread to property yields remained close to all-time highs. In the current environment, however, valuation concerns will be secondary to worries about income security and rents.
  • As expected, property yields rose in almost all sectors in Q2 as the lockdown pushed activity to all-time lows. (See Chart 20.) But the impact was not uniform. Not surprisingly, a shuttered retail sector was hardest hit, notably shopping centres, along with associated leisure. The all-property shift was perhaps slightly less severe than feared, though yields rose across office and industrial subsectors and only supermarket yields held firm during lockdown.
  • Although the economy is starting to recover, sentiment remains fragile and we expect that yields will continue to move higher over the next six months. In part, this reflects the ongoing malaise in retail, which predated the crisis and will outlast it. But we also expect (small) upward movements in both industrial and office yields before end-2020.
  • Previously, we expected that after lockdown eased and activity revived, the initial 40-50bps rise in property yields would unwind, albeit slowly. We now expect slower falls in all-property yields next year and beyond. (See Chart 20.) This is in spite of UK interest rates stalling at record lows and is chiefly the result of the downgrading of rental growth prospects. (See Chart 21.) This will keep all-property yields above their pre-virus lows until the end of the five-year forecast period.
  • Higher yields will weigh on capital values. We still expect a 10% y/y decline on the all-property measure this year, the steepest since 2008. (See Chart 22.) But next year’s recovery is less vigorous, as economic and structural headwinds curb the rental recovery and, thereafter, a subdued profile is forecast with sub-2% growth.
  • The first negative annual returns since 2009 are expected this year. (Chart 23.) The post-COVID recovery brings a rebound in 2021, with returns averaging around 7% p.a. in 2022-24. Given the relatively weak recovery, sector fortunes are heavily coloured by 2020 out-turns. Retail, leisure and hotels fare the worst over a five-year horizon, while industrial and regional offices are more resilient. (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 Inquiries (% Net Balance)

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

Chart 20: Equivalent Yields (change Q2, bps)

Chart 21: All-property and 10-year Bond Yields (%)

Chart 22: All-property Capital Value Growth (%)

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Chart 23: Total Returns (% p.a)

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

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


Office Market

Remote working hits rental outlook

  • The near-term outlook for jobs is weak and this is expected to undermine rental growth in 2020-21. Admittedly, the outlook for office-based job growth is expected to be stronger than for total employment over the longer term. (See Chart 25 and our Update.)
  • Usually, this would be good news for office demand. But we think that the direct impact of this will be reduced as more employees spend more time working from home. This weaker demand is reflected in our downgrade of rental value growth over the next five years from 1.7% p.a. to just 0.3% p.a. (See our Focus.)
  • There was a sharp fall in take-up in London, with Knight Frank reporting a fall of 60% y/y in Q2 to its lowest quarterly level on record. (See Chart 26.) This decline was slightly more pronounced in the City than the West End, as take-up fell by 70% compared to a 60% decline.
  • Meanwhile, availability crept higher in Central London. In part, this was due to secondary space in the West End coming back to the market. In turn, the Central London vacancy rate rose to 6.1% in Q2 from 5.7% in the previous quarter. (See Chart 27.) But the rate remains well below the previous peak of 10.9% reached in 2009.
  • Yet, according to Deloitte, completions in Central London are set to double from last year to around 8m. sq. ft. in 2020, mostly from new space in the City. (See Chart 28.) This is likely to put upward pressure on vacancy as the year progresses, though delays to construction mean that some completions will now be pushed into 2021. While half of this new space has been let, there are also concerns that some occupiers could react to the crisis by reducing their long-term requirements and releasing second-hand space into the market.
  • Admittedly, London office rents have not fallen by as much as we had feared. In Q2, West End rents dropped by 0.6% q/q’ while rental values in the City declined by just 0.2% q/q. But the Q2 RICS commercial survey of rental expectations saw its biggest fall in London. (See Chart 29.) A net balance of 68% of surveyors expected London rents to fall over the next 12 months, down from 30% in Q1.
  • And, while we expect the economy to recover in H2, we also think the unwinding of the furlough scheme will drive a rise in unemployment. We also expect that as tenants review space requirements in light of the success of remote working, some will not renew leases or seek out as much space as they formerly occupied. This will put further downward pressure on rents in the second half of this year. As a result, we forecast rents in the West End and City will fall by 2.5% y/y and 2% y/y respectively in 2020.
  • After next year, a recovery in office-based jobs will provide some support to occupier demand in London. But this is likely to be at least partially offset by a rise in remote working. In turn, we have revised down our longer-term view for London rental growth. (See Table 3.)
  • Away from London, demand across most of the regional city centres was also weak in Q2. On a year-on-year basis, take-up fell by 80% to 330,000 sq. ft across the top nine regional office markets. The only market that saw a rise in take-up was Cardiff, but this is a relatively small market and the increase was from a very low level. (See Chart 30.)

