UK Real Estate Market Outlook

Transcription

1 February 214 UK Real Estate Market Outlook Part of the M&G Group

2 Executive summary The UK economy continues to recover, boosted by strengthening labour and housing markets. A strong 214 expected for UK property, as rental growth accelerates and yields harden. Increasing optimism surrounds the occupier market, with improving prospects for rental growth in the South East and the regions. Strong return prospects for the South East and regional markets, boosted by improving fundamentals and lessening investor risk aversion. Retail expected to lag overall, reflecting continued structural change, although prospects polarised. Rising appetite expected for planning development projects. Rising investor interest in the Alternatives as competition rises for assets in the traditional commercial sectors. The hunt for value to become an increasingly important trend. 9 Up, up and away... Just over five years after the financial crisis began in earnest, the UK economy finally looks as if it is starting to gather escape velocity. Although economic activity still stands at over 1% below its 2-peak level, there are reasons to believe that it will have recovered, and perhaps even exceeded, this level of output by the end of 214. One of the most notable success stories of 2 has been the labour market. Having remained at around 8% for the first half of the year, unemployment has been falling relatively sharply ever since, reaching 7.1% in November, its lowest level for nearly five years and below most forecasters expectations. This has helped to push UK employment to a record high of 3.2 million. Unemployment is expected to continue to fall in the short term, supported by continued growth in service sector employment. Sharply falling unemployment Another bright spot has been the housing market. The government s Help to Buy initiative certainly seems to be boosting confidence and, in that respect, should perhaps be renamed Buy to Help as the ensuing rebound in house prices and activity has been responsible to some extent for helping the wider economy to recover. Prices have been rising across much of the country: London in particular has been seeing strong growth and the rate of increase in the region is thought to have been in double-digits over 2, although growth has been more moderate elsewhere. Despite the strengthening economy, inflation has also been edging downwards in recent months, reaching the government s CPI target of 2% in December 2 for the first time in just over four years. Inflation is expected to remain moderate in the short term, a factor that should both boost disposable incomes, benefiting the consumer sector and also encourage the MPC to maintain interest rates at their current low levels, supporting the economic recovery longer term. ILO Unemployment rate % Source: Office for National Statistics. 2

3 IPD All Property Rental Growth (% pa) Market fundamentals In contrast to the view in early 2, there is optimism over the outlook for the occupier market in the UK. In large part, this reflects the strengthening in the national economy and the perception that risks have lessened for the global and, specifically, the Eurozone economy. IPD all property rental growth forecasts Source: IPD, M&G Real Estate. Whilst previously positive sentiment was generally confined to the Central London markets, this has broadened over the course of 2 and most areas of the UK market are now seeing rents stabilise or begin to grow. We expect this trend to continue to strengthen this year, underpinned by a continued lack of supply, particularly at the prime end, and improving occupier demand. Office Polarisation will remain a feature of the commercial property market in general. We remain more optimistic about the office sector from an occupier perspective. This reflects the recent and anticipated strength of the labour market and the expected return to growth of the finance and insurance sector this year as well as continued support from the professional and ICT sectors. Meanwhile, as demand from corporates improves on the back of increased confidence, occupiers especially those with near-term lease events are becoming increasingly aware of the supply and demand imbalance that is now building in the market. Completions in the sector have been running at roughly half their historic annual average for the last four years, at levels lower even than after the early-199s supply-driven downturn. We expect this to continue to drive prime rents in particular over the year and also start to impact nonprime property as overall vacancy rates decline further this year. Central London is forecast to remain the main winner of this improving sentiment; we expect to see rental growth accelerate in 214/15 in all three of the main sub-markets. Further down the line, however, the relative buoyancy of these markets is expected to encourage a return to speculative development, a scenario that would be expected to dampen growth prospects in the medium term. Having said that, fringe locations undergoing regeneration, driven by significant infrastructure developments, are likely to see stronger growth. Away from the Capital, it is a measure of how far recovery has progressed that we now expect the South East office market to see above-inflation rental growth this year as well as being the best performing commercial property market outside of Central London in rental growth terms. While still expected to lag, the regional office markets are also forecast to return to rental growth after four years of decline, although it must be noted that recovery is more likely to get patchier the greater the distance from the larger metropolitan areas. Industrial The stronger outlook for the economy is also expected to benefit the industrial occupier market. Again, we forecast growth to be strongest in the London and South Eastern markets, reflecting the more buoyant local economy and, although completions are expected to rise slightly over the year compared with 2, they are anticipated to remain well below the levels seen over the years leading up to the financial crisis. Indeed, developers remain hesitant to deliver stock where they cannot guarantee a pre-let, and it is still felt that only the strongest schemes in the best locations are likely to see any significant increase in rents. With rents having broadly stabilised in the regional markets in 2, we expect a slight acceleration in rental growth in these areas in 214. However, the markets away from London and the South East continue to suffer from extremely high levels of availability. This could be an issue for secondary stock in particular which landlords may, despite improving economic conditions, still struggle to let, and this will likely hold a more tangible recovery back for some time yet. Retail The retail sector is perhaps the area of the market that will see the greatest level of polarisation. We expect it to see the weakest rental growth this year overall. Despite the move into a new phase of the economic cycle, we believe the sector will remain beset by wider structural problems owing in part to the retrenchment of consumers over the past five years. Retailers are continuing to rationalise their shop portfolios, meaning that vacancy rates are continuing to rise on high streets across the country. As a result, we expect these markets to see further rental declines in the short-term. Even so, there are huge disparities between the hot spots and the not spots of the country s retail landscape. 3

