THE UK COMMERCIAL PROPERTY ANALYST

THE UK COMMERCIAL PROPERTY ANALYST Q No sign yet of a peak for capital values The economy should grow steadily over the next few years, without generating much inflation, allowing interest rates to stay sub-%. Slower employment growth will be partially offset by higher productivity, allowing rents to rise, albeit more slowly, for some time yet. South East offices are likely to deliver some of the best returns next year, but taking -9 as a whole, industrial will outperform.

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THE UK COMMERCIAL PROPERTY ANALYST Q Economic Analysis for UK Commercial Property Investors, Developers, Lenders and Brokers th August No sign yet of a peak for capital values Executive Summary Main Forecasts The Investment Market - Economic Drivers The Investment Market - Property Investment Outlook Office Occupier Market Retail Occupier Market Industrial Occupier Market Leisure and Hotels Sectoral Rankings Chart Bank The UK Commercial Property Analyst Q

Executive Summary The changes to our commercial property That is not to say, however, that yields have forecasts this quarter are minor and primarily now hit their floor. Our forecasts assume that reflect some modest upgrades to our forecasts they will continue to grind a little lower, but for office and industrial rental value growth in only by perhaps bps or so, and at a slower. However, we have also made some rate than has been typical over the past year. reductions to our forecasts for retail rental values. Meanwhile, occupier market fundamentals still look solid, even taking into account the The net effect of these is to leave our forecasts surprise dip in employment in April and May. for capital value growth and total returns in For one thing, the falls were minor and need to unchanged at.% and % be seen against the backdrop of employment respectively. But we now expect returns of rates that are already very high. What s more, % in, down from.% in the they imply a recovery in productivity which previous Analyst. should support business confidence and profits. The minor nature of these revisions seems justified by recent developments which, In any event, although supply is beginning to broadly speaking, have been in line with our respond, it is typically still the case that expectations. For example, as we anticipated, occupier markets are characterised by excess data for the second quarter shows that the dip demand, especially at the higher end of the in the pace of the economic recovery in Q market. So although we do expect rental value was a one-off. growth to begin to moderate in most markets next year, we do not expect to see a collapse. While the weak first quarter means that we have trimmed our full year forecast a touch, In terms of winners and losers, we suspect that following a decent.% q/q rise in GDP in the in the near term, offices will continue to second quarter, growth looks to be on track to outperform, with the South East in particular, rise by around.% this year. We then expect leading the way. In the later stages of the growth to slow to.% in, as the fiscal forecast horizon, however, we expect squeeze kicks in again and the Bank begins to industrial property to deliver the highest tighten monetary policy returns, although in relative terms, we also see some scope for stronger retail returns. However, we expect that tightening to be very gradual. And combined with the solid In terms of the main risks to our forecasts, the economic backdrop that should mean that slowdown in China is one obvious area for investor confidence in the UK market holds up concern, but the risks that would stem from a well, despite the fact that on some measures larger and sharper rise in risk-free rates than property is now starting to look expensive. we expect almost certainly pose the bigger downside threat. The UK Commercial Property Analyst Q