Office Market

Chart 25: UK Employment (End Year, 2019 = 100)

Chart 26: London Office Based Jobs and CL Take-up

Chart 27: City and West End Vacancy Rate (%)

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

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Chart 29: RICS Surveyors Expecting Rising Office Rental Values (% Net Balance)

Chart 30: Regional City Centre Take-Up (000s Sq. Ft.)

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

Chart 32: South East Take-Up (000s Sq. Ft.)

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

Office Market

Returns to turn negative for the first time since the GFC

  • In the Rest of UK market, rents were flat in Q2 after recording a small rise in Q1. And we expect a deterioration in H2 leaving rents around 1% lower by the end of 2020. But the decline in regional rents should be mitigated by a tight supply pipeline. On average, there is less than one year’s worth of new supply based on annual take-up over the past five years. (See Chart 31.)
  • In the South East, a large letting to the Government Property Agency meant that the quarterly fall in take-up in Q2 was not as severe as elsewhere. (See Chart 32.) But take-up was already relatively weak in this market and the latest figures are even further adrift of the historical averages.
  • Rest of South East rents were flat in the first half of this year. Chart 31 shows a particularly constrained supply pipeline in the South East, but we don’t think this will be enough to prevent rents from falling. With rental levels already looking high relative to their long-term trend (see Chart 33), we expect a decline of around 2% in 2020. Further ahead, we think the recovery won’t begin to take hold until next year, when we expect growth will be between 0.0-0.5%
  • We expect a tighter supply pipeline in the regions will help Rest of UK rental growth outperform the UK average at 0.5% a year over the next 5 years. Meanwhile, Rest of South East rents, at just 0.3% a year, are likely to remain slightly weaker. (See Chart 34.) But these regional differences are small and the bigger picture is that office rental performance is poor in comparison to other commercial sectors, retail aside.
  • Office equivalent yields rose by 11bps in H1, and we think the deterioration in rental expectations will bring further increases of around 20bps before the end of 2020. (See Chart 35.) For context, this is far less than the increase we expect in retail yields, but more than the rise in industrial yields.
  • With interest rates and bond yields expected to remain low, we forecast the economic recovery to support an improvement in investor appetite for riskier assets such as property. We think a return to rental growth next year will help to stabilise office yields in 2021. Thereafter, our expectations are that with rental growth weak, yields will only see very modest declines before the end of the forecast period. As a result, levels remain above their pre-virus lows.
  • This year, we forecast that office capital values will decline by 6%, as a result of higher yields and falling rents. The deterioration will be seen across all markets. However, with less steep rental falls, we see Rest of UK offices capital values declining by less than Central London and Rest of South East offices. We think that office capital values will be flat next year, before sluggish growth resumes over the medium term. (See Chart 36.)
  • Against this backdrop, office returns will turn negative in 2020, the first annual decline since Q3 2009. Over the forecast horizon, we think returns will move back into positive territory, but will average only around 4% per year. This is a downgrade on our previous expectations explained largely by the gloomier rental outlook. We think total returns in Rest of UK will outperform, while West End and City returns languish at just 3% and 4% a year. (See Chart 36 again.)

