DTZ Foresight UK Fair Value Q Widening yield gap raises scores
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1 DTZ Foresight UK Fair Value Q2 Widening yield gap raises scores 23 August Contents Overview 1 Fair Value Index 2 UK market classifications 4 UK versus global forecasts 5 Office market forecasts 6 Retail market forecasts 7 Industrial market forecasts 8 Economic drivers 9 Authors Ben Burston Forecasting & Strategy Research +44 (0) ben.burston@dtz.com Zubaer Mahboob Forecasting & Strategy Research +44 (0) zubaer.mahboob@dtz.com Contacts Martin Davis Head of UK Research +44 (0) martin.davis@dtz.com Tony McGough Global Head of Forecasting & Strategy Research +44 (0) tony.mcgough@dtz.com Hans Vrensen Global Head of Research +44 (0) hans.vrensen@dtz.com The DTZ Fair Value Index TM score for the UK stands at 50, indicating that investment market attractiveness has improved significantly since Q1, when the score was a low 28 (Figure 1). Market pricing is now well balanced, with an equal number of HOT and COLD markets. The improvement in the index score has arisen because of a sharp fall in the UK five year government bond yield, which is lowering our estimated required return for commercial property and making UK markets relatively more attractive. In Q1 we had rated ten markets in the UK as COLD, but the sudden drop in bond yields means that there are now only two. We now consider 18 of the 20 UK markets in our coverage to be appropriately priced for investment. London will continue to lead the office occupier market, with the West End and the City providing the best rental growth. High income returns in Nottingham are forecast to contribute to annual total returns of more than 8%, similar to total returns in London. Rental growth and total returns in the retail sector will be modest in most markets, with Manchester outperforming London and Glasgow. Manchester is also expected to generate the best total returns in the industrial sector, with double-digit returns throughout the forecast period. Growth forecasts for the UK economy have been revised down in light of renewed external threats. The Bank of England is thus holding interest rates at 0. for now, in spite of rising inflation. Figure 1 Improving UK Fair Value Index Scores All-property Q All-property Q2 6 6 Office Q1 Cold Warm Hot 11 1 Office Q2 1
2 Fair Value Index UK Fair Value Index score jumps to 50 in Q2 The DTZ Fair Value Index TM score for the UK stands at 50, indicating that the investment market has become significantly more attractive to investors since Q1, when the score was a low 28 (Table 1). Market pricing is now well balanced, with an equal number of HOT and COLD markets. Table 1 UK Fair Value Index scores Q2 Q2 Q1 UK all-property UK office Global all-property Global office Global retail Global industrial The improvement in the index score has arisen because of a sharp fall in the UK five year government bond yield, which is lowering our estimated required return for commercial property and making UK markets relatively more attractive. This reverses the trend of Q and Q1 when the bond yield was rising and leading to lower UK index scores. Our outlook for property returns in UK markets remains largely unchanged, and is characterised by solid income returns but weak rental growth in most markets. However, these income returns look Table 2 increasingly attractive in the current climate of increased equity market volatility and very low fixed income returns. UK market classifications Q2 HOT markets Change since Q3 COLD markets Change since Q3 UK all-property 2 2 UK office 0-1 Rest of UK allproperty 2 1 The sharp drop in required returns led to several upgrades for UK markets this quarter. In Q1 we had rated ten markets in the UK as COLD, but the sudden drop in bond yields means that only two are now rated COLD (Table 2). We now consider 18 of the 20 UK markets in our coverage to be appropriately priced for investment. This marked shift underscores the appeal of the solid income returns offered by prime property amidst a clouded economic outlook. While capital growth is expected to be subdued in coming years, and there are downside risks, most retail and office markets are trading at yields of around 5-, which offers a substantial premium over five-year bond yields, which sat at just over at end Q2, and have since fallen further. Box 1: Guide to the DTZ Fair Value Index The DTZ Fair Value Index is intended to provide investors with insight into the relative attractiveness of current pricing in global commercial property markets. Fair Value Index scores reflect the proportion