Main Forecasts TABLE : KEY COMMERCIAL PROPERTY FORECASTS, YEAR-END f f f f 9f -9-9 ALL PROPERTY Rental value growth, % y/y........ End yr equiv. yield, %........ Capital value growth, % y/y.9....... Income return, % y/y........ Total return, % y/y.9...9.. 9.. OFFICE PROPERTY Rental value growth, % y/y...9..... End yr equiv. yield, %........ Capital value growth, % y/y........ Income return, % y/y........ Total return, % y/y. 9...9.9... RETAIL PROPERTY Rental value growth, % y/y........ End yr equiv. yield, %........ Capital value growth, % y/y........ Income return, % y/y........ Total return, % y/y. 9....... INDUSTRIAL PROPERTY Rental value growth, % y/y.......9. End yr equiv. yield, %.9....... Capital value growth, % y/y. 9....... Income return, % y/y........ Total return, % y/y...... 9.. LEISURE PROPERTY Rental value growth, % y/y........ End yr equiv. yield, %..9...... Capital value growth, % y/y 9. 9... -.... Income return...9..... Total return, % y/y...... 9.. HOTELS PROPERTY Rental value growth, % y/y.......9. End yr equiv. yield, %........ Capital value growth, % y/y........ Income return.....9.9..9 Total return, % y/y.. 9..9.... Sources Capital Economics, IPD TABLE : KEY UK ECONOMIC FORECASTS, YEAR-AVERAGE f f f GDP, %y/y..... -yr swap rate, % (end-period).9.... -yr gilt yield, % (end-period)..... CPI inflation, %y/y..... $/ (end-period)..... Euro/ (end-period)..9... Financial & business service sector output, %y/y..... Manufacturing output, %y/y..... Household spending, %y/y..... Unemployment rate (ILO measure), %..... Employment, %y/y..... Average earnings, %y/y..... Nationwide house prices, %y/y in Q..... Sources Capital Economics, Thomson Datastream The UK Commercial Property Analyst Q

The Investment Market Economic Drivers Rising productivity should keep interest rates low Provisional estimates for GDP in the second quarter show that the sharp slowdown in growth seen at the turn of the year was a oneoff. GDP is estimated to have risen by.%q/q, above most estimates of the economy s potential growth rate. Indeed, if we are right that this momentum will be sustained, the economy looks set to grow by.% this year and by.% in. (See Chart.) One reason why we expect the economy to slow next year is that firms and households are likely to be digesting the first rise in interest rates since. However, if we are right that any rate rises will be very small and very gradual, the renewed tightening in fiscal policy is likely to be the stronger headwind. Indeed, after a pause in / in the run up to the election, the economy faces a fiscal squeeze worth around % of GDP in each of the next few years. (See Chart.) However, we doubt that this will have a major adverse impact on the economy. For one thing, we think that concerns that the recession did substantial, lasting damage to the economy s productive potential are often overstated. After all, long-term unemployment peaked at far lower rates than in previous recessions and recovered quickly. (See Chart.) That does not sit well with the idea that large numbers of workers have lost skills. Encouragingly, there are also signs that firms appetite for investment is recovering. Indeed, although investment growth slowed sharply in Q, surveys of investment intentions strongly suggest that this was noise in the data rather than a fundamental loss of confidence in the outlook for demand. (See Chart.) We expect investment to rise by % this year and by % in. Combined with a moderation in employment growth, reflecting the fact that the employment rate is already at record highs, this should ensure that the recovery in productivity gathers pace over the next year or so. That is important because we believe that with unemployment now approaching % and skills shortages emerging, the recovery in real wages will run for some time. (See Chart.) That suggests that consumer confidence is likely to stay relatively high, in turn supporting growth in consumer spending, the largest single component of GDP (See Chart.) We expect spending growth of perhaps.% in followed by growth of % to.% over the next couple of years. However, providing that real wages are supported by rising productivity, we will not see a material rise in unit wage costs or inflation. Indeed, we expect inflation to be at or below the MPC s % target throughout until at least the end of. (See Chart.) Accordingly, we do not expect the first rate rise until sometime in. And we expect the MPC to move very cautiously. In fact we think that rates will not rise above.% before the end of. In turn, that should ensure that bond yields also stay low by past standards. (See Chart.) The UK Commercial Property Analyst Q

The Investment Market Charts : Real GDP : Change in Cyclically-Adjusted Net Borrowing (% of GDP) - - - - - - - - % q/q (RHS) % y/y (LHS) CE Forecasts: =.% =.% =.% 9.... -. -. -. -. -. -. - - - OBR Forecasts Fiscal stance looser.. Mar. Jul. Fiscal stance tighter / / / / / / / / /9 9/ / - - - : Unemployed for more than months (% of Workforce) : Business Investment 9 9 Surveys holding up well - - - - Weighted average of surveys (adv. m) - Real business investment (%y/y) - 9 9 9 9 9 99 9 - - - - - - : Real Wages (Index, Q = ) : Consumer Confidence and Consumer Spending Forecasts 9 9 9 - - - - - - - - - GfK Consumer Confidence (Balance, LHS) Real Household Spending (% y/y, RHS) 9 9 9 9 9 - - - - - - : CPI Inflation : Bank Rate and Government Bond Yields (%) Headline CPI inflation Core CPI inflation CE Forecasts Year Year Bank Rate CE Forecasts % target - 9-9 Sources Thomson Datastream, HM Treasury, GfK, Capital Economics The UK Commercial Property Analyst Q