Office Market

Chart 33: Rest of South East Real Office Rents and Historical Trend

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

Chart 35: Office Equivalent Yields (%)

Chart 36: Office Property Forecasts

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

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Sources: MSCI, Capital Economics

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

 

2019

2020

2021

2022

2023

2024

2019

2020

2021

2022

2023

2024

All Office

Rest of South East 30% of office stock by value

Rental value growth

1.5

-1.9

0.6

1.0

1.0

0.8

Rental value growth

1.2

-1.8

0.3

1.1

1.1

1.0

End yr equiv. yield, %

5.6

5.8

5.8

5.7

5.7

5.7

End yr equiv. yield, %

6.3

6.6

6.6

6.5

6.5

6.4

Capital value growth

0.3

-6.0

0.2

1.9

1.4

1.2

Capital value growth

-0.1

-5.5

0.3

1.9

1.9

1.8

Income return

4.1

4.3

4.3

4.3

4.3

4.3

Income return

4.3

4.6

4.5

4.6

4.5

4.5

Total return, % p.a

4.4

-1.7

4.5

6.3

5.7

5.5

Total return, % p.a

4.3

-0.9

4.8

6.5

6.4

6.3

London City 11% of office stock by value

Rest of UK 24% of office stock by value

Rental value growth

1.7

-2.0

0.2

1.0

1.0

1.0

Rental value growth

1.9

-1.2

0.8

1.0

1.0

0.8

End yr equiv. yield, %

5.4

5.6

5.6

5.5

5.5

5.5

End yr equiv. yield, %

6.4

6.7

6.7

6.7

6.6

6.6

Capital value growth

0.7

-6.4

1.1

1.9

1.0

1.0

Capital value growth

0.4

-5.4

-2.8

1.8

1.8

1.6

Income return

4.0

4.3

4.3

4.3

4.3

4.3

Income return

4.8

5.2

5.1

5.2

5.2

5.1

Total return, % p.a

4.7

-2.0

5.4

6.2

5.3

5.3

Total return, % p.a

5.2

-0.2

2.4

7.0

7.0

6.7

London West End 34% of office stock by value

Rental value growth

1.3

-2.5

0.8

1.0

0.9

0.6

End yr equiv. yield, %

4.4

4.6

4.6

4.5

4.5

4.5

Capital value growth

0.5

-6.9

1.9

2.1

0.9

0.9

Income return

3.4

3.5

3.4

3.4

3.4

3.4

Total return, % p.a

3.8

-3.4

5.3

5.5

4.3

4.0

Sources: MSCI, Capital Economics


Retail Market

Virus brings lasting legacy for retailers

  • Even as shops reopen in June, the outlook for retail remains poor. The collapse of major landlord Intu was only the most high-profile sign of the crisis in the sector. Anecdotal evidence on rent collection suggests payment rates remain particularly low compared with other sectors. And after shops began to reopen in June, footfall had only recovered two-thirds of its previous levels by August, even with the boost from VAT cuts and the Eat Out to Help Out scheme. (See Chart 37.)
  • Against this backdrop, it is no surprise that rental values plummeted in Q2 and remain under pressure. Indeed, the 3% q/q decline in Q2 was the steepest fall on the 40-year MSCI series, further pushing down the annual growth rate to -7.7% y/y. (See Chart 38.) And we expect more pain ahead. Indeed, the latest RICS survey of rental expectations for the sector recorded a further sharp deterioration in Q3.
