UK Commercial Real Estate Market Outlook

Transcription

1 UK Commercial Real Estate Market Outlook April 214

2 Foreword Paul Coates, Head of Real Estate Welcome to this first of a series of notes exploring the outlook for UK Commercial Real Estate. In this note we reflect on what the market is telling us by considering transaction volumes, pricing and risk premium. Alongside this, we set out our capital and rental growth forecasts, derived from RBS Economics macrolevel outlook for the UK economy. Finally we highlight the lead indicators of listed companies share price performance and analyst recommendations.

3 Summary The Wall Street proverb When the ducks quack, feed them is a good way to set the scene for our UK Commercial Real Estate (CRE) market outlook. The sector has been dominated by accelerating growth over the past 6-12 months. We think this is set fair for the near-term. With the prospects for UK CRE intertwined with the economy s recovery we set out below the RBS Economics forecasts for GDP, RPI and rates. Our opening chart highlights the pace of transaction volumes and capital growth through 213, with the former supported by some notably large lot size deals, for example Broadgate, More London and Chiswick Park. Appetite for UK CRE drove transaction volumes to 3.bn in 213, an increase of 6% on 212 with Q4-13 reflecting a quarterly increase of c.7%. This strong tailwind of demand pushed capital growth for 213 to 4.6%. The scale of this growth is highlighted by the month on month recovery that took capital growth from negative territory at the start of the year (-.2% Jan-13) to 1.4% by Dec-13. Whilst forecasts of steady growth in GDP and broadly flat RPI bode well, the consequential increase in rates (albeit not forecast until the end of 21) will exert upward pressure on CRE yields. The timing and pace of this inevitable rise is likely to be the biggest source of downside valuation risk to UK CRE, even though it is expected to be off-set, to some extent, by forecast rental growth. Looking out to the end of 217, each economic and rates forecast shows growth GDP RPI 3 Base rate 1 yr gilts yr swaps Source: RBS Most with experience in the market are either cautiously optimistic or modestly pessimistic. Our forecasts point towards increasing All Property capital growth for 214 (1.%) and 21 (2.9%), with mild declines through 216 (-.4%) and 217 (-1.7%). Economic Forecasts (Nov - 13)

4 If rates are expected to lead the pack in terms of impact on UK CRE, risk premium is likely to be a close second. One of the most striking characteristics of current forecasts (including RBS) is the reducing risk premium for the period to the end of 217. RBS forecasts show a reduction from c.3bps to c.1bps between the end of 214 and 217. This forecast reduction absorbs at least some of the upwards pressure on yields arising from increased rates and could potentially underestimate the scale of downside valuation risk. Before we delve into risk premium, capital and rental growth forecasts, we set the scene with a snapshot of investment activity. UK Commercial Real Estate Market 213 The accelerating pace of transaction volumes and capital growth ( bn) Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Transaction Volume - Quarterly All Property (LHS) Capital Growth - Monthly All Property (RHS) Sep-13 Oct-13 Nov-13 Dec Source: Property Data, CBRE 4

5 Transaction volumes Whilst each of the metrics covered by this note are linked, we consider transaction volumes to be the best starting point. This is because it highlights the dominance of specific investor groups and the areas of the market for which there is most demand. Polarisation was a much used word in 213. The interaction of dominant Overseas Investors (across acquisitions and sales), Central London Office transaction volumes and yield compression driven capital growth, is a good example of the win:win dynamic at play in some of the most dominant areas of the market. The scale of activity by Overseas Investors with regards to Central London Offices, and its downward pressure on yields is so dominant that it can overshadow the more measured activity and pricing across the rest of the UK market. Whilst there is a risk of groupthink pushing the Central London and the highest quality, large lot size retail markets to levels dislocated from traditional real estate investment fundamentals, we do not think this applies across the market as a whole. Investment Transaction Activity 213 Overseas Investors accounted for 4% of acquisitions and 32% of disposals ( bn) Institutions Quoted Property Companies Private Property Companies Overseas Investors Private Individuals Aquisitions Sales Net Occupiers Financial/ Banks Others Source: Property Data In addition to CRE fundamentals, whether Overseas Investor demand is maintained will be dependent on the known unknown external factors of, for example, the actions of international governments, central banks and regulators, global economic growth, political and civil unrest, and FX. Anecdotal evidence and sentiment from the start of 214 suggests Overseas Investor demand is likely to continue for now. However, any marked decline in its pace or a switch to net sales will likely have a material impact on the UK CRE market. Notwithstanding these uncertainties, the absolute and relative returns from UK CRE continue to feed investor demand. In the following section we consider the income return and risk premium attractions of the market. Investment Transaction Activity 213 (Volumes vs. Yield) Central London Offices accounted for 4% of transactions ( bn) Central London Office Rest of UK Office Transaction Volume (LHS) Net Initial Yield (RHS) Shopping Centre Retail Warehouse Shop/ Supermarket Industial Leisure Source: Property Data