The Investment Market Property Investment Outlook London starts to lose its lustre... The IPD Quarterly index showed that all- and which have not fallen anything like as far property yields dipped below % in the as sovereign bond yields, present a more second quarter of this year. At.9%, they balanced picture. At bps, the spread were just bps lower than in the first quarter. between property and corporate bond yields Even so, that modest dip left yields at levels suggest that property is cheap, but not last seen in late and within bps of their especially so. (See Chart.) low in the previous boom. (See Chart 9.) And a simple ratio of residential to commercial While the pace of yield compression has property prices shows that commercial halved in the past six months or so, it is not property looks cheap relative to housing. (See immediately clear that this is a sign that yields Chart.) To the extent that prices in both are bottoming out. For one thing, yields in the sectors should be benefitting from low interest central London office and retail markets, rates, this comparison implies that valuations already among the lowest of any sub-markets, in the commercial sector may not be quite as all registered above-average falls last quarter. stretched as they seem at first sight. In addition, at roughly bps, the gap On balance, therefore, we believe that between property yields and -year bond property is increasingly looking fully-valued, yields is still extremely high by historical but is not yet obviously overpriced. However, standards. (See Chart.) That implies that the fact that yields are much further below property is still undervalued and that there is normal levels in Central London and the South ample scope for yields to drift lower. East markets than elsewhere implies that this conclusion may be more appropriate for some However, other measures of relative value are sub-markets than others. (See Chart.) less reassuring. Comparing property yields to equity dividend yields, for example, suggests Indeed, if we assume that the property/bond that property is almost as expensive as at the yield spread returns to its pre-credit crunch height of the mid-s boom. (See Chart.) norms by the end of the forecast horizon, while bond yields rise to.%, Central What s more, while bond yields are close to London office yields would need to rise by all-time lows, equity dividend yields are not bps from today s levels. (See Chart.) materially out of line with the range of past experience, implying that they may be the Consistent with that, investors appear to be better guide at present to comparative value. increasingly wary of London. Property Archive data show that the share of activity involving However, a comparison to corporate bonds, London property fell to a -year low of.% which also provide a guide to investor s in the year to June. (See Chart.) attitudes to the health of the occupier sector, The UK Commercial Property Analyst Q

The Investment Market Charts (Continued) 9: All-Property Initial Yields (%) : All-Property Initial Yields less -Year Gilt Yields (Bps)........... Quarterly change (Bps, RHS) Initital Yield (%, LHS) 9 - - -9 - - - - - - - - 9 9 99 99 99 999 : All-Property Initial Yields Less FTSE All-Share Equity Dividend Yield (Bps) : All-Property Initial Yields Less -Year BBB Corporate Bond Yield (Bps) - - - - - - 99 99 999 99 99 999 : Ratio of Residential to Commercial Property Prices (Index, Q 9 = ) : Initial Yields By Main Sector (Difference from Long-Run Average, Bps) Housing comparatively expensive Trend - - - - - - - - - - - - 9 9 99 99 : Illustrative Projection of Property/Bond Yield Spread for Central London Offices (Bps) : Commercial Property Investment in London and the Regions (m moving average) Assumes property yields unchanged and bond yields rise to.% London's share, % (RHS) London, bn, (LHS) Rest of the UK bn (LHS) - Average = bps - - 99 99 999 - Sources IPD, Thomson DataStream, Property Archive The UK Commercial Property Analyst Q

