July UK Real Estate Market Outlook. For Investment Professionals only

Transcription

1 July 18 UK Real Estate Market Outlook For Investment Professionals only

2 Executive summary Recent moderation in economic activity unlikely to continue Brexit transition period agreement provides some certainty for businesses Prime retail to remain most resilient against structural change The requirement for flexibility driving the shape of office demand Continued shift to alternatives as investors seek diversification opportunities 1

3 Snow flurries mask the continued, modest economic expansion The start of 18 saw a slowdown in the UK economy, with real GDP growing by only.% over the first quarter. The arrival of the socalled Beast from the East storm in March, bringing construction to a standstill and deterring consumers from hitting the shops, contributed in part to this lacklustre expansion. The prevailing view is that the slowdown in Q1 was largely due to one-off factors and that growth will start to pick up again. Indeed, there are a number of reasons to remain optimistic about the UK economy. The labour market remains buoyant, with the employment rate reaching a new high in March. The number of unfilled job vacancies also remains high (an indication of the tightness of the labour market), placing upwards pressure on wages, while inflation has been on a downwards trajectory since the start of 18. The combination of these factors should directly benefit workers who are not only experiencing healthy nominal average earnings growth (.6% p.a. in April 18), but also rising real earnings growth too. After a year of falling real wages in 17, this shift, which is expected to continue as inflation eases further, should help to underpin consumer spending as Britons start to feel better off. Figure 1: Real wages start to rise (%) Mar-13 Dec-13 Sep-14 Jun-1 Source: ONS, Experian, June 18. Mar-16 Average earnings' growth CPI Inflation Positive macro factors, such as stronger employment and rising real wages, could push the Bank of England towards a rise in the base rate, while easing inflation, a cooling housing market and more moderate economic growth could act against this. These mixed messages are enough to have led policymakers to hesitate in their decision to tighten monetary policy, but the consensus still expects interest rates to rise this year. The pace of hiking, however, is likely to be slow and gradual. Dec-16 Sep-17 Jun-18 Forecast Mar-19 Dec-19 Some certainty on the road to Brexit Brexit continues to affect business sentiment, with the uncertainty around our future position in the European market meaning that many corporations and also investors are maintaining a wait and see approach to investment. The path ahead for the economy therefore continues to look volatile. That said, however, some progress is being made, including an agreement regarding the terms of the Brexit transition period being finalised, providing some certainty over Britain s relationship with the EU until the end of. In addition, the recent agreement by the cabinet on the UK s wish list for Brexit has also created some clarity over what the nation is aiming for in terms of its relationship with the EU. This is likely to lend some support to the economy, boosting business investment to some extent. As such, while Brexit-related uncertainty continues to affect the economy, there remains the potential for upside as talks progress. Figure : Business investment still held back by Brexit worries Business investment growth (% p.a., SA) 16 EU 14 Referendum 1 vote Mar-1 Sep-1 Mar-11 Sep-11 Source: ONS, June 18. Mar-1 Sep-1 Mar-13 Property market returns holding up Sep-13 Despite a slightly softer economic environment, total returns have remained around their year-end 17 highs, with the MSCI All Property index showing performance of 11.1% over the 1 months to May 18. Mar-14 This total return was split almost equally between income return and capital growth, with continued yield compression largely responsible for rising values. Rents are still rising on average, reflecting ongoing demand, but also still-limited development. The average is, however, increasingly masking a growing level of divergence between sectors. The undersupplied and structurally-growing industrial market is going from strength to strength, while e-tailing competition and weaker consumer demand continues to impact the retail market. Sep-14 Mar-1 Sep-1 Mar-16 Sep-16 Mar-17 Sep-17 Mar-18