6 Risk premium Both transaction data and IPD s index point to a c.6% All Property net initial yield as at the end of 213. This supports the absolute and relative income return attractions of the UK CRE asset class. In addition to the absolute return of a c.6% yield, the sector s relative attractions are clearly illustrated by the spot risk premium against alternative asset classes. As at December 213 the spread relative to 1 year gilts was 3.2%, with 2.4% against corporate bonds and 2.9% against the FTSE dividend yield. Whilst the spread narrows as we look out to the end of 217, it remains positive at 1.% (1 year gilts), 1.4% (corporate bonds) and 1.7% (FTSE dividend yield). Time will tell whether this level of yield gap is sufficient to maintain investor demand for UK CRE. We estimate that a range of 2% - 3% is the long-term average applied by UK CRE investors. A return towards this range would be likely to amplify the downside valuation risks across the market - especially if combined with a period of rising rates. Income Return & Risk Premium Attractions of UK CRE The positive yield gap ranges from 3.2% to 2.4% (as at Dec-13) Jan-4 May-4 Sep-4 Jan- May- Sep- Jan-6 May-6 Sep-6 Jan-7 May-7 Sep-7 Jan-8 May-8 Sep-8 Jan-9 May-9 Sep-9 Jan-1 May-1 Sep-1 Jan-11 May-11 All Prop Initial Yield Initial Yield less 1 Yr Gilts Initial Yield less Corporate Bonds Initial Yield less FTSE Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Source: Bloomberg, RBS, IPD Forecast Income Return & Risk Premium Attractions of UK CRE The positive yield gap narrows to between 1.7% and 1.4% by end of YE 21YE 216YE 217YE Initial Yield less 1 Year Gilts Initial Yield less Corporate bonds Initial Yield less FTSE All Prop Net Initial Yield Source: PMA, Bloomberg, RBS 6

7 Whilst reflecting on the risk premium applicable to UK CRE, it is important to keep in mind that history provides examples of CRE yields falling at the same time as rising gilts yields. The longest period was from early 26 to mid 27, for 16 months. This could be argued to support forecasts that include a narrowing positive spread, at least in the near-term. Although it is clear that the dominant relationship is for rising gilt rates to be followed by higher CRE yields. With CRE yields being an important component of risk premium, it would be remiss not to point out that investor demand has driven many yields down to below their long-term averages. Yield levels relative to their long-term average is an established proxy for market risk. Comparing the long-term average (back to the late 198s) and recent yields, suggests potential valuation downside across many sectors. Having touched on forecasts in the context of risk premium to illustrate why UK CRE retains a compelling investment case, we now set out these numbers in more detail. Risk Premium Timeline: periods when yields rose and equivalent yields fell Whilst there are exceptions, the dominant trend is for CRE yields to follow gilt rates (rebased) Jan-87 Jan-89 Jan-91 Jan-93 Jan-9 Jan-97 1 yr Gilt Yield All Property Equivalent Yield CRE yields falling at the same time as gilts yields are rising Jan-99 Market Risk Illustration via Equivalent Yield (Long-term average vs. Feb-14) Jan-1 Many areas of the market point to potential valuation downside CBRE Prime Industrial Estates IPD South East Industrial Estates CBRE Major Provincial Office IPD Rest UK Office CBRE West End Office IPD West End Office IPD City Office CBRE Retail Warehouse IPD Retail Warehouses CBRE Best Secondary SC CBRE Prime SC IPD Shopping Centres 3 Jan-3 Jan- Jan-7 Jan-9 Jan-11 Jan (% Equivalent Yield) Source: Bloomberg, RBS Source: PMA, CBRE 7