The Investment Market Property Investment Outlook (Cont d)...but investor demand should underpin yields for some time Yet the bigger picture is that investor appetite One reason for that is that the UK is for UK property shows few signs of slowing. performing well, especially when compared to Indeed, in June, the value of deals struck Europe. Accordingly, rental value growth exceeded bn for only the third time on expectations are high. (See Chart.) That will record. (See Chart.) In turn, that pushed the make the UK a potentially attractive average spend per month in the past year to proposition for both domestic and overseas within a whisker of.bn, well up on the investors. And on past form, the high level of.bn peak seen in mid-. rental value growth expectations means that further falls in yields cannot be ruled out as Moreover, despite a rare fall in June, the investors try to buy into anticipated gains in underlying trend in net investment by overseas capital values. buyers shows few signs of going into reverse. In the year to June, overseas buyers accounted On balance, we think that in aggregate, for % of the value of all purchases of UK property yields are now within bps to bps property, thus outweighing the combined of what may ultimately prove to be their floor activity of UK institutions, REITS and property in this upswing. But with the economy set to companies. (See Chart.) perform well, and interest rates and bond yields set to peak at far lower levels than in the The high weight of overseas demand is past, we have penciled in only marginal rises arguably another reason not to be too in yields in the second half of the forecast concerned about UK property valuations, even horizon. That relatively flat profile will return in London. Of course, were that demand to the property/bond yield spread to more normal evaporate rapidly, then values could well fall, levels by the end of 9. (See Chart.) perhaps sharply. Yet it is possible that the presence of overseas investors on this scale But our yield forecasts mean that capital value may have lowered the liquidity premium in growth will decelerate steadily over the London. If so, then the fair value spread forecast horizon as yield impact fades and between property yields in London and risk- rental value growth becomes the sole driver. free rates may be lower than in the past. (See Chart.) Total returns will follow a similar profile, but will average a fairly healthy Regardless, surveys show that there are no 9.% taking the period -9 as a whole. signs yet that investor demand is waning. (See Chart.) Indeed, in the second quarter, the balance of RICS surveyors noting that investor enquiries By sector, we expect returns in the office had risen stood at %, a new high (See Chart sector to average.%, compared to 9.% 9.) for industrial and.% for retail. However, strip out and we suspect that average industrial returns will fare best. (See Chart.) The UK Commercial Property Analyst Q

The Investment Market Charts (Continued) : Value of Commercial Property Deals ( m per month) : Value of Deals By Main Buyer Type (% share, m average), 9,,,,,,,,, -month average 9, 9,,,,,,,,, Institutions Overseas buyers REITS & Listed Prop. Cos. Private Prop.Cos. 9 9: RICS Surveyors Reporting a Rise in Investment Demand (% Balance) - - - - - - - - 9 : Annual Change in All-Property Initial Yields and the Balance of Surveyors Expecting Rents to Rise Rental Expectations (% bal, LHS) - Annual change in all-property yields, (Bps, - RHS, inverted) - - - - - - - - 999 9 : All-Property Initial Yields and -Year Bond Yields (%) : Contributions to All-Property Capital Value Growth (%-pts) 9 All-Property Initial Yields, % -Year Gilt Yields, % F'cast 99 99 999 9 - Forecasts Impact of rental value growth Impact of yield movement 9 - : All-Property Total Returns Forecasts (%) : Total Returns Forecasts For Office, Retail and Industrial Property (%) Forecasts 9-9 avg Forecast All-office All-industrial All-retail 9 Sources IPD, Property Archive, RICS, Thomson Datastream 9 The UK Commercial Property Analyst Q

