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Q3 Market Overview

28 September 2018

Brexit – deal or no-deal?

The deadline negotiations are fast approaching, although much of the detail of the future relationship is likely to be pushed into the post-Brexit period. The chance of a general election before Brexit is low, but not negligible, with no overall majority the most likely outcome.

The property market is proving fairly resilient to this environment, supported by increasing investment allocations to property and a shortage of stock. Uncertainty however persists and whilst this may delay occupational or investment decisions for some it also creates opportunity for those with the appropriate expertise and experience.

Economy standing firm

UK GDP grew by 0.6% in the three months to July, up on the first quarter.  The yearly out-turn for 2018 is expected to be 1.3% y/y.

 

Source: ONS/Oxford Economics

Some respite for households?

Unemployment continues to edge lower, with tentative signs that wage growth is accelerating. The next few months are expected to remain weak and the consumer (assuming a satisfactory Brexit outcome), will be boosted by a combination of rising incomes, falling inflation and stronger sterling. The chancellor is certainly looking forward to better times ahead, with the budget deficit back to manageable proportions, although the PM has already earmarked additional spending for the NHS.

Were the UK to leave the EU without a satisfactory Brexit agreement, a repeat of the post-referendum fall in sterling is likely to follow with the knock on to a rise in inflation. Interest rate cuts would provide some cushion, but households would inevitably take a hit in the short-term, possibly a significant one.

Bond yields remain becalmed

The 10-year government bond yield shows little sign of rising, currently at 1.4%, barely higher than it began the year. Prices are growing only modestly, with CPI inflation up 2.7%. Base rates are therefore expected to rise slowly, with a 25bp rise expected in 2019 to 1%.

Source: ONS/Oxford Economics

UK property market

The commercial property market has performed very strongly over 12 months to June 2018, with returns of 9.3%, out-performing both equities (8.3%) and bonds (0.7%) (MSCI data).

The weak spot in the market has been the retail sector, particularly shopping centres, generating marginally negative returns over the 12-months to June. This performance also reflects the struggling high street, with a further 2,085 stores already affected by retailer insolvencies in 2018.

The performance of industrial property is quite a contrast to the retail sector with total returns exceeding 20% over the last 12 months. Rental growth in this sector accelerated to 5% p.a. (H1, 2018), partly due to retailers investing heavily in their supply chains to fulfil online sales and goods demand from Aldi, Lidl and trade-counters (e.g. Screwfix). Looking ahead, we expect that industrial rental growth will slow to 2-3% p.a. but continue to show strong performance.

In the office sector, the fall in vacancy seen in most cities since 2013 has halted, at least temporarily and office rents are in general likely to remain positively stable. Although development in most cities has already peaked, a relaxation of planning controls mean that many towns and cities are losing both office and industrial space.

Regional offices

The sustained increase in economic output has fed through into rising regional office rents, with prime rents in all eight major regional office markets above their previous highs (CBRE).

The recovery has been strongest in the South East, up from £27 per sq ft (2010) to £39 per sq ft (Q1). Elsewhere the recovery has been positive, but more modest.

Source: CBRE

Office demand remains very positive with stronger office-based employment growth expected in most major cities, compared to the past 10 years.

Source: ONS/Oxford Economics

The expansion of the flexible serviced office providers, especially WeWork, into Grade A buildings has helped push prime vacancy rates down in the 6 largest locations to 1.7%(JLL). Despite such low vacancy rates, speculative development fell to 2.1m sq ft at the end of 2017, laying the foundations for future rental growth.

Multi-let industrials and logistics

Industrial rents have also been growing strongly, as seen in Glasgow (£6 to £8 per sq ft) and Birmingham (5.2% y/y).

Industrial rents tend to respond to broad based output growth, which is expected to be positive in all major regional locations, with Manchester and Edinburgh expected to see the strongest rates of growth.

Source: Oxford Economics

Alternatives

Only two-thirds of real estate transactions in the last 12-months were for office, retail and industrial property, with investors keen to expand their exposure to non-traditional property types (Property Archive).

Student accommodation accounted for 6.4% of this, demonstrating its emergence as a mature sector and one commanding ever higher prices.

Hotels are now arguably a firmly established institutional sector and one which is performing strongly.  Occupancy remains very healthy, comprising 86% of serviced accommodation sector (Visit Britain Occupancy Survey). Revenue per room in July was up even more strongly from £85.78 in July 2017 to £91.15 in July 2018.

Other forms of residential could well dwarf the student accommodation sector, if even a small proportion of the UK housing stock were to be managed by institutions. For now, the sector remains very small and performance is still driven by the wider housing market.  House prices climbed 3.1% in the year to July (ONS), with the strongest growth in the regions at 5.6% (North West).

The long-term occupier demand for both primary care and care homes is also attracting increased institutional investment and with an ageing population, this is only likely to grow.  With a multitude of operational exposure and leasing arrangements, risk and returns are very scheme specific. For the time being, investor interest is mainly in focused on lease based opportunities.

Summary

A period of change is ahead of us.  Time will tell whether it is the rise of serviced office providers, internet-based/multi-channel retailing, the increased allocation to ‘alternatives’ or Brexit that will have the longest lasting impact on the UK property market.

For now, the search for yield and value in a low interest rate environment and the attraction of ‘real’ assets, is expected to keep pricing high and reward investment strategies that create value and deliver secure income streams.

 

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