Recovery in UK property to gain momentum. Recovery in UK property market to gain momentum. Research & Strategy. June Economic growth recovering

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1 Research & Strategy Recovery in UK property to gain momentum June 13 Recovery in UK property market to gain momentum This hasn t been a typical recession and it won t be a typical recovery. Nevertheless a recovery is in sight. Mervyn King, Governor of Bank of England, 1 May 13 A better than expected rise in GDP, the FTSE 1 index within touching distance of all time highs, historic low yields of 1-year government bonds and rising UK real estate investor confidence are a few of the reasons that we believe the recovery in the UK commercial property market is gaining momentum. In this note, we list few key themes that, in our view, are driving the market forward: Economic growth recovering Rents have already found a floor for offices and industrials, with leading indicators suggest improving trends Net lending to return and investor confidence is rising Weight of money is chasing yields and risky assets A real estate upturn is imminent Economic growth recovering According to the Office for National Statistics, the UK economy grew.3% q/q in Q1 13, which was better than the consensus expectation. Moreover, recent statements by the Bank of England s Governor, Sir Mervyn King, and the Chancellor of Exchequer, George Osborne, suggest that the economy is seeing a modest but sustained recovery. If we are to draw conclusions from comparing existing economic cycle with the previous ones, economic growth is expected to accelerate over the coming quarters. This view is also consistent with that of consensus forecasts provided by Consensus Economics. Figure 1: Real UK GDP growth (rolling y/y %) s' recession (Mar-197 to Dec-197) 199s' recession (Sep-19 to Jun-199) s' recession (Jun- onwards) Source: Bloomberg, Consensus Economics, Cordea Savills History and forecasts suggest stronger economic growth No.of quarters With general elections due within two years, economic growth has become a political issue. The Government has announced a series of schemes to boost lending, the housing market and construction. These steps are supporting house prices, with more RICS members suggesting rising than falling house prices in April. Households are also supported by higher levels of income from employment. According to Markit, with inflation subdued, the squeeze on household budgets is easing. This will help to improve consumer spending over the coming quarters. Figure : Households position is improving Pricces declining Pricces rising Feb-9 May-9 Aug-9 Nov-9 Feb-1 May-1 Aug-1 Nov-1 Feb-11 May-11 Aug-11 Nov-11 Feb-1 May-1 Aug-1 Nov-1 Feb-13 May-13 RICS UK house prices net balance (%; LHS) Markit Household Finance Index (RHS) Source: Bloomberg, RICS, Markit 1

2 Looking at granular detail, economic growth in the UK is being driven by the service sector. The sector, which accounts for three-quarters of the UK s GDP, is seeing further improvements, with April recording the fastest increase in activity. Since the start of the year, growth has steadily strengthened, boosted in part by increased volumes of new business. Sales volumes continue to accelerate, which is putting some pressure on capacity. Moreover, in April over % of service providers were forecasting a rise in business activity from present levels in 1 months time. The CBI/PwC financial services survey also shows a further improvement in sentiment, matched by a recovery in business and top-line revenues. In our view, this is positive for office take-up and rental growth Figure 3: Services sector is powering ahead Q1 7 Q 7 Q3 7 Q 7 Q1 Q Q3 Q Q1 9 Q 9 Q3 9 CBI/PwC Financial Services Indicator (LHS) Services sector has continued to expand, with new business volumes rising at the strongest rate Q 9 Q1 1 Q 1 Q3 1 Q 1 Q1 11 Q 11 Q3 11 Q 11 Q1 1 Q 1 Q3 1 Q 1 Q1 13 Source: Confederation of British Industry, PricewaterhouseCoopers 3 Services UK PMI Markit Survey (RHS) Rents are approaching floor The occupier requirement balance from the RICS commercial property survey continues to improve and surveyors think that rents have already found a floor for offices and industrials. As a percentage of balance, a greater number of surveyors are expecting demand for offices and industrials to improve. Demand for retail property is less bearish compared to 1. However, internet and vacancies will continue to act as a headwind for the sector. Figure : Surveyors reporting improving occupier demand (% of balance) Office Industrial Retail Source: RICS, Cushman & Wakefield Furthermore, Cordea Savills prime rent monitor* based on Cushman & Wakefield s data suggests that year-on-year rent changes are stabilising,, with more centres experiencing rental increases than falls in Q1 13. Figure : Prime rent stabilising in key regions for all sectors (y/y change) No. of centres Q Q1 Q Q3 Q Q1 Q Q3 Q Q1 7 Q 7 Q3 7 Q 7 Q1 Q Q3 Q Q1 9 Q 9 Q3 9 Q 9 Q1 1 Q 1 Q3 1 Q 1 Q1 11 Q 11 Q3 11 Q 11 Q1 1 Q 1 Q3 1 Q 1 Q1 13 Rents rising Rents stable Rents falling Source: RICS, Cushman & Wakefield, Cordea Savills * The monitor observes yearly changes in prime rents for all three sectors in eight key cities in the UK.