Office Occupier Market London rental growth poised to slow in Central London office markets have been at the forefront of the recovery in occupier markets over recent years. But there is little sign that their upswings are running out of momentum. Indeed, after dipping fairly sharply in the first quarter, take-up in the Central London office markets jumped by a third in the second quarter to stand at.m square feet. (See Chart.) Although that was a little lower than the levels seen in the closing stages of last year, it was still around % above the.m square feet figure that has been typical over the past decade or so. Moreover, take-up was strong enough to push vacancy rates in the West End down from.% to.% and in the City, from.% to.%. (See Chart.) Against that backdrop of strong demand and limited and diminishing availability, it was no surprise that the already sizeable gains in Central London office rents were extended in the second quarter. Indeed, if anything, the steady drop in the vacancy rate over recent quarters suggests that, having reached % y/y in Q, rental value growth in Central London could gather further momentum over the remainder of this year. (See Chart.) One dampening factor, however, might be signs that development activity has begun to respond. According to Knight Frank, the amount of space under construction stood at almost 9.m square feet in the second quarter, up by % compared to the same period last year. (See Chart.) However, even in the City, which has seen the bulk of that increase, space under construction currently equates to a relatively modest.% of stock. History suggests that it is not uncommon for development booms to be slow to get going, but then to snowball rapidly. For now, however, on its own, we do not think that the development response is large enough to act as a material brake on Central London office rental value growth; a conclusion that is reinforced by the fact that active demand in the capital is currently running at aboveaverage rates. (See Chart.) That said, we do believe that rental value growth will hold fairly steady at around % over the rest of this year, before slowing to % in and perhaps % to % thereafter. After all, the pace of London office-based employment growth has already slowed sharply and we expect this to mark the start of a weaker trend. In turn that should act as a brake on rental growth. (See Chart.) Yet even with that slowdown, our forecasts envisage that rental values could rise by roughly a fifth from current levels. In nominal terms, that would push rental values in the West End up to levels that are well above previous highs, while in the City, rental values would reach levels not seen since the early 99s. (See Chart.) While those forecasts look challenging, we think it is more informative to assess them in real terms to allow for the fact that other costs and prices have also risen. On that basis, our forecasts do not look onerous. (See Chart.) The UK Commercial Property Analyst Q

Office Occupier Market Charts : Central London Office Take-Up (Sq.ft. s) : Office Vacancy Rates in the City and West End (% of Stock) Central London office take-up per qtr, Sq.ft. s West End City 9 9 99 99 999 : Office Vacancy Rates and Rental Values in Central London : London Office Space Under Construction (% of Stock) Central Ldn vacancy rate, % (LHS, inverted) Central Ldn office rents %y/y (RHS) 9 - - - - - West End City 9 : Active Demand in the Central London Office Market (Sq.ft. Mn) -year avg =. 9 : Office-Based Employment and Central London Office Rental Values (%y/y) - - - - London office-based jobs (LHS) Central London office rents (RHS) average of City and West End Forecast 99 9 - - - : Index of City and West End Office Rental Values in Nominal Terms West End City Forecast 9 9 99 99 99 : Index of City and West End Office Rental Values in Real Terms 9 9 West End (LHS) City (RHS) Forecast 9 9 99 99 99 9 9 Sources IPD, Thomson Datastream, Knight Frank, Capital Economics The UK Commercial Property Analyst Q

Office Occupier Market (Continued) Regional office rents have scope for further steady gains Outside of London, the pattern of office market take-up was more mixed in Q. In the South East, for example, the M, M and, in particular, the M markets all experienced a drop. (See Chart 9.) Nevertheless, when viewed as a whole, takeup across the three markets came in at a touch over m square feet, only slightly weaker than the.m average figure seen over the previous six quarters. In any event, despite dipping a little, take-up was strong enough to push a measure of the aggregate vacancy rate in the South East to.%, down from.% in the previous quarter and the lowest level recorded since at least. (See Chart.) Indeed, the low level of the vacancy rate means that, as appears to have been the case in London at times over the past year or two, the lack of availability may be acting as a brake on take-up levels in the South East. Elsewhere, take-up in the major regional cities posted an impressive % rise between the first and second quarters of the year. However, that jump was distorted by Birmingham where, at just under, square feet, take-up in the second quarter was more than four times higher than in Q. (See Chart.) Yet even leaving Birmingham aside, most cites reported that take-up was broadly unchanged or higher in the second quarter. And in almost all cases, that take-up was in line with, or a little higher than, the average level reported over the previous five years. Indeed, the only city to report a meaningful dip in take-up was Glasgow, and that was off a comparatively high base. As in London, we expect the recent slowing in the pace of office-based employment to prove the start of a more subdued trend, as productivity rather than job creation becomes the key driver of economic growth. Yet with surveys reporting that the availability of office space is still deteriorating across the country, the moderation in job creation may take time to feed through. We are therefore forecasting that Rest of the South East office rents will rise by % this year and by % in, before settling at a rate of around % thereafter. In the Rest of the UK, we expect rents to post a rise of.% this year and to grow by around % to % thereafter. If we are right, our forecasts imply that rental values in the Rest of the UK market will return to their highs by the end of the forecast horizon, while in the South East, rents will return to levels last seen in the early 99s. (See Chart.) Our forecasts for the main office markets are summarized in Chart. Having led the recovery for so long, we now think that Central London offices might lag behind over the next few years, as a modest rise in yields in the later stages of the forecast horizon acts as a drag on capital value growth. Elsewhere, the scope for faster rental value growth means that the Rest of the South East should deliver slightly stronger returns than the Rest of the UK. The UK Commercial Property Analyst Q

