Real Estate Market Outlook UK

Transcription

1 July 217 Real Estate Market Outlook UK Part of the M&G Group For investment professionals only

2 Front cover photo: Hardman Square, Manchester.

3 Executive summary UK economic growth moderates, but still supportive of real estate fundamentals Some occupiers cautious due to heightened uncertainty, but continue to take space in certain sectors Industrials, offices and residential outside central London remain favoured Net investment dominated by overseas buyers Performance potential supported by long term UK fundamentals 42 years since UK unemployment rate was lower 1 1% expected increase in average regional office rents over the next 5 years 2 3% Rest of the UK residential rental growth expected for Source: ONS, 2 Source: M&G Real Estate Economic strength moderates, but UK still on a firm footing Furthermore, business investment since the start of this year has seen strong growth, with sentiment remaining positive. Economic momentum appears to have continued into 217, but has been modest growth in real GDP in the first quarter, at.2%, was below expectations. Consumer spending, the main driver of expansion in recent years, is being undermined by higher inflation, partly caused by sterling s depreciation and modest growth in average earnings. As disposable incomes are being squeezed, households are under increasing pressure to be more cost conscious in their spending. While political uncertainty has been a consistent feature in the UK recently, the labour market has been in rude health. The rate of unemployment, at 4.5%, is the lowest since Real GDP Growth (% p.a.) Fig. 2: Long term economic growth prospects remain strong for the UK UK US Canada Euro zone Next 2 years Long Term Germany France Italy Japan Investment Growth, 4 qtr. Mov. Avg., % Fig. 1: Investment growth despite heightened uncertainty SD -1 SD +1 Standard Deviation -1 Standard Deviation Investment Growth Source: ONS, M&G Real Estate 17 Source: Consensus Economics (June and April 217), countries ranked by forecast The UK has entered the uncertainty of Brexit negotiations on a relatively positive economic footing. The latest consensus forecasts see the UK economy growing by 1.6% 3 this year, on a par with Germany and ahead of France. While a further softening is expected, it is not anticipated to be pronounced, with the consensus pencilling in growth of 1.4% for 218. Long term, the UK economy is set to outperform its peers. The failure of the Conservative government to secure a majority in the general election has created renewed uncertainty. However, there is now a greater likelihood of pursuit of a softer Brexit. In addition, there seems to be less appetite for more austerity policies. Accommodative monetary policy continues with the Bank of England s base rate not expected to rise above.5% until Source: Consensus Economics 3

4 Rental growth index, 1 = Dec Rental market conditions holding up, but some occupiers cautious Compared to six months ago, occupier demand for space is starting to ease, arguably reflecting the uncertainty around Brexit. However, the economy s resilience immediately after the vote last year suggests the link between political uncertainty and economic activity is not overwhelmingly strong. This uncertainty, however, creates an environment in which it is difficult to make long-term decisions on investment or employment and therefore on taking space. It is no surprise then that businesses are pausing for breath and approaching certain decisions with a wait and see mentality. This is likely to continue until there is more clarity on the final outcome of the Brexit process. Evidence from MSCI s IPD index points to a reduction in the pace of rental growth at the all property level, but average rents for each of the broad property sectors continue to grow. We expect the all property average to see fairly flat rents over the next year or so, with some segments seeing decline (notably central London offices), but others, (such as industrials and residential outside of central London), to deliver healthy uplifts. Fig. 3: Rental growth continues with industrials leading the pack Brexit Referendum 1 Dec Jan Feb Mar Apr Jun Jul 15 Retail Office Industrial Aug Sep Source: MSCI (IPD) Monthly Index for 217 Oct Nov Dec Central London offices remain challenged, but there may be opportunities in the long-term A gradual weakening of rental growth in the office sector appears imminent. This is particularly so in London, which is much further ahead in its cycle and looks most susceptible to downside risks from Brexit negotiations. The drop in sentiment in the financial services sector towards the end of 2 was significant enough to reduce take-up levels across all central Jan 17 Mar of London jobs London markets. Some financial institutions have already announced plans to cut or relocate Londonbased staff, but estimates are this will be only 5-1% of the overall financial job market in London. In the long run, we expect London to remain a global financial hub. Traditional occupiers are likely to remain more cautious, keeping demand for office space in the capital at bay. Over the next two years, elevated supply of new office stock does not bode well for positive rental growth. We expect headline rents in the core office markets in the City and West End to see downwards revisions of 5-7% by 219, by which time the new supply should be absorbed and the outcome of Brexit clarified. Fig. 4: London job market is well-diversified TMT Finance and Insurance Source: M&G Real Estate, ONS, Experian Technology is radically changing the make-up of office tenants, their business models and consequently their requirements for space. There are now more technology, media and telecoms (TMT) jobs in London than jobs in finance and insurance. A well-diversified job market in London may create opportunities in the long-term. There is more demand for technologically advanced, open and collaborative workspace. A good example is WeWork agreeing to take 28, square feet on London s South Bank, to provide its largest global office space. We believe office buildings which meet occupiers requirements prompted by technological transformation will offer firm rental growth even in the current challenging environment. In the regions, demand for office space has held up. In the short term, the shortage of Grade A office stock (particularly in Bristol, Edinburgh and Manchester) is set to support rental growth. We anticipate rents rising by just under 2% pa over the next five years. Supported by major infrastructure projects, regeneration of city centres and improved office stock with a greater emphasis on facilitating work-life balance, the occupational markets in UK regional cities should continue to fare relatively well in the wake of Brexit. 4