  • Even a rapid rebound in retail sales provided limited comfort for physical stores. The 14% m/m gain during June was enough to push volumes close to their pre-pandemic levels. This was impressive given the 22% peak-to-trough fall in April and that most stores had just reopened. (See Chart 39.) But these figures overstate the speed of recovery. Some of it reflects a substitution away from non-retail spending, say from restaurants to groceries. This will likely reverse as the virus is contained, weighing on the recovery in physical sales.
  • Of greater concern is how online demand will evolve further out. Having risen to a third of all retail spending in lockdown, will some of this demand never return to high streets? (See Chart 40.) If so, this will likely mean weaker offline demand growth which will put further pressure on retailers. In our view, the impact will be significant and we have downgraded our medium-term rental view in line.
  • The intensity of the near-term pressure on rents should ease into next year, once retail trade returns to more normal levels. Nonetheless, we expect rents to end 2020 almost 10% y/y lower, with little or no recovery next year as retailers struggle. Thereafter, there is a return to growth, but at weaker rates than in other sectors as the structural headwinds persist.
  • Given the dire rental backdrop, we think retail yields will rise over the rest of 2020. In addition, we are unconvinced that the rise seen this year will be reversed in response to the economic recovery. While we expect yields will stabilise once rents bottom out, given prospects for anaemic growth, we don’t see much scope for retail yield falls, despite low bond yields. (See Chart 41.) This leaves a legacy of retail yields over 100bps above 2017’s cyclical low. This means retail remains comfortably the highest yielding major commercial sector in future.
  • We expect retail capital values to decline by 20% this year, with shopping centre values down by a quarter. This is less severe than the post-GFC fall, though it is in stark contrast to the milder corrections expected in other major sectors this time. We expect a slow recovery in values from 2021, but they are 10% below their pre-virus levels at the end of the forecast.
  • Retail returns are expected to fall sharply in 2020, but revive to average around 7% a year between 2021-24. This reflects higher income returns as rental prospects remain poor. (See Chart 42.) Within this, shopping centres fare worst, with a recovery hampered by distancing and sluggish footfall, and a long-term outlook more exposed to online competition.

Retail Market

Chart 37: Retail Footfall Index

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

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

Chart 40: UK Online Share of Retail Sales (%)

Chart 41: Retail Yields by Subsector (%)

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

Sources: MSCI, Springboard, Refinitiv, Capital Economics

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

 