4 Figure 3: Performance increasingly polarised by sector MSCI total returns (%p.a.) May-13 Aug-13 Nov-13 Feb-14 May-14 Source: MSCI, June 18. Aug-14 Nov-14 Feb-1 May-1 Aug-1 Nov-1 Feb-16 All Property All Retail All Office All Industrial Omni-channel retailing offers the path to success News headlines over the last few months focusing on high-profile administrations and portfolio right-sizing have led to a general sense of doom and gloom around the retail sector, resulting in muted rental expectations. Retailers continue to experience rising costs in the face of softer consumer demand, placing pressure on margins, particularly for mid-market brands. E-tailing competition also continues to take its toll, with retailers such as Toys R Us, which perhaps focused on in-store to the detriment of its online offer, suffering the consequences. Although the shift to online shopping will continue to disrupt the industry for some time, bricks will remain important as will clicks in the retail story. To maintain competitiveness, retailers will need to focus increasingly on how they engage with their customers. Survey evidence suggests that offering multi-sensory experiences and the best possible one-to-one customer service will help retailers make the most of the natural advantages that in-store has over online. This will have an important impact on how retailers use physical space and where that space is located. We still believe that retail occupiers will increasingly focus on prime locations, which are well-connected and accessible, as well as having destination appeal and favourable demographics, to the detriment of secondary and tertiary submarkets. Equally, assets which are both functional and flexible will be of greater appeal than those older and smaller units. These types of locations and assets are therefore more likely to see the strongest rental growth going forward. May-16 Aug-16 Nov-16 Feb-17 May-17 Aug-17 Nov-17 Feb-18 May-18 Physical retail format also plays an important part in this new retail age. With retailers shifting towards omni-channel strategies, there is a greater focus on the best click-and-collect locations. This type of approach plays to the strengths of big-box retail parks, which tend to be easier to access and offer extensive parking, as well as being larger and more flexible in terms of their physical format. Well-located assets in this category are likely to see better rental performance. Figure 4: Rental growth in prime locations remains resilient Rental growth (%p.a.) May-13 Aug-13 Nov-13 Feb-14 May-14 Source: CBRE, May 18. Aug-14 Nov-14 Feb-1 May-1 Aug-1 Prime retail Nov-1 Feb-16 May-16 Aug-16 Nov-16 Feb-17 Secondary retail Industrials: rental growth spreads to fringe submarkets While retail becomes increasingly polarised, the industrial market is experiencing growth across the board. Industrial occupier demand reached a three-year high in the first quarter, 1 with almost 6% of industrial demand coming from retailers looking to move into purposebuilt industrial space as part of the restructuring and future-proofing of their supply chains. Some retailers, M&S and H&M for example, are rationalising their store portfolios and instead investing in major new distribution centres to service consumer online demand. Logistics has been an important focus for retailers in recent years (Figure ), with major companies increasing their logistics portfolios in line with their sales growth. Department store John Lewis, for example, has invested heavily into its distribution network to offer an omni-channel solution across the UK and build capacity for expected future online demand. Its focus on logistics is certainly proving beneficial and far-sighted. This symbiosis between retail and industrial is likely to drive industrial rental growth going forward, particularly in wealthier and supply-restricted areas, such as London and the south east where there is strong competition for space. May-17 Aug-17 Nov-17 Feb-18 1 Source: Cushman & Wakefield, Q

5 Total occupied floor space, millions sq ft 1 1 However, as is usually the case when new, larger players take a greater share of space in a sector, pushing rents to ever-higher levels, some of the more traditional players who cannot compete get forced out into more peripheral locations. This is particularly true of the multi-let sector, where this type of tenant displacement is causing rents in more fringe areas to rise. We expect this trend to go on as competition for space continues. Figure : Retailers logistics floorspace versus retail sales Sainsbury s Lidl John Lewis Amazon 4%p.a. %p.a %p.a. 1%p.a. Total Logistics Floorspace (LHS) Source: PMA, Company reports, April %p.a. 6%p.a. Sales/Revenue (RHS) 3%p.a. 31%p.a London office market continues to defy gloomy post-referendum predictions Despite ongoing uncertainties surrounding Brexit, demand for London office space remains relatively robust and overseas employers, in particular, continue to form a significant proportion of take-up in the Capital. London s reputation as a market that provides access to high-quality buildings and a deep, talented labour force is helping to allay Brexit-related concerns. That said, cyclical factors continue to affect the market and significant development is still acting to constrain rental growth, particularly in the City and Canary Wharf. As we move further into the development cycle, however, we expect this effect to gradually subside, leading to the potential for a recovery in values in around 18 to 4 months time. Brexit aside, the shift towards flexible office space is increasingly driving occupier demand in Central London. With the continued growth in tech start-ups and the move towards entrepreneurialism going hand-in-hand with the millennials mindset, this new-style occupier is looking for more flexible space, both in terms of lease and working environment. Even traditional occupiers are embracing this greater workspace flexibility, meaning that landlords will need to adapt their existing floorplates to include an element of flexible or co-working space to maintain appeal to both new- and old-style employers. We envisage that the demand for flexible office space will only increase in the future. While reworking existing space may increase landlords costs in the short term, it is sure to pay dividends over the longer term Sales/Revenue ( BN) Figure 6: Flexible office space driving take-up in London Take-up, millions sq ft WeWork The Office Group Regus Source: PMA, December 17. Cushman & Wakefield, Q MWB Busi. Exchange i Office Executive Offices 1 Public sector continues to drive regional markets Other Flexible space occupiers as % all Central London take-up Companies continue to gravitate towards the regional markets to take advantage of lower occupational costs as well as lower living costs for their employees. While take-up in the regions saw its usual post year-end dip in Q1, volumes remained above five-year averages, particularly in cities like Manchester, which is increasingly growing its reputation as a great place to live and work. Nowhere is this shift away from London more evident than in the public sector, which accounted for almost a third of regional take-up in the first quarter, similar to 17. Resilient demand is, however, meeting restricted supply. Although the supply pipeline has been firmly turned on in London for some time, development remains more restricted in the regions and as such, Grade A office space is increasingly competed for by occupiers. Although the larger investors, in particular, are starting to build selectively in the biggest regional cities, this lack of good space is placing significant upwards pressure on prime rents. Regional demand drives the residential Private Rented Sector Polarisation remains an important theme for the Private Rented Sector s (PRS) occupational market. With affordability constraints and Brexit uncertainty affecting tenant demand in London and the more central submarkets seeing high levels of housing development, rental growth remains subdued. However, prime Central London rents, which fell first and furthest, appear to be stabilising, partly as reluctant landlords feel more confident about their prospects for selling, reducing the rental supply on the market. We also seem 4 Flexible space occupiers as % all Central London take-up