5 Availability and take-up, 4 qtr. rolling, (million sq ft) Bright rental outlook for industrials The industrial sector remains one of our top picks for rental growth potential. The structural changes created by e-commerce have prompted a significant pick-up in occupational demand for logistics space. When combined with the limited availability of the right quality and specification of industrial stock, this means that the sector continues to deliver very healthy rental growth (3.9% y-o-y to 217 and c.3.2% pa over the past four years according to MSCI). With large retailers such as Amazon, Lidl and Aldi, as well as many smaller retailers, expanding their supply chains further and enhancing the online distribution capabilities to satisfy consumer demand for everything, everywhere, anytime, we believe strong demand for industrial space will continue. According to Lambert Smith Hampton, unsatisfied active demand stood higher in March of this year than it did in 2, which bodes well for decent levels of take-up going forward. That said, the dramatic jump in leasing reported last year, boosted by huge requirements by Amazon, may not be matched this year or next. The market is far from complete reliance upon Amazon, but unless the company surprises analysts by continuing to take such large volumes of space, it seems plausible to expect take-up and consequently rental growth to moderate somewhat and be driven more by other retailers and traditional industrial occupiers. Fig. 5: Demand remains strong whilst new supply wanes New/modern Take-up Source: Gerald Eve, M&G Real Estate Vacancy Tight supply should also support healthy rental growth. Development starts for distribution warehouses remain 5% above trend, but they have dropped significantly since last year s Brexit referendum result, while the majority of development is pre-let. Meanwhile the supply of multi-let industrial units continues to underwhelm given the demand, putting more pressure on existing stock. The prospect for further rental growth are evident. Vacancy rate (%) In London and larger cities like Manchester and Birmingham, the lack of available land on which to build, given competing higher value uses and green belt restrictions, is likely to accelerate a shift towards more innovative design solutions. These include multi-storey, subterranean, and mixed use space like beds and sheds assets which combine industrial with residential uses. The use of mezzanine floors, advanced robotics and increased racking automation could eventually lead to improvements in occupier productivity, enabling higher rents to be more affordable, thereby offering the potential for more rental appreciation. Flight to prime in retail; better outlook for retail warehousing While the industrial sector is benefiting from e-commerce, retail continues to have to adapt. In addition, the introduction of the higher National Living Wage has increased staff costs for many retailers, and the business rates review has resulted in higher costs of occupation for retail space in the most successful markets (notably in London). Higher inflation is another challenge. Retailers may pass on higher costs to their customers, but whether consumers will accept this is debatable. The significant discounting seen over the last few years, as a function of food store price wars alongside the competition and price transparency brought by online retailing, has continued up until recently. The BRC Nielson Shop Price Index is still negative but has reached -.4%, its highest level since the end of 213. Retail sales picked up in June, boosted by the hot weather, but the outlook is far from strong for high street spending in the near term. Consequently, rental growth for the retail sector is likely to be muted at best, with declines expected for some parts of the market. Many retailers are experimenting with new formats and physical space rationalisations, while the successful intown retailers are expanding out of town (e.g. Smiggle and Paperchase). Faced with the challenging environment, retail occupiers are focusing on prime pitches and prime assets. Demand for the best-in-class shops and shopping centres remains solid. Secondary and tertiary assets, however, are increasingly falling out of favour with retailers and consequently investors. The best opportunities for rental growth remain in major cities and regional centres with attractive public space and leisure offerings. In London, supported by tourism and a strong, often luxury, occupier base, rents are likely to continue rising, but at a slow pace given stretched affordability for occupiers. 5