3 This positive backdrop will support office take-up and is expected to curb recent decline in average office rents outside London and the South East. We believe there is an upside risk to our average rental growth forecast, of 3.% pa over 13-17, if there is a quicker than expected decline in vacancy rates or stronger occupier demand. Figure : Service sector to support office rents Correlation: CBI/PwC Financial Services Indicator (LHS; lead 9m) IPD Central London office rental growth (y/y%; RHS) Source: PricewaterhouseCoopers, IPD, Cordea Savills Retail vacancy rates are high compared to pre-recession levels. However, availability remains constrained in prime pitches and RICS members are reporting less adverse conditions.. In our view, polarisation will continue in this sector, with catchment and asset set selection remaining key. We currently expect average retail rents to increase by 1.% pa over 13-17, 17, with further growth led by Central London shop rents offset by declines in the rest of UK in the shortterm. Figure 7: Gradual improvement in retail sales Correlation: ONS retail sales value (rolling 3m average y/y%; lead m; LHS) IPD All Retail real rental value growth (y/y%; RHS) Source: Bloomberg, IPD, Cordea Savills Further evidence that the UK s stuttering industrial sector is regaining its footing has emerged, with a survey finding that global industrial companies are increasingly favouring the UK as a place to source automotive and high-tech components, and to seek future profits. A poll conducted by the Economist Intelligence Unit ranked the UK above betterknown manufacturing powerhouses of Germany and Japan, as well as above emerging economies such as India and Brazil, as a destination for future profit growth. The survey of 33 senior manufacturing executives around the world placed the UK third, behind the US and China, as the country where global companies expect to derive the majority of their profit growth over the coming years. Moreover, a survey by the Confederation of British Industry suggests that employment intentions for the sector are near their highest recorded levels.. With the economy gaining further momentum, we believe there is an upside risk to our rental growth forecast of 1% pa over Figure : Industrial employment intentions are near their highest levels Correlation: CBI Industrial Employment Intentions (lead 1m; LHS) IPD All Industrial real rental growth (y/y%; RHS) Source: Confederation of British Industry, IPD, Cordea Savills

4 Return of net lending and rising investor confidence There are clear indications from various surveys that we are seeing first signs of easing lending conditions. According to the latest Bank of England Credit Conditions survey, both credit availability and credit demand improved in Q1 and are expected to improve further in Q. While improvements in such survey-based indicators have yet to be reflected in the hard data on net property lending, it is evident that pressure on lending is abating. Although traditional lenders, such as banks and building societies are still reducing their exposure to commercial property, lending flows have started to increase from new entrants, such as debt funds, pension funds and life insurance companies. We expect this trend to continue and, as lending from banks stabilises, we expect total net lending to turn positive by the latter half of this year. The improving economic backdrop and availability of credit are supporting real estate investor confidence, which rose further in Q1 according to Jones Lang LaSalle. The confidence index is up 3% y/y and has been on an upward trend since Q 1. Improving sentiment has been reflected in the investment market, with Q1 investment volumes higher than expected, at GBP 9.3 billion, representing a % increase y/y. There is a notable decline in investor expecting investment return to be a lot lower, with the majority of respondents according to the Jones Lang LaSalle survey now expecting improving returns. In our view, this is likely to support investment volumes going forward,, with increasing numbers of investors targeting core-plus and value-add add opportunities. Whilst activity from the UK institutions, increasing their property allocations, is expected to remain strong, the economic growth differential between the Eurozone and the UK will also continue to attract capital from overseas buyers.. However, most of the overseas investors are fixated on London; in Q1, most deals were in Central London, and involved overseas buyers from the Far East and Middle East. Figure 9: Net lending is expected to improve Net new lending (GBP bn; LHS) Source: Bank of England, Capital Economics Contraction in lending to commercial real estate is slowing Figure 1: Both investor confidence and return expectations are improving % of responses 1% 9% % 7% % % % 3% % 1% % Q 1 Q1 11 Q 11 Q3 11 Source: Jones Lang LaSalle, Property Data, Cordea Savills Q 11 Return expectations: a lot higher (LHS) Return expectations: slightly lower (LHS) Real estate investor confidence survey (RHS) Figure 11: Investment volumes are on an upward trend (GBP billions; rolling quarters) Average Q1 1 Property % of loan books (RHS) Q1 1 Q3 1 Q1 Q3 Q1 3 Q3 3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 7 Q3 7 Q1 Q3 Q1 9 Q3 9 Q1 1 Q3 1 Q1 11 Q3 11 Q1 1 Q3 1 Q1 13 Q 1 Q3 1 Q 1 Q1 13 Return expectations: slightly higher (LHS) Return expectations: a lot lower (LHS) Volumes are picking up JLL Confidence Index Office Retail unit Retail warehouse Industrial Mixed Average Source: Jones Lang LaSalle, Property Data, Cordea Savills Shopping centre Leisure