4 Central London is very much in a world of its own, supported chiefly by international demand, whether from foreign occupiers looking to enhance their UK portfolio or entering the market for the first time, or from overseas tourists keen to take advantage of a stillattractive exchange rate. This enthusiasm for retail in the Capital is unlikely to change in the short term and therefore we expect to see rental levels continuing to rise at a robust rate. Away from this market, however, rental growth will likely be seen more on a market-by-market basis, rather than across regions. The more traditionally popular high streets appear to have better rental growth prospects, particularly on the prime side, supported by consumers with higher disposable incomes. Meanwhile, markets where underlying consumer demand is much weaker and competition from other retail formats is greater are expected to continue to lag and even see rental levels slide further. The story is marginally more positive for the shopping centre and retail warehouse sectors, both of which we forecast to see some mild rental growth this year. Again, however, the wider structural issues of the retail sector are expected to ensure the continued polarisation of prospects for growth at local market level. Residential Occupier fundamentals in the non-mainstream residential markets remain relatively positive: despite a possible increase in the number of first-time buyers moving onto the housing ladder because of the Help to Buy initiative, the significant supply and demand imbalance that exists for the private rented residential sector in the Greater London market has continued to drive rents upwards. However, in contrast to the experience of the commercial market, the prime Central London residential market has seen rental levels fall over the past year, reflecting the relative weakness of the financial services sector, to which the market is unequivocally linked. Nevertheless, as financial services companies start to hire again, rents should bottom out and begin to rise, albeit more gradually than in the wider London market where supply constraints are potentially more of an issue and rising house prices may encourage more would-be buyers to remain in the rented sector for longer. As in the commercial market, regional rental growth is expected to remain muted and a stronger rebound in average earnings will be required before these markets see significant rises in rental levels. Yield (%) The investment market: trends for the year ahead: Risk aversion continuing to recede, boosting returns The most notable trend in 2 was undoubtedly the rapid intensification in investor sentiment. Although already positive as we moved into 2, the mood changed palpably in the summer months, resulting in sharply accelerating total returns. According to IPD, the UK market recorded a total return of 2% in December alone, pushing performance for the year into doubledigits, well ahead of consensus expectations. We see this strong investor confidence continuing into 214: with economic and occupier fundamentals improving, it is likely that the current risk on environment will be maintained. Indeed, those investors who had previously only been focussing on prime property in the Capital are already looking elsewhere, whether geographically out in the South East or, to a lesser extent, in the regions or in quality terms by looking at good secondary or even secondary property with the potential for using asset management to boost returns. This is already causing yields on secondary and regional property to start to harden, after several years at unusually high levels relative to prime property. 7 Prime versus secondary yields in the office sector 7 Prime West End Offices Prime city offices Prime regional offices Good secondary offices Source: CBRE. We anticipate that this trend will continue, and even intensify, this year, suggesting that the UK property market will record returns well into the double-digits. However, there is likely to be significant divergence between different parts of the market. Overseas investors, and particularly those from Asia, are anticipated to remain a major source of capital this year. Although not exclusively the case, they are likely to remain focussed on the Central London markets, whether office or retail. Secondary offices 14 4