6 to be moving past the peak in the development pipeline and this should lend support to rental values going forward, especially when combined with rising real wages. The regional markets are currently holding up better, as lower living costs and a greater focus from employers on the regional office markets are driving occupier demand, while development pipelines remain at a relatively early stage. This should boost rental values in the main urban centres across the UK. Figure 7: Polarisation in the PRS rental markets Index of Private Housing Rental Prices (% p.a.) May 13 Sep 13 Jan 14 May 14 Source: ONS, June 18. Sep 14 Jan 1 May 1 Sep 1 Jan 16 May 16 Sep 16 Jan 17 May 17 Sep 17 London South East GB excluding London Build-to-Rent also continues to gain traction, both in London and further afield, with British Property Federation figures saying that there are now 1, such homes in the pipeline. The input from institutional investors may, however, be needed now more than ever as ARLA Propertymark, the professional body for lettings agents, has indicated that April saw the greatest number of Buy-to-Let landlords leaving the market in three years, with more likely to follow as anti-landlord regulation and political uncertainty reduce the attractiveness of the market. This potential easing in rental supply comes as research from the Resolution Foundation indicates that up to one third of millennials may never be able to own their own homes, suggesting that tenant demand, and thus rental values, will continue to rise over the long term. Transaction volumes show greater breadth in interest Investment volumes saw their usual seasonal dip in the first quarter, recording 1.7 billion of transactions, a 3% drop on Q4. Nevertheless, this figure was broadly comparable with levels for the same period in 17, suggesting that it is very much business-asusual when it comes to the UK investment market. Jan 18 May 18 An increasingly notable trend is the changing nature of activity from a sector perspective. With investors becoming increasingly selective when it comes to retail assets, this is facilitating a push towards broadening portfolios more generally. Although industrial, backed by a strong structural and cyclical story, is seeing increased activity, it is the non-mainstream sectors that are mostly benefitting from investors change in appetite. Just over a fifth of deals in Q1 were within the Alternatives sector, more than twice the 1-year average. Figure 8: Transaction volumes by sector Outer circle: Q1 18 Inner circle: 1-year average (Q 8-Q1 18) Offices Industrials Leisure/hotels Alternatives (incl. PRS) Retail Source: Property Data, Q 18. This shift away from the mainstream is reflected in the fact that the top three deals since the start of the year were for portfolios in the other sectors, focusing on hotels or residential-related assets. This broadening in activity will likely pay off for investors as portfolios benefit from greater diversification, whilst also accessing long-term trends such as the ongoing shift towards private renting. Indeed, many of the Alternative property sectors are benefiting from fundamental supply and demand imbalances, often exacerbated by structural change in terms of housing, demographics or spending patterns. Therefore, as well as the diversification potential of adding such exposure, investors can also tap into strong long-term rental and capital growth potential. Structural change leading to sector role reversals Investors have traditionally viewed the three main sectors in particular ways: retail has tended to be classed as the sector for growth, both in rental and capital terms; offices for cyclical plays; and industrials for income. However, the ongoing structural change in the market is turning this on its head. Evidencing this, the income return on industrial property dipped below that of retail (4.9% p.a. vs..1% p.a.) in the first quarter of the year for the first time for over 4 years.