5 Weight of money chasing yields and risk We expect multi-asset allocators to diversify out of their investments in both equities and sovereign bond. Both of these markets are trading at or close to their peaks and, to a certain extent, look over-stretched. The recent trends also suggest the outlook for corporate profits has improved significantly, with monetary policy expected to remain relaxed for longer. Historically, this has been a sign for a higher risk taking. Figure 1: FTSE 1 close to new highs and 1-year bond yields near record lows,,,,,,,,,, Apr-1 May-1 The trends are driven by positive economic outlook and relaxed monetary policy May-1 Jun-1 Jul-1 Jul-1 Aug-1 Sep-1 Sep-1 Oct-1 Nov-1 Nov-1 Dec-1 Jan-13 Jan-13 Feb-13 Mar-13 Apr-13 Apr-13 May Source: Bloomberg FTSE 1 index (LHS) UK 1-year government bond yields (%; RHS) In comparison with 1-year government bond yields, IPD All Property equivalent yields offer significant spread. The spread is very close to the levels seen during the peak of the financial crisis. Figure 13: Spread between IPD All Property equivalent yields and 1-year government bond yields (%) Spread Average Source: IPD, Bloomberg, Cordea Savills Property equity prices remain buoyant and suggest that an upturn in property values is imminent.. The buoyancy in property securities is supported by the better than expected results from the larger real estate investment trusts, especially those that have a higher that industry average exposure to London. Shares in both Land Securities and British Land are now trading at around a 1% premium to their last reported net asset values. Figure 1: Property securities suggesting an imminent upturn in property values Aug- Jan- Jun- Nov- Apr- Sep- Feb-7 Jul-7 Dec-7 May- Oct- Mar-9 Aug-9 Jan-1 Jun-1 Nov-1 Apr-11 Sep-11 Feb-1 Jul-1 Dec-1 May-13 Oct-13 Source: IPD, Bloomberg, Cordea Savills FTSE EPRA NAREIT UK index (y/y %; lead m; LHS) IPD UK All Property capital growth (y/y%; RHS)

6 The upturn is imminent After declining for 17 months, the IPD Monthly All Property capital growth index recorded a relatively unchanged month in April. While a comparison with the cycle of the late 19s /early 199s suggests that we are very close to a turning point, most of the leading indicators and the economic backdrop suggests that the recovery should gain momentum. Figure 1: Comparison of IPD All Property capital growth cycles No. of months late 19s'/early 199s' (LHS) 7-13 (RHS) Source: IPD, Cordea Savills Cordea Savills prime yields monitor* based on Cushman & Wakefield s data suggests that quarter-on-quarter yield changes are stabilising,, with more markets seeing yields moving in compared to moving out in Q1. Figure 1: Yields moving in (q/q) No. of markets Q1 Q3 Q1 199 Q3 199 Q1 199 Q3 199 Q1 199 Q3 199 Q1 Q3 Q1 199 Q3 199 Q1 Q3 Q1 Green shoots? Q3 Q1 1 Q3 1 Q1 Q3 Q1 3 Q3 3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 7 Q3 7 Q1 Q3 Q1 9 Q3 9 Q1 1 Q3 1 Q1 11 Q3 11 Q1 1 Q3 1 Q1 13 Yields moving in Yields unchanged Yields moving out Source: Cushman & Wakefield, Cordea Savills Despite our current forecast for positive capital growth in 13 (All property.%, Office 1.%, Industrial.% and Retail -.%), we believe given the backdrop and sentiment, there is an upside risk to our numbers.. The performance is expected to be led by the office sector, notably Central London offices. We expect opportunities to emerge in strong service sector centres outside London, with core yields moving in first. Industrials also remains a favourite given the supporting economic and property trends. Figure 17: Total return forecasts (%) All Office All Retail All Industrial Source: IPD, RealFor, Cordea Savills * The monitor observes quarterly change in prime yields for all three sectors in eight key cities in the UK

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