5 Transaction volumes ( m) 7,, 5, 4, 3, 2,, There are still a number of new entrants to the UK market waiting in the wings who are keen to buy into the prime Central London markets and we see this driving further yield compression in the short term. Nevertheless, new investors in these markets should be cautious: with prime yields already extremely low, at 3.75% in the West End office market for example, and poised to move lower this year, they are already at or very close to their historic lows, suggesting limited longrun return potential, particularly on a relative basis. Some of the overseas players who have already dipped their toes into the London market are now, like domestic investors, looking elsewhere in the country in the hunt for yield. Although London has been a dominating force in performance terms for the last few years, a burgeoning revival in occupier demand and the availability of higher-yielding, yet attractive, property with good asset management potential is tempting capital out into the South East. The South East office and industrial markets saw performance that was on a par with, or even better than, their counterparts in the Capital in the second half of last year, according to IPD. These markets look set to outperform more convincingly this year, and in the case of the South East office market, potentially by quite a substantial margin, as a result of yield compression stemming from this likely flow of capital, strengthening rental growth as well as being boosted by a high income return. Increasing interest in the non-london markets Central London Greater London South East Rest of UK Source: Property Data. Moving still further away from London, we also expect the regional UK markets to benefit from this lessening in risk aversion, leading to significant yield-driven capital growth. While the South East office market is likely to outperform its regional neighbours this year, the position is likely to be reversed for the industrial sector. With equivalent yields in the South East industrial market already in line with their -year averages, according to IPD, and pricing on better-quality secondary assets starting to look expensive, there is perhaps less potential for further yield compression here than there is for this sector elsewhere in the country. Despite the strong potential returns on offer, when considering buying in the regions in particular irrespective of the sector investors, especially those with lower risk tolerances, should ensure that pricing does not get too far ahead of underlying fundamentals: although we expect significant yield compression across these markets, the outlook for the occupier market remains relatively patchy in places. Structural change in retail to affect performance prospects While the prospects for the office and industrial markets appear relatively attractive, investors should be more cautious when considering the retail sector. We view retail as having the weakest performance potential of the main commercial sectors this year, chiefly reflecting the major structural change that it is still undergoing: several high street markets appears over-shopped, and e-tailing remains a threat to both weaker markets and retailers who cannot reposition their businesses. This view leads us to believe that the Central London shops market is likely to continue to perform relatively well this year, driven largely by overseas cash, and that high streets away from the Capital will continue to struggle. Other retail formats such as retail warehouses and shopping centres, whilst slightly stronger, also look set to lag, still affected by the relative weakness of consumers disposable incomes and the squeezed middle(-class). For this reason, investors may need to wait before the retail market starts to recover in earnest. In addition, with yields already low for supermarkets and limited prospects for strong rental growth, return prospects for this sub-sector also seem modest, although their long index-linked leases will continue to remain popular with risk averse investors and those seeking assets with assetliability matching potential. Attention to shift to development after a long hiatus? We have now seen four consecutive years of construction levels running at roughly half their historic average. This lack of new supply is already putting strain on the market, a trend that is only going to be exacerbated by an improving economy. With confidence returning to the property market and the improving availability of finance, we expect to see increasing interest in and appetite for starting planning for development projects. Nevertheless, development opportunities are likely to remain focussed on those markets with the better occupier outlooks, existing (lack of) supply issues and the greater potential for pre-lets. In contrast, speculative development, for now at least, is likely to remain the preserve of those investors with the greatest risk tolerance, particularly when moving out into the regions, although as the economic recovery accelerates and shows evidence of being sustained, this type of development will undoubtedly become more attractive. 5