7 Figure 9: Industrial income return falls below retail MSCI income returns (%p.a.) March March 3 March 4 March Source: MSCI, May 18. March 6 March 7 March 8 March 9 March 1 March 11 March 1 March 13 March 14 Industrial Office Retail With industrial now also providing the highest rate of rental growth (.3% p.a. in Q1 18) and retail the lowest (.9% p.a.), it seems the switch of industrial to growth sector and retail to income play is well underway. Although highlighting the current potential for outperformance from overweighting industrial, this also demonstrates the importance of maintaining a diversified portfolio throughout the property cycle, in order to ensure that investors are always in a strong position to benefit from new short and long-term trends. Risk aversion provides long-term opportunities While continuing uncertainty means that investor focus remains on the highest-quality assets in the most prime markets, pricing on these assets appears keen. As such, those investors who are willing to take on a little more risk in the search for value may find that this approach can open up the potential for higher returns in the medium to long term. Good secondary assets across the sectors continue to offer a healthy yield premium above prime. Even assets in the highly competitive industrial sector display premiums of c.1bps for good secondary or above bps for standard secondary versus prime yields, while the premiums on offer for the other sectors are higher still. With careful consideration of the risk/reward trade-off, underpinned by strong knowledge of local market fundamentals and a focus on active asset management initiatives, investors could look to take advantage of current market mispricing. UK offers value in a global context Although Brexit uncertainty is still affecting the outlook for the UK economy, overseas investors remain attracted to the real estate market due to its strong underlying fundamentals. The UK continues March 1 March 16 March 17 March 18 to offer value, particularly in an international context, with prime office yields in London at a discount to those in many other core markets, such as Hong Kong, Paris and Frankfurt. Indeed, with the Central London occupier market starting to see signs of stabilisation, this will start to provide the opportunity for investment, particularly from an overseas perspective. However, risks remain for this market, notably related to Brexit, and so strong local market knowledge will be vital when considering buying into the Capital. The UK market as a whole also offers yields that are significantly over comparable government bond rates. At.9%, the MSCI All Property equivalent yield is well above the UK 1-year gilt rate of 1.%, providing a yield premium of 4.6%, significantly higher than the long-term historic average. Such a healthy cushion implies that UK property is likely to remain protected from the impact of expected moderate rises in interest rates. As progress continues to be made on Brexit negotiations, any shortterm impact of more moderate economic growth on the occupier markets is also likely to fade, leaving the UK commercial property market in a strong position to outperform in the future. Focus on structural change Take advantage of the shift to e-tailing by looking for welllocated industrial assets Embrace flexibility by repositioning retail and office assets for changing occupier needs through active management Look for PRS assets in major urban centres set to benefit from the continued trend towards city-living Mitigate cyclical uncertainty Seek quality assets in strong locations to withstand any short-term economic concerns Maintain a balanced and diversified portfolio Add alternative assets with defensive characteristics and favourable long-term demand fundamentals, such as residential property Take advantage of investor caution Look to develop/redevelop assets in the most attractive cities to capitalise on limited supply Consider investing further up the risk curve to take advantage of mispriced assets Get ready to look for opportunities in Central London, once supply issues are resolved 6

8 Contact Emma Grew Associate Director: Property Research +44 () Richard Gwilliam Head of Property Research +44 () Lucy Williams Director, Institutional Business UK and Europe, Real Estate +44 () Stefan Cornelissen Director of Institutional Business Benelux, Nordics and Switzerland +31 () For Investment Professionals only. This document is for investment professionals only and should not be passed to anyone else as further distribution might be restricted or illegal in certain jurisdictions. The distribution of this document does not constitute an offer or solicitation. Past performance is not a guide to future performance. The value of investments can fall as well as rise. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and you should ensure you understand the risk profile of the products or services you plan to purchase. This document is issued by M&G Investment Management Limited (except if noted otherwise below). The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority s Handbook. They are not available to individual investors, who should not rely on this communication. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. M&G does not offer investment advice or make recommendations regarding investments. Opinions are subject to change without notice. Notice to recipients in Australia: M&G Investment Management Limited does not hold an Australian financial services licence and is exempt from the requirement to hold one for the financial services it provides. M&G Investment Management Limited is regulated by the Financial Conduct Authority under the laws of the UK which differ from Australian laws. Notice to recipients in Hong Kong: The contents of this document have not been reviewed by any regulatory authority in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. Notice to recipients in Singapore: This document is issued by M&G Real Estate Asia Pte Ltd. This document may not be circulated or distributed, whether directly or indirectly, to persons in Singapore other than (i) an institutional investor pursuant to Section 34 of the Securities and Futures Act, Chapter 89 of Singapore (the SFA ) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. M&G Investments and M&G Real Estate are business names of M&G Investment Management Limited and are used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under numbers with its registered office at Laurence Pountney Hill, London EC4R HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. M&G Real Estate Limited is registered in England and Wales under number with its registered office at Laurence Pountney Hill, London EC4R HH. M&G Real Estate Limited forms part of the M&G Group of companies. M&G Investment Management Limited and M&G Real Estate Limited are indirect subsidiaries of Prudential plc of the United Kingdom. Prudential plc and its affiliated companies constitute one of the world s leading financial services groups and is not affiliated in any manner with Prudential Financial, Inc, a company whose principal place of business is in the United States of America. JUN 18 / W937