of HOT and COLD markets, with higher scores implying more HOT markets. Markets are categorised by comparing expected and required returns. Markets estimated to be more than under-priced are classified HOT; markets more than over-priced are classified as COLD; and, markets between this range are classified as WARM. Index Fair Value Classifications Property Forecasts Page 2-3 Page 4 Page 5-8 The DTZ Fair Value Index is a forward looking index based on econometric forecasts incorporating local econometric drivers and local market knowledge. Economic Forecasts Page 9 For further information on the methodology used for classifying different markets and calculating Fair Value Index scores, see the DTZ Research report: DTZ Fair Value Index TM Methodology, Solid Foundations for Future Returns. 2
3 Fair Value Index Figure 2 Global Fair Value Index scores Q Global Europe Asia US UK Pacific Cold Warm Hot Modest upgrades to global outlook in Q2 An increase in the index scores for Europe and Asia Pacific has contributed to the rise in the global score in Q2, from 50 to 55 (Figure 2). As in the UK, the European score has risen on the back of lower bond yields in core markets, lowering the required return for property. In the US, the score fell slightly this quarter, as the negative impact of the gradual lowering of cap rates from their elevated levels more than offset the positive impact of lower Treasury yields at end Q2. According to our index scores, prime property investment in the UK is now more attractive than in most of Europe, the latter still having a heavier weighting toward COLD markets, in keeping with a weak economic outlook. Figure 3 Five year government bond yields selected markets Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Source: Bloomberg Figure 4 UK Germany France Sweden Belgium Italy Spain UK Index scores: change from Q1 to Q All-property Q All-property Q2 6 6 Office Q1 Cold Warm Hot 11 1 Office Q2 Box 1: Turmoil in European debt markets impacting on the UK Recent weeks have seen continued ructions in European debt markets, which have impacted on the economic outlook and correspondingly lowered bond yields in the UK (Figure 3). The sovereign debt crisis has spread to Spain and Italy, as markets seek reassurance that European authorities will take the necessary steps to restore liquidity and solvency. This uncertainty is damaging the wider economy, as are the associated falls in equity prices and tightening of credit conditions, and there are clearly significant downside risks to the European outlook in the current environment. With the US economy also having deteriorated, the global outlook is casting a shadow over the UK recovery, and markets now expect interest rates to be on hold well into This revised outlook, and an associated flight to safety from other asset classes has caused the UK bond yield to be bid down below 1. in recent weeks. Market participants are hoping for a firmer signal from European authorities that they are prepared to take whatever steps are necessary to contain the risks of the crisis deepening. Should contagion escalate, banks in larger countries such as the UK will be impacted by uncertainty over their exposure to overseas events, increasing the risk of a renewed downturn. 3
4 UK market classifications Markets getting warmer in Q2 Eight UK markets were upgraded from COLD to WARM this quarter, reflecting a rebalancing of expected and required returns (Figure 5). The Manchester retail market shifted back into the HOT category. Manchester industrial is also in the HOT category, with both markets expected to see stronger rental growth than other regional centres over the next five years. Regional office markets upgraded Figure 5 Selected changes in Fair Value rating Q1 to Q2 Q1 COLD WARM Q2 COLD WARM HOT Glasgow offices Birmingham retail Heathrow industrial Newcastle offices Manchester offices Glasgow retail London City offices West End retail Edinburgh offices Birmingham industrial Manchester retail Following the uplift in Glasgow office yields last quarter, the Newcastle office yield has also shifted out by 25 basis points to 6.. We have held the view for some time that yields in regional markets were too firm in late 2009 and early 2010, and see this as an encouraging move toward more attractive pricing for investors in regional office markets. HOT Manchester industrial Figure 6 Regional offices upgraded: Newcastle offices WARM Rents are expected to remain steady in the Newcastle office market and as such capital growth will remain muted, but supported by higher income returns, the market has been