2019

2020

2021

2022

2023

2024

2019

2020

2021

2022

2023

2024

All Retail

Shopping Centres23% of retail stock by value

Rental value growth

-4.9

-9.6

-0.3

0.9

0.9

0.9

Rental value growth

-5.7

-12.0

-3.0

0.0

0.0

0.0

End yr equiv. yield, %

6.1

6.8

6.8

6.8

6.8

6.8

End yr equiv. yield, %

7.3

8.5

8.5

8.5

8.5

8.5

Capital value growth

-11.6

-19.0

-0.3

1.6

0.9

1.4

Capital value growth

-17.7

-24.3

-3.0

0.0

0.0

0.0

Income return

5.3

6.0

6.2

6.3

6.3

6.3

Income return

5.4

6.3

6.5

6.8

7.0

7.0

Total return, % p.a

-6.8

-12.9

5.9

7.8

7.3

7.7

Total return, % p.a

-13.2

-18.0

3.5

6.8

7.0

7.0

Retail Warehouses – 47% of retail stock by value

Standard Shops – 31% of retail stock by value

Rental value growth

-5.6

-9.5

0.0

1.0

1.0

1.0

Rental value growth

-4.6

-8.0

1.0

1.5

1.5

1.5

End yr equiv. yield, %

6.8

7.6

7.6

7.5

7.5

7.5

End yr equiv. yield, %

5.0

5.5

5.5

5.5

5.5

5.5

Capital value growth

-14.5

-18.6

0.0

2.3

1.0

2.0

Capital value growth

-9.2

-16.0

1.0

1.5

1.5

1.5

Income return

6.0

6.7

6.9

6.9

6.9

6.9

Income return

4.4

4.9

4.9

4.9

4.9

4.9

Total return, % p.a

-9.3

-11.9

6.9

9.3

7.9

9.0

Total return, % p.a

-5.2

-11.1

5.9

6.4

6.4

6.4

Sources: MSCI, Capital Economics


Industrial Market

Online sales to boost rental growth

  • The sharp rise in online sales during lockdown led to a ramp-up in delivery capacity, particularly by supermarkets and Amazon, meaning that industrial demand strengthened. According to CBRE, take-up increased by 60% y/y to 12.8 m. sq. ft. in Q2, which was the strongest second quarter on record. (See Chart 43.)
  • Nevertheless, surveyors’ expectations for rents have fallen dramatically this year. The RICS commercial survey for Q2 showed that a net balance of 11% expected a fall in industrial rents over the next 12 months, a marked deterioration on the previous quarter. (See Chart 44.)
  • What’s more, industrial rental growth was slowing even before the lockdown. But this slowdown intensified in Q2, with rents growing by only 0.2% q/q, their slowest rate since Q3 2013.
  • Despite the boost to occupier demand, vacancy has remained stable at 6.6%. With speculative construction down a third on last year and demand strong, this will limit any rise in vacancy rates in the coming quarters. But with some retailers going bankrupt and others cutting costs, there will be an increase in second-hand warehouse space returned to the market, which is expected to weigh on rental growth. (See our Update.)
  • We see rental growth slowing sharply to 0.8% y/y this year. All things considered, this would still be a positive outcome, making industrial the only sector to record a rise this year. (See Chart 45.)
  • Over the five-year forecast horizon, we expect growing demand from online sales and the wider economic recovery to drive average rental growth of 1.7% p.a. Although this would be a marked slowdown on the recent past, it remains faster than the other commercial sectors.
  • On a regional basis, we think the factors driving the outperformance of the Rest of South East in the recent past will continue over the forecast horizon. New supply appears tight and, against a backdrop of strong demand, speculative space under construction in the South East has fallen by 50% over the past year. (See Chart 46.) Over the next five years, we expect rental growth will average 2.2% per year in the Rest of South East compared with 0.9% per year in the Rest of UK.
  • Industrial yields rose by 15bps to 5.5% in Q2 reflecting investor concerns about the impact of coronavirus on rents. We expect that yields will stabilise at this level for the remainder of this year. (See Chart 47.) Next year, as prospects for rents improve and investor caution eases, industrial yields are set to nudge lower again.
  • On the back of rising yields, capital values fell by 1.5% in the first half of the year. We expect further falls in H2 to drive a total decline for the year of around 2%. Next year, the slight fall in yields that we are expecting is set to more than reverse this year’s decline.
  • Indeed, over the five-year forecast, we expect capital values to rise by 2% p.a., supporting average total returns of 6% p.a. (See Chart 48.) This is a sharp slowdown from the past five years, which saw average annual returns in double digits. Even so, we expect that industrial property will outperform other traditional property sectors, albeit that the gap is closed after 2020.

Industrial Market

Chart 43: Industrial Take-Up (M. Sq. Ft.)

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

Chart 45: Industrial Rental Values (% y/y)

Chart 46: Spec. Space Under Construction (M. Sq. Ft.)

Chart 47: Industrial Equivalent Yields (%)

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

Sources: CBRE, MSCI, RICS, Capital Economics

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

 