6 Rental Growth Index, 1 = 2, Retail warehouses, in our view, offer the potential for rental growth, and favourable pricing can be found. This type of property is a good income play given current elevated yields and is better placed than other types of retail property to benefit from click-and-collect. In addition, by positioning themselves as lifestyle shopping destinations with landscaping and Food & Beverage (F&B) offerings, retail warehouses should attract more occupiers and visitors. The constrained development pipeline lends further support for some modest rental growth. Residential Private Rented Sector (PRS) benefiting from heightened uncertainty The Nationwide House Price index has shown three consecutive months of decline in June for the first time since the height of the financial crisis in 29, dragging down the rate of growth over the last 12 months to just 2.1%. However, with rock bottom interest rates, limited supply and ongoing demand, house price growth is likely to remain positive. A lack of affordability for would-be first time buyers and the heightened uncertainty which contributes to caution towards big purchase decisions, such as buying a home, continue to underpin demand for rented accommodation. The RICS UK Residential Market Survey suggests tenant demand has continued to rise across the country, with the exception of central London. With a substantial development pipeline contributing to more new space, our rental projections for the central London PRS market remain negative. Conversely, rents in the rest of London and the wider South East are set to rise faster than inflation going forward. Tenant demand in these markets maintains momentum. Regional residential in large urban centres is becoming more favoured. According to MSCI, residential rents in the rest of the UK grew by 2.5% in 2 (ahead of rents in London and the South East), driven by healthy demand and decent rental growth prospects (JLL). Fig. 6: IPD Residential Index rental growth outside of central London more evident recently Resi: Central London Resi: Rest of London/SE Resi: Rest of UK Source: MSCI (IPD) Annual Residential Index for 2 Net Investment ( bn) Solid demand from investors for the right stock Brexit uncertainty doesn t seem to have deterred overseas investors from buying UK real estate. According to JLL, London was the largest recipient of foreign investment in 217 (c. 6.5bn). Sterling s weakness has surely contributed, but the long-term characteristics of UK property and especially London, such as a liquid and highly transparent market supported by a very well-established and respected legal system, have contributed to attracting international capital. For Asian investors in particular, a desire to diversify away from their own domestic markets remains a key motivation. The acquisition of the landmark Cheesegrater office building in London, by CC Land, a Hong Kong listed company, at c. 3.4% net initial yield, looks at least 5 bps cheaper compared to pricing in Hong Kong. Fig. 7: Overseas buyers dominating net investment Q2 Q4 Q2 Overseas Investors UK Institutions Quoted Prop. Companies Private Companies and Individuals Source: PropertyData.com (April 217) Q4 Other Q2 Q4 17 Demand for real estate assets has also come from local authorities aiming to take a more active role in the regeneration of their locations, who can also take advantage of the low cost of debt on offer from the Public Works Loan Board (PWLB). Central London offices, which appear expensive for domestic players, remain attractive to overseas investors. Whilst the compelling occupational fundamentals and income return perspective of the industrial sector is appealing, pricing is getting more aggressive. Where a lack of suitable investment stock and development land exists coupled with growing investor competition for the same product, yields are reaching record lows. In contrast, retail sector transaction volumes are low. Yields on retail warehouse assets in particular are elevated, following fairly significant softening post the Brexit referendum. We believe there now exists buying opportunities with good investment performance potential. 6

7 12 1 Supported by attractive pricing relative to government bonds the spread of the IPD All Property equivalent yield over 1-year gilt yields is around 5bps we anticipate investors will continue to favour real estate. Fig. 8: Real estate investors offered significant risk premium we expect to continue. However, we also believe that ongoing risk aversion and yield expansion for non-core stock creates opportunities. Higher yielding assets with challenges, such as refurbishment or repositioning needs, vacancies or short leases, have a future if they are managed well. These assets, particularly if bought when taking advantage of cheap pricing, can offer healthy investment returns for those willing to take on the potential for volatility. Yield (%) Yield Spread 98 2 UK 1-year Government Bond Yield IPD All Property Equivalent Yield Source: Bloomberg, MSCI (IPD) Monthly Index for 217 This spread offers a significant cushion against upwards yield pressure should bond yields start rising. Uncertainty has contributed to increasing risk aversion and pricing for secondary assets has weakened, which Reason for cautious optimism on UK real estate While we are aware of downside risks related to the uncertain political backdrop, we believe there is reason for cautious optimism on UK real estate. Rental growth may soften, but in some markets the supply/demand dynamics point to further uplifts in rents, particularly for better quality space. In addition, interest from investors given UK real estate s attractive characteristics and pricing compared to competing investments should continue to support yields for prime assets. Investors should remain cautious, but they should also be ready to take advantage of the opportunities that will emerge. Brexit mitigate risks Remain cautious Focus on property fundamentals and long term attractions of the UK and London Maintain a balanced, diversified portfolio Disruptive technologies rental growth potential Future proof retail assets through active management Access industrial benefitting from e-commerce-driven change Embrace potential of modernised offices RISK RIS R LOW HIGH HIGH LOW R E T URN N T U R R N Risk aversion opportunities emerge Investor focus on short term risk influencing pricing Identify underpriced riskier assets with viable long term future Be wary of London office market in short term, seek opportunities there for long term 7

8 For more information Aneta Wiak Research Manager +44 () Richard Gwilliam Head of Property Research +44 () Christopher Andrews, CFA Head of Client Relationships and Marketing, Real Estate +(65) 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 investors in the Netherlands: This document does not constitute investment advice or an offer to invest or to provide discretionary investment management services. Notice to recipients in Hong Kong: The contents of this document have not been reviewed by any regulatory authority in Hong Kong. If you have 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 289 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. DEC 17 / W2528 8