upgraded to WARM (Figure 6), along with Manchester, Leeds, Birmingham and Bristol % COLD WARM Stronger rental growth but lower yields in London The London office markets continue to lead the way, in terms of rental growth, over the next five years. Rents have come back strongly since the downturn, but are still well below their peak levels, and we see scope for continued growth. Required return Expected return While this will support capital value growth over the period, lower yields in these markets will limit income returns and as such, they are rated as WARM rather than HOT. Table 4 UK Fair Value Index: major market classifications Office Markets Retail Markets Industrial Markets Market Category Degree of overvaluation (negative indicates under-priced) London City WARM - Edinburgh WARM 1% Glasgow COLD Manchester HOT London WE WARM -1% Birmingham COLD Manchester HOT 8% Birmingham WARM - London Heathrow COLD 4
5 UK versus global forecasts Figure 7 UK rents set to underperform in UK vs global all-property rental growth UK Global Prime property rents in the UK rose by 7.7% in 2010, boosted by a sharp rebound in the London office market. However, although UK rents performed better than global rents last year, this year the positions are likely to be reversed (Figure 7). Overall, UK rents are expected to grow by just 2.7% in, compared to 2.9% rental growth globally. In the five-year forecast period, UK rental growth and global rental growth will be quite similar, at 2. pa. Average rental growth in the UK will also be stronger than in the US or in Europe, with Asia Pacific the only region recording faster rental growth over the forecast period. UK capital value growth to be flat from 2012 onwards Figure 8 UK vs global all-property capital growth UK Global Capital values also bounced back quite sharply last year, driven by an uplift in rents concentrated in London and some yield compression. Capital growth of 17% easily outpaced the global growth figure of 7.. But in, UK capital growth at 4. will undershoot global growth of 7. (Figure 8). In the medium term, capital growth will underperform in the UK. Over the five-year forecast period, UK capital values are forecast to rise by just 1. pa, compared to the 2.8% rise per annum forecast at the global level. It should be noted however that from 2012 onwards, yields will come under upward pressure, and capital growth figures will be quite modest. Any difference between UK and global capital growth figures are thus expected to be marginal. Figure 9 total returns forecasts downgraded UK vs global all-property total returns UK Global Total returns on UK property were 22.8% in 2010, well ahead of returns of 14.1% at the global level. In we expect total returns in the UK to be around 9.. This is a downgrade from the Q1 forecast of 10.1%, and it will also trail the 13.8% returns forecast at the global level. The higher global figure reflects the rise in capital values, particularly in Asia Pacific (Figure 9). From 2012 onwards we expect total returns in the UK to be slightly lower than at the global level. This is due to marginally weaker capital value appreciation and a lower income return. Thus for the five year period -15 we expect UK total returns to be 6.9%, compared to 9. at the global level. 5
6 Office market forecasts Strongest office rental growth forecast in London London West End has shown the sharpest uplift in office rents in the UK in. In the first six months, rents jumped by, taking year-on-year rental growth to 12.. London Midtown which grew by 3 in 2010 has yet to show any rental growth this year. However, London City has managed to record growth of 2.8% year-to-date. Apart from the West End and the City, rents in the other UK office markets have held at 2010 levels. We expect London to continue to lead the way over the next five years, with the strongest office rental growth forecast there. We expect West End office rents to rise at 6. pa over the -15 period and City rents to rise by 4.9% pa. Strong rental forecasts reflect relatively tight supply combined with steady demand (Figure 10). By contrast, we expect much more modest rises in rents in office markets outside London, which tend to be less volatile to begin with. Over the period, we expect Edinburgh rents to grow the most, albeit by just 1.8% pa. Glasgow and Bristol will be the worst performers, with forecast growth of just 0.7% pa. Yields to move higher from 2012 London West End and City are the only locations that have experienced any yield compression in the past year. Even that compression has been marginal - only 25 basis points (bps). Another seven markets, all in the regions, have seen prime yields soften by 25 bps in the same period. In Q2, Glasgow and Newcastle yields moved out by 25 bps. In the remaining quarters of, we expect office yields to show no change in every market but one. Only in London West End do we think that yields will drop, by 25bps, supported by sustained investor demand. From 2012 onwards we expect office yields to edge higher as they come under pressure from rising interest rates and bond yields. However, we think that rises will be relatively modest (Figure 11). Highest returns forecast in Nottingham and London Total returns for -15 are forecast to be above 8% pa in Nottingham, London West End and London City. In these markets, rent rises should boost capital value growth and push up total returns (Figure 12). Outside London, lacklustre rental growth and softening yields will hold back capital growth. As such, total returns outside London are forecast as below 8% pa over the next five years. In Glasgow, capital values are forecast to decline marginally, generating returns of 5. pa. Figure 10 UK office rental growth forecasts -15 (% pa) 7% 1% Figure 11 UK office yield forecasts 8% 7% Figure 12 Birmingham Edinburgh Leeds London (City) London (WE) Manchester UK office total return forecasts -15 (% pa) 1 8% - Income Return Capital Value Growth Total Return 6
7 Retail market forecasts Figure 13 Manchester retail rents to show strongest rise UK retail rental growth forecasts -15 (% pa) In 2010 there was a sharp contrast between trends in retail rents in London and in the regional centres. London West End rents rose by 27%, while in Birmingham, Glasgow and Manchester, rents fell by more than. London retailers have been supported by tourist trade on the back of a weak pound. 1% Figure 14 UK retail yield forecasts Over the next five years we expect retail rents to show modest growth of 1- pa in Birmingham, Glasgow and London West End. Retail will perform strongly in Manchester, where rental growth is expected to average about 3. pa (Figure 13). Following sharp increases in 2010, we think that there is less scope for similar spikes in London rents in the near term. We forecast that retail rents in the West End will rise by 1.7% pa over the forecast period. Yields to edge up over next five years Prime retail yields fell over the course of 2010 in Birmingham, Glasgow and London West End. London remains the most expensive retail market in the UK, with a yield of 4.2 at the end of 2010, followed by Birmingham and Glasgow at Birmingham Glasgow London (West End) Manchester Figure 15 In we expect yields in London to edge down even lower to 4. on the back of continued investor demand for high-quality properties. Outside London though, prime retail yields will show no change this year, except in Glasgow where a softening of 25 bps is forecast (Figure 14). From 2012 onwards we expect retail yields to come under upward pressure as interest rates and bond yields start to increase. However, we expect the rises in yields to be fairly modest, with the West End yield forecast to rise to only 4.3 by UK retail total return forecasts -15 (% pa) 1 8% - Total returns forecast to be highest in Manchester Total returns over the forecast period are expected to be highest in Manchester, at 8% pa, supported by a solid yield and relatively robust capital growth of pa (Figure 15). London West End is forecast to deliver the next best returns over the period, at 5. pa. West End returns are expected to be boosted by a modest uplift in capital values on the back of moderate rental growth. Income Return Capital Value Growth Total Return In contrast, negligible capital growth is expected in Glasgow and marginally negative capital growth in Birmingham. Total returns in Glasgow are forecast to be 5.1% pa over the next five years, and 4. pa in Birmingham. 7
8 Industrial market forecasts Industrial rental growth weak in most markets Figure 16 Prime rents in most industrial markets showed no change in 2010, although London Heathrow rents declined. During the forecast period of -15, we expect rental growth to be below pa in all the UK industrial markets covered in this report. In Manchester, where we forecast rental growth to be strongest, we expect rises of just 2. pa. Edinburgh is the market with the weakest forecast, as annualised rental growth of only 0. is expected over the five-year period (Figure 16). UK industrial rental growth forecasts -15 (% pa) 1% Modest rise in industrial yields in the medium term Prime industrial yields edged lower in most markets in 2010, with sharp declines of 