8 Forecasts RBS Economics forecast All Property capital growth for 214 of 1.%, rising to 2.9% in 21. Mild declines are forecast through 216 (-.4%) and 217 (-1.7%). These All Property figures comprise more volatile forecasts at a sub-sector level, with Central London Retail leading the field (18%) and Secondary Shopping Centres lagging behind (-14.%) - based on 4 year compound growth. Breaking these forecasts down by capital growth and rental growth shows that with the exception of Small and Medium Town Retail, and Secondary Shopping Centres, ERV growth is expected to be positive. The balance of capital growth is much more mixed with c.6% of the submarkets in positive territory. It is important to recognise that rental growth has been increasingly positive for the past two years. Whilst this growth is forecast to continue, higher rents are not expected to off-set the dominant downward pressure on asset values from yield expansion. This is illustrated by the capital declines forecast from 216 onwards. Capital Growth Forecast (4 year compound) All Property forecasts include a wide range of sub-sector performance Offices Retail Industrial All Prop West End M2 City Rest UK Big 6 Cities Business Parks Central London Supermarkets Big Shopping Centres Leisure London Suburbs Retail Parks Big Towns Retail Warehouses Prime Smaller Shopping Centres Small & Medium Towns Secondary Shopping Centres London South East Distribution Warehouse Rest UK Source: RBS, PMA Capital and Rental Growth (4 year compound) Positive capital and rental growth dominates sub-sector forecasts Rental Value Growth Capital Decline & Rental Growth t Capital Growth Capital Decline & Rental Decline Capital Growth & Rental Growth 19 Capital Growth & Rental Decline Source: RBS 1 Secondary Shopping Centres 11 Rest UK Offices 2 Small & Medium Town Retail 12 South East Industrial 3 Prime Smaller Shopping Centres 13 London Industrial 4 Industrial Rest UK 14 City Offices Distribution Warehouses 1 Big Shopping Centres 6 Big 6 Offices 16 M2 Offices 7 Ret Warehouses 17 Supermarket 8 Leisure 18 West End Offices 9 Business Parks 19 Central London Retail 1 All Property We have confidence in our forecasts to show the trajectory and quantum of CRE valuation changes, without any expectation that they will be bang on. To aid the identification of forthcoming valuation movements across the market, we consider the listed sector to be a good guide. 8

9 Lead indicators Share prices across the UK listed CRE sector have been a useful forward indicator for capital growth in the direct market. Share prices topped out in December 26, six months ahead of the All Property Capital Growth Index, and started to recover in February 29, again six months ahead of the direct market. 213 was a strong year for UK listed stocks share prices, up 21%, with 214 YTD recording c.7% growth already. A snapshot of analyst recommendations applied to the UK listed CRE sector suggests continued confidence in the market s performance. The chart summarises the position at January 214, since when recommendations have moved to be mildly more positive at 3% Buyers, 36% Holders and only 11% Sellers. All Property Capital Growth vs. UK Listed Sector Share prices have shown themselves to be a lead indicator Indexed: 1 = Jan Jan-6 May-6 Sep-6 Jan-7 May-7 Sep-7 Jan-8 May-8 Sep-8 Jan-9 May-9 Sep-9 Jan-1 May-1 Sep-1 Jan-11 May-11 Sep-11 Jan-12 All Property Capital Growth UK Listed CRE Sector May-12 Sep-12 Jan-13 May-13 Source: Bloomberg, IPD Analyst Recommendations (Jan-14) The continued dominance of BUY recommendations suggests confidence in a positive outlook Buy Hold Sell Jan-14 Jan-13 Jan-12 Source: Bloomberg 9

10 Conclusion Whilst we can see potential downside risks to valuations forming across some areas of the market, we consider the near-term outlook to be set fair. The conditions appear set for investor demand to be maintained by the current virtuous circle of attractive income returns, transaction volumes, yield compression and capital growth. Specifically, the attractions of UK CRE s income return and capital growth potential have and continue to be sufficient to attract strong demand - especially from overseas investors. Whilst there is a risk of group-think pushing the Central London and the highest quality, large lot size retail markets to levels dislocated from traditional real estate investment fundamentals, we do not think this applies across the market as a whole. Rate rises and the level of risk premium investors will accept will continue to be key determinants to the market s progress through this cyclical upswing. With the former an inevitable consequence of a sustained economic recovery, consistent with positive rental growth forecasts, we expect the practice of rate watching and associated chatter to continue to grow in popularity. A clear warning sign will be commentary suggesting that this time things will be different, and specifically that the outlook for UK CRE will be able to immunise itself from rate increases. 1

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