Office Occupier Market Charts (Continued) 9: Office Market Take-Up in the Main South East Office Markets (Sq.ft. s) 9 Table : CE Office Sector Forecasts (%y/y, Year-End) 9 M M M f f f f 9f All offices Rental value growth...9... End yr equiv. yield, %...... Capital value growth...... Income return...... Total return. 9...9.9. London City % of office stock by value 9 : Vacancy Rates in the South East M, M and M Average 9 Rental value growth...... End yr equiv. yield, %......9 Capital value growth..... -. Income return...... Total return.....9. London West End % of office stock by value Rental value growth...... End yr equiv. yield, %......9 Capital value growth 9.9...9. -. Income return...9..9. Total return.. 9.9.9.. : Office Take-up in the Main Regional City Office Markets (Sq.ft. s) 9 Q Q 9 Rest of South East 9% of office stock by value Rental value growth...... End yr equiv. yield, %...... Capital value growth.. 9.... Income return....9.. Total return.9...9.. Rest of UK % of office stock by value Rental value growth...... End yr equiv. yield, %....9.9.9 Capital value growth 9...... Income return...... Total return.9 9.. 9... : Office Rental Values in the Rest of UK and Rest of South East Office Markets (Indices) 9 RoSE RoUK Forecast 9 9 99 99 99 9 : Office Market Forecasts (% y/y, -9 Average) Total Returns Capital Values Rental Values RoSE RoUK City West End Sources IPD, Knight Frank, Capital Economics The UK Commercial Property Analyst Q

Retail Occupier Market A gradual recovery may be underway In our previous Analyst, we argued that there were reasons to expect the recovery in retail occupier markets to begin to gather a little momentum. By and large, those expectations have been supported by the recent data. For example, the balance of RICS surveyors reporting that demand for retail space had improved edged up in the second quarter to stand at %, the third highest reading in the survey s history. (See Chart.) Demand also seems to be solid across the country. Comparing the latest readings to what has been typical over the previous two years, shows that in most regions demand improved a little in the second quarter. (See Chart.) The strength of demand prompted another sharp rise in the balance of surveyors expecting retail rental values to rise. Historically, this survey balance has been a decent lead indicator of IPD retail rental value growth. (See Chart.) However, that relationship has clearly broken down in the post-recession period and we would be wary of reading too much into the latest rise. That said, the recent data on rental values were more encouraging. Disappointingly standard shop rental values fell in both quarterly and annual terms in the second quarter, despite strong gains in the Central London market. But the data elsewhere were more encouraging. (See Chart.) In particular, retail warehouse rental values rose by.% q/q, a sharp improvement from the.% q/q gains seen in each of the previous three quarters. Meanwhile, with both in-town and out-of town centres recording a modest rise in rents, annual shopping centre rental value growth moved into positive territory for the first time in almost seven years. Nevertheless, we doubt this will mark the start of a rapid upturn. For one thing, the structural changes affecting the retail sector show few signs of having run their course. In particular, the volume of goods sold online or via other non-store formats continues to rise far more rapidly than total retail sales. (See Chart.) That suggests that the sector is still likely to be suffering from excess supply. Indeed, surveys show that between and, retail availability increased almost continuously. (See Chart.) So the latest falls will only have partially resolved the supply overhang. Moreover, the latest data from CBRE show that despite the fragility of the recovery to date, shopping centre supply has picked up sharply in recent months. (See Chart.) Demand for this modern stock is likely to be far keener than for older stock. But, all else equal, greater supply will do little to strengthen the rental recovery. Nevertheless, the surge in consumer confidence over the past year or so makes it hard to argue with the idea that the retail occupier market backdrop is becoming more favourable. (See Chart.) Especially, when the recovery in real wages is also factored in. The UK Commercial Property Analyst Q