75bps in Glasgow, Newcastle and Park Royal. Going forward, we expect limited further compression. Indeed, with interest rates and bond yields rising over the forecast period, we expect yields to move out by 2015 in a number of locations, e.g. London Heathrow, Glasgow, Milton Keynes and Park Royal. However, we expect the increases in yields to be relatively modest, between 25 bps and 50 bps (Figure 17). Figure 17 UK industrial yield forecasts We expect yields in Birmingham to remain at 7. over the forecast period. In Manchester, yields are expected to edge down to 7.1 by 2015 from the present level of 7.2. London Heathrow should still remain the most expensive industrial market in the UK, with a forecast yield of just 6. in Total returns forecast to be highest in Manchester Birmingham Glasgow London (Heathrow) Manchester Total returns over the period -15 are forecast to be highest in Manchester, at 10.1% pa. Returns are supported by a high income return and uplifts in capital values, as rents rise and yields fall (Figure 18). Total returns in Birmingham, Bristol, Cardiff, Dartford and Leeds are forecast to be above 8% pa throughout the period -15, aided by modest uplifts in capital values as rents rise. Park Royal is the weakest market, where total returns are forecast to be just 5. pa over the next five years. This reflects rents showing no change and yields edging higher, which will have a slight negative impact on capital values. Figure 18 UK industrial total return forecasts -15 (% pa) 1 1 8% - Income Return Capital Value Growth Total Return 8
9 Q Q Q Q Q Q Q Q Q Q Q Q Q1 Q3 Economic drivers Figure 19 UK GDP growth by quarter (% q/q) Source: Oxford Economics Figure 20 UK consumption growth and unemployment rate 1% -1% Cons. spending growth Unemployment rate Source: Oxford Economics Figure 21 UK inflation and interest rates 7% GDP growth disappoints in Q2 The preliminary estimate of quarterly GDP growth for Q2 came in at 0. (Figure 19). This disappointing result was largely attributed to a series of temporary factors, including the extra bank holiday in April and the supply chain disruption caused by the natural disasters in Japan. Without these exceptional factors, the ONS estimates that growth would have exceeded the first quarter's pace. Most of the disruptive events occurred early in Q2. It may have been expected therefore that the economy would be stronger going into Q3, but survey evidence on this remains inconclusive. More recently, turmoil has returned to the financial markets with some force, spurred by rising concerns over the sovereign debt crises in Europe as well as the ongoing economic and political stalemate in the US. Higher unemployment leads to negative consumer spending growth Forecasts for GDP growth have therefore been revised downwards for both and As of August, Oxford Economics expects GDP to grow by 1.1% in and 2. in Both numbers are 0. lower than the corresponding figures in July. The outlook for exports and business investment has weakened substantially due to ongoing uncertainties. Figures released in August showed an unexpectedly large rise in unemployment in Q2. The number of jobless increased by 38,000 between March and June, driving the unemployment rate higher. Correspondingly, forecasts for consumer spending have deteriorated. It is now expected that consumer spending will actually show a decline of -0. in before returning to positive territory in 2012 (Figure 20). Bank of England to hold rates steady through % A series of adverse developments has led the Bank of England to revise its stance on monetary policy. In spite of persistently high inflation, the Bank has recently indicated that interest rates will stay at present levels till the end of 2012 (Figure 21). CPI inflation picked up in July to 4., but for the moment, uncertainty about the strength of the recovery is trumping other concerns. Indeed if there is a substantial worsening of the outlook, further quantitative easing cannot be ruled out. Source: Oxford Economics CPI inflation Lending interest rate 9
10 Disclaimer This report should not be relied upon as a basis for entering into transactions without seeking specific, qualified, professional advice. Whilst facts have been rigorously checked, DTZ can take no responsibility for any damage or loss suffered as a result of any inadvertent inaccuracy within this report. Information contained herein should not, in whole or part, be published, reproduced or referred to without prior approval. Any such reproduction should be credited to DTZ. DTZ August
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