2019

2020

2021

2022

2023

2024

2019

2020

2021

2022

2023

2024

All Industrial

Rest of UK Industrial 35% of industrial stock by value

Rental value growth

2.9

0.8

1.3

2.0

2.1

2.3

Rental value growth

1.6

0.4

0.5

1.0

1.1

1.3

End yr equiv. yield, %

5.3

5.5

5.4

5.3

5.3

5.3

End yr equiv. yield, %

6.0

6.2

6.1

6.0

6.0

5.9

Capital value growth

2.4

-2.1

2.6

2.9

2.9

3.1

Capital value growth

0.5

-2.6

1.7

1.8

1.9

2.2

Income return

4.4

4.6

4.5

4.6

4.5

4.5

Income return

5.1

5.3

5.2

5.3

5.3

5.2

Total return, % p.a

6.9

2.4

7.1

7.5

7.5

7.6

Total return, % p.a

5.6

2.7

6.8

7.2

7.2

7.4

South East Industrial 65% of industrial stock by value

Rental value growth

3.8

1.0

1.7

2.6

2.7

2.8

End yr equiv. yield, %

4.9

5.1

5.0

5.0

4.9

4.9

Capital value growth

3.5

-1.9

3.1

3.4

3.5

3.6

Income return

4.0

4.1

4.1

4.2

4.1

4.1

Total return, % p.a

7.6

2.2

7.2

7.6

7.6

7.7

Sources: MSCI, Capital Economics


Leisure and Hotels

Weak tourism to weigh on returns

  • With most venues forced to shut or operate at restricted capacity during the lockdown, leisure operators saw revenues plummet in Q2. Indeed, the ONS report that output of the restaurant and accommodation sector was down by 84% between June and February, one of the worst hit parts of the economy.
  • The leisure industry was boosted by the official reopening of pubs and restaurants in July. (See Chart 49.) Indeed, the temporary VAT cut for the hospitality and tourism sectors and the Eat Out to Help Out scheme may offer some businesses a lifeline this year. However, as government support is removed, we think the resulting job losses will hurt households’ ability to spend, with real disposable household incomes likely to fall by around 6% peak-to-trough. This would hit the UK leisure sector hard.
  • Capital values showed a sharp deterioration in in H1, falling by 14% y/y. (See Chart 50.) There was a marked decline in rental growth, while equivalent yields have also risen by 95bps since the start of the year. Once the Eat Out to Help Out scheme ends in August, we expect many operators will struggle again and values will be hit further. As such, we have pencilled in a 24% y/y decline in capital values for this year, worse than the retail sector.
  • We don’t expect household consumption to return to its pre-pandemic level until 2023, which will hold back the recovery in the leisure sector over the medium term. While capital growth is restored from next year, between 2020-2024, total returns are expected to average 2.3% a year, well below the all-property average. (See Chart 51.)
  • For the hotel sector, there has been a sharp fall in stays due to travel restrictions on overseas visitors and caution from domestic holiday makers. As more people opt for “staycations,” there has been an improvement in hotel occupancy, but many consumers are choosing self-catering options over hotels with the virus still in circulation. Also, Google mobility data show that the pick-up in activity is focused in a few seaside holiday locations, with most markets still below their pre-COVID levels. (See Chart 52 and our Update.)
  • Although hotels have resumed business, they have heavily discounted their rates, which has squeezed profit margins. We think this could result in some operators struggling and rents falling. Surprisingly, rents have remained flat since the start of the year, though yields have risen by 25bps. As a result, capital values declined by 6% y/y in H1. (See Chart 53.) With no respite in sight, we expect hotel values to see further decline by the end of the year.
  • With a resurgence in virus cases in many locations and the UK government adding more countries to its quarantine list at short notice, we expect uncertainty around foreign travel will remain elevated well into 2021. As such, we expect a muted recovery for hotels next year. As it will be a few years before the global economy returns to its pre-virus path, this is likely to hold back demand for overseas travel and hotels into the medium term.
  • We have revised down our forecasts for hotel returns over next five years. With yields expected to stay close to their current levels and rental growth prospects subdued, we now expect returns of just below 4% p.a. on average. (See Chart 54.)

Leisure and Hotels

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

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

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

Chart 52: Visits to Recreation Locations (% vs January)

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

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

Sources: OpenTable, Google, 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

-9.5

-0.5

0.5

1.0

1.0

Rental value growth

1.8

-2.0

0.5

0.9

1.0

1.0

End yr equiv. yield, %

5.7

6.8

6.8

6.7

6.7

6.7

End yr equiv. yield, %

4.5

5.0

5.0

4.9

4.9

4.9

Capital value growth

-1.6

-24.2

0.2

1.2

1.0

1.0

Capital value growth

1.8

-11.9

1.5

1.9

2.0

2.0

Income return

5.3

6.5

6.4

6.4

6.4

6.4

Income return

4.1

4.7

4.7

4.6

4.6

4.6

Total return, % p.a

3.6

-17.7

6.7

7.6

7.4

7.4

Total return, % p.a

6.0

-7.2

6.2

6.6

6.6

6.6

Sources: MSCI, Capital Economics


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