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Q3 Market Overview Seeing through the Brexit fog


October 2019

On the back of a summer of cricketing heroics and glorious weather in the UK, the global economy has by contrast been sluggish and lacklustre.

There have been economic storms over the North Atlantic with a slowing of US growth, largely driven by the trade tensions between China and the US, The Fed has responded by cutting US interest rates for the first time in more than 10 years. These economic storms to the West are matched in Germany, where a fall in business confidence and manufacturing output could lead to a second consecutive quarter of negative growth. Over in China, there is the rapidly inflating debt bubble wobbling its economy. Then we have the world’s sixth largest economy and the small issue of Brexit.

There has been a cloud of uncertainty over the last quarter surrounding the UK political and economic environment, which some have called “unprecedented turmoil” in Westminster. The government has lost its majority and there has been a triple defeat for Boris in the Commons, not to mention its suspension. All the while, the Brexit saga rolls along and political commentators have been queuing up to tell us this is the lowest point in the UK’s recent history with warnings to expect stormy economic weather this autumn.

The expectations, both globally and in the UK have been grim reading, except that is not quite what is happening!

In the UK, the economy expanded by 0.3% in July, faster than expected. Employment is up, with the latest ONS estimate reporting that the UK employment rate is at a record high of 76.1%, and the trade deficit narrowed slightly as imports fell. After a dismal spring where there were fears of the UK slipping into a recession following the 0.2% fall in output in June, car production has been a factor that has eased the spluttering engine of the UK economy. The services sector (accounting for c.80% of the UK economy) also grew by 0.2% in the three months to July, at a solid yet unspectacular pace.

Despite the increase in output, consumer spending continues to decline with household expenditure down by -1.3% year on year, following a -1.2% decrease in July according to Visa’s UK Consumer Spending Index, compiled by IHS Market. Furthermore, one of the more significant falls was seen in Britain’s building industry. The latest business sentiment surveys, HIS Markit UK Construction PMI dropped to 45.0 in August, below the 50.0 mark threshold that signals growth. Lower volumes of construction output have been attributed to a worsening of order books and a lack of new projects. In addition, a tight labour market continues to exert upward pressure on wage growth, which has reached a post financial crisis high of 4% year on year whilst CPI inflation fell to 1.7% in August, its lowest level since the end of 2016.

Whatever the reason for the economy continuing to purr along to the point where it looks like a technical recession is avoided, we should be cognisant of the fact that the economy is still weak and we should still brace ourselves for the possibility of a no deal Brexit. This is the weakest first three quarters of any year since the financial crisis.

by Jonathon Ellerington

UK Property Market

As summer draws to a close, it is perhaps unsurprising that real estate markets are more subdued with low transaction volumes across the commercial markets. The sector is inextricably linked to the current macroeconomic situation and despite its differences to other asset classes the real estate market is not immune to the Brexit related political and economic uncertainty that is dominating the headlines.

The volume of UK commercial real estate transactions in H1 2019 slumped to £17.3bn, almost half the £30.9bn of H1 2018, with both domestic and overseas investment activity in UK real estate losing momentum. However, overseas investors are still active and remained net buyers in the UK market.

 

 

 

 

 

 

 

 

The IPF consensus anticipates weak but positive total returns, with a trough in 2019 and then gradually recovering. The UK commercial property market delivered an all property total return of 0.9% over August 2019, up from 0.3% in July 2019, but down from 1.8% a quarter ago. This is driven by reductions in retail capital growth forecasts, due to the weakness in the retail market following significant long term structural changes in the sector.

 

 

 

 

 

 

 

 

Source: IPF UK Consensus Forecasts Summer 2019

Returns for commercial property are still high when compared to other asset classes. Furthermore, a weakening bond yield makes a strong case for investing in UK real estate. No matter which property sector, bond yields will need to rise significantly before UK real estate becomes relatively unattractive. The current spread between 10 year bonds and the All Property average transaction yield stands at a near record high of 480bps, as seen below:

 

 

 

 

 

 

 

 

Source: MSCI Eurostat

Given that we are no closer to establishing if the UK leaves the EU with or without a deal, yields are stable and there has not been a movement in pricing for August.

Sector Specific Focus

Amid this shadow of Brexit there are still reasons to be positive. Whilst investment volumes are low in comparison to typical Q3 averages, investor appetite has increased for the alternatives sector. Of the capital deployed, Savills have stated that 56% has been in this sector demonstrating investors hunger for diversifying into sought after segments of the market. The alternatives sector itself is still set to grow, at a projected rate of up to 20%. Hoteliers are still looking to modernise and extend their estates, care home operators are on a similar drive and key worker provision is still way below the necessary requirements.

The industrial sector has also remained resilient after a subdued start to the year. Strong rental growth has boosted overall total returns for the sector. Deals in August were up at £232m from July’s £196m, with transactions including Royal London’s acquisition of a multi-let park in West Thurrock and Equites purchase of our very own Super G. On the occupational side, rental growth was maintained in Q2 (MSCI quarterly index). The major commercial property research houses are still expecting all industrial rents to show growth of 3% year on year by the end of 2019.

Other sectors aren’t enjoying the same levels of activity with retail coming under increased pressure. There have been a number of Company Voluntary Arrangements (CVA’s) over recent months and many retailers are planning to close stores. This is all summed up with the iconic Marks & Spencer dropping out of the FTSE 100 Index following a near 20% fall in its share price. The ongoing structural shift towards online retail is impacting retailers who have inflexible leases, high rents and excess properties, which all have been contributing to the negative total returns throughout 2019.

Summary

Entrepreneurial investors like Barwood Capital, are still able to create value from the real estate market through the evolving industrial tenant base and the demographic change in population, offering opportunities to achieve strong returns from both the multi-let industrial and care home sectors and we see this continuing. In addition, the low levels of grade A office space in our main regional cities and the falling values in the retail sector, are likely to present certain opportunities in the future and Barwood Capital with its development and asset management skills, is well positioned to selectively acquire such opportunities that can be repositioned through active asset management. A deep understanding of the micro location is vital for the best prospects of outperformance and Barwood Capital’s regional reach is key to this.

We are heading into the crunch period for Brexit and it will be interesting to see whether a deal can be achieved in October. Until we have certainty, the fog that surrounds Brexit will continue to weigh on appetite in the UK real estate market with the short term outlook for the commercial property market arguably volatile. This current uncertainty means less competition for the undermanaged, more secondary assets that require development and asset management expertise to create core income producing investments for which there is greater competition. Market insiders believe that if we do exit Europe, then a post-Brexit binge is entirely possible, releasing a huge pent-up demand. Fundamentally however, the market remains resilient in terms of both yield and capital growth and investors will continue to look to it as an attractive asset for those looking for growth.

by Jonathon Ellerington

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