6 Completions (m sq ft) Limited construction activity Town centre retail Retail warehousing Offices Historic average (198-2) Source: PMA Seeking an Alternative In spite of being one of the largest global markets, the sheer weight of domestic and overseas money looking to access UK property is starting to make the traditional commercial property market feel crowded. Rather than risk overpaying for assets in the mainstream sectors, investors are already looking elsewhere for potential returns. The so-called Alternatives sectors, from residential to student accommodation and even more esoteric investments like M&G Real Estate s recent purchase of a portfolio of car auction sites, are likely to attract greater investor interest as a way to complement existing commercial portfolios. Residential property in particular is expected to perform well this year, albeit away from the prime Central London market, where yields look extremely low and rents are continuing to soften. Increasing numbers of first-time buyers and home movers are looking to buy, spurred on by more attractive financing conditions, meaning that mortgage approval levels are improving. Meanwhile, the number of properties for sale remains relatively restricted. The imbalance of demand and supply is therefore expected to continue to push yields downwards in the short term Investors should also consider that the performance of residential investments will also be driven by the rental market and, here too, the prospects remain positive, most notably in the London area. While we may continue to see people moving from the private rented sector (PRS) into owner occupation this year, it is important to remember that there are still significant numbers of renters who are unable to or are uninterested in climbing onto the housing ladder. The demand for renting still far outweighs supply in the Capital and this is likely to ensure continued rental growth this year, although perhaps not at the same rates seen during the mortgage-starved years of the financial crisis. Although prospects for regional rental growth are not as strong, these markets will still benefit from the increased availability of debt, boosting capital growth this year. Once the economic recovery in the regions is more advanced, these markets will also likely show significant recovery potential, which would be expected to boost performance further down the line. In conclusion The year ahead looks set to be one of the most positive for UK property since the onset of the financial crisis. Investors need to be aware, however, that with so much capital from a variety of sources targeting the UK market, actually acquiring assets may become increasingly challenging. This begs the question: will 214 become the year where the hunt for value becomes the most important trend of all?

7 How to contact us UK M&G Real Estate City Place House 55 Basinghall St London EC2V 5DU Governor s House (Registered Office) Laurence Pountney Hill London EC4R HH +44 () () Singapore Marina Boulevard #31-3 Marina Bay Financial Centre Tower 2 Singapore Contacts Emma Grew Senior Analyst, Property Research +44 () emma.grew@mandg.com Richard Gwilliam Head of Property Research +44 () richard.gwilliam@mandg.com Chris Nash Director of Institutional Business Real Estate, UK +44 () chris.nash@mandg.com Chris Andrews (CFA) Head of Client Relationships and Marketing chris.j.andrews@mandg.com The value of investments can fall as well as rise. This article reflects M&G Real Estate's present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. The distribution of this article does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G Real Estate does not accept liability for the accuracy of the contents. M&G Real Estate Limited is registered in England and Wales under number with its registered office at Laurence Pountney Hill, London EC4R HH. M&G Real Estate Limited forms part of the M&G Group of companies. M&G Real Estate Limited is an indirect subsidiary of Prudential plc, a company incorporated and with its corporate head office in the United Kingdom. Prudential plc and its affiliated companies constitute one of the world s leading financial services groups and is not affiliated in any manner with Prudential Financial, Inc, a company whose principal place of business is in the United States of America. FEB 14 /