Retail Occupier Market Charts : RICS Surveyors Reporting a Rise in Retail Demand (% Balance) - - - - - 999 - - - - - : RICS Surveyors Reporting a Rise in Demand By Region (% Balance) Previous two years Q London South Mid/Wales North : All- Retail Rental Values and Surveyors Expecting a Rise in Retail Rents - - - - Rental Expectations adv.9m (%Bal, LHS) Retail Rental Values (% y/y, RHS) 999 9 - - - - - : Rental Value Growth By Main Sub-Sector (Q )...... -. -. -. -. % q/q % y/y...... -. -. -. -. : Volume of Non-Store and Total Retail Sales (Jan = ) Non-store sales Total (excl petrol) : RICS Surveyors Reporting a Rise in Retail Availability (% Balance) - - - 999 - : Retail Space Under Construction (Sq.Ft. Millions) : Retail Rental Values and Consumer Confidence Shopping Centres Retail Warehouses 99 99 999 9 Retail rents (%y/y, LHS) Consumer confidnce, adv 9m (% Bal., RHS) - - - - 99 99 99 999 - - - - - - - - Sources IPD, Thomson Datastream, RICS, CBRE The UK Commercial Property Analyst Q

Retail Occupier Market (Continued) But returns will struggle to match past norms Indeed, that recovery in real wages is one reason why we expect the next few years to deliver a steady improvement in consumer spending. After rising by % or more this year, spending is likely to slow to % next year as the fiscal squeeze is renewed and consumers digest the rises in interest rates. Thereafter, we expect spending growth to average perhaps.% per annum. Given that fairly supportive backdrop, we expect the supply overhang to be steadily eroded and for rental value growth to respond to the steady increase in demand implied by the consumer spending forecast. (See Chart 9.) Indeed, although we think retail rental values will rise by less than % this year, a lower forecast than in our previous Analyst, we have then penciled in growth of around % per annum. Admittedly, given the structural changes going on in the retail sector, it is possible that the relationship between consumer spending and retail rental values has permanently altered. However, the relationship between retail rental values and housing transactions has held up well in recent years. And our forecasts for retail rental values also seem consistent with our views that activity in the housing market will steadily normalise over the next few years. (See Chart.) Aside from the rebound in retail warehouses in 9, the growth of rental values in the three main retail formats has been remarkably close in recent years. That tends to suggest that the supply overhang is impacting all three submarkets to a similar degree. For now, we can see no clear reason to argue that demand for one type of space will be materially stronger than for others, so our forecasts assume that this convergence in rental value growth will be sustained. (See Chart.) In terms of total returns, our forecasts envisage that they will range between % and % over the forecast horizon. (See Chart.) We expect the strongest returns to be seen this year and next when, together with some modest growth in rental values, capital values are boosted by further modest falls in yields. Thereafter, however, we see returns easing to between % and %, as capital value growth becomes wholly dependent on rental value growth. Taking the period to 9 as a whole, we expect returns to average.%, around a percentage point lower than their long-run average At the sector level, the fact that our rental value forecasts are similar suggests that returns will also be fairly uniform. However, on balance, we think there is a little more scope for yields in the retail warehouse sector to fall than there is for standard shops or shopping centres. As a result, we expect returns in the retail warehouse sector to average 9.% over the period to 9. The comparable figures for standard shops and shopping centre returns are.% and.% respectively. (See Chart.) The UK Commercial Property Analyst Q

Retail Occupier Market Charts (continued) 9: All-Retail Rental Values and Consumer Spending (%y/y) : Housing Transactions and All-Retail Rental Values (%y/y) - - - - Forecast Retail rents (%y/y) Consumer Spending (%y/y, adv m) - - - - - - - - Forecast Retail rents (%y/y) Housing Transactions (s per qtr, adv 9m) 99 99 9 99 99 9 : Retail Rental Values by Main Sub-Sector (%y/y) Table : CE Retail Sector Forecasts (%y/y, Year-End) - - - - Shopping centres Standard shops Retail Warehouses Forecast 99 99 9 - - - - All retail f f f f 9f Rental value growth...... End yr equiv. yield %...... Capital value growth...... Income return...... Total return. 9..... Retail warehouses 9% of retail stock by value : All-Retail Total Returns (%) Forecast Rental value growth...... End yr equiv. yield %.9..... Capital value growth..9.... Income return.9....9.9 Total return...9 9. 9..9 Long -run average Shopping centres % of retail stock by value 9 Rental value growth...... End yr equiv. yield %...... Capital value growth...... Income return...... Total return. 9. 9....9 : Summary Forecasts by Main Retail Property Type (%y/y) (-9 Average) 9 Total Return Capital Values Rental Values Retail Ware Std Shops Shopping Centre Standard shops 9% of retail stock by value Rental value growth -...... End yr equiv. yield %.9..... Capital value growth...... Income return...... Total return.. 9.... Sources IPD, Thomson Datastream, Capital Economics The UK Commercial Property Analyst Q

Industrial Occupier Market Supply response won t curtail the rental recovery The industrial sector has gone from strength to strength in recent quarters. The Rest of the South East segment is seeing the strongest growth in rents. In the year to Q, rents rose by.%. But even in the Rest of the UK, over the same period, rental growth was a healthy %. As a result, taking the industrial sector as a whole, rental value growth reached.%y/y in Q, two and a half times faster than the rate recorded a year earlier and the strongest rate since mid-. However, that pace of growth looks consistent with the strong rates of job creation seen in the wholesale and distribution sector in recent quarters. (See Chart.) Surveys show that the strength of demand is reducing the amount of available space at close to the fastest rates on record. Not surprisingly therefore, rental value expectations have also hit new highs. (See Chart.) The good news, however, is that there still appears to be ample scope for rental values to rise from here. In real terms, rental values across the sector as a whole are currently around % below the level implied by a simple linear trend. And it is typical for rental values to overshoot such trends during major upswings. Indeed, our forecasts envisage that an overshoot will also be seen over the next few years. (See Chart.) Nevertheless, the overshoot we have penciled in looks modest by past standards. In part, that is because new supply has picked up strongly in recent quarters. According to IPD, the combined value of spending on new development and improvements reached almost m in the year to Q, a total only previously surpassed at the height of the last boom. (See Chart.) As this supply comes on to the market over the next few quarters, we suspect it will take some of the heat out of rental value growth. However, unless the pace of development picks up considerably further, we think it is more likely to slow, than to stall, the rental recovery. After all, as we have already argued, rental values are, if anything, still a little on the low side. And if we are right that the recovery will continue at a decent clip for some time yet, demand should be strong enough to deliver further steady gains in real rental values. (See Chart.) Therefore, after posting growth of roughly % this year, we think rental value growth will drop to % in and to between % and.% over the remainder of the forecast horizon. Moreover, taking the period as a whole, we suspect that there is some scope for rents in the Rest of the UK to catch up with the gains already seen in the South East. So we think that the rest of the UK may well outperform in the later stages of the forecast. In view of that, and taking into account its slightly higher income returns, we suspect that total returns in the Rest of the UK will outperform marginally. Our forecasts envisage that between and 9, returns in this market will average.%, compared to 9.% for the Rest of the South East. (See Chart.) The UK Commercial Property Analyst Q

Industrial Occupier Market Charts : Industrial Rental Values and Employment in the Distribution Sector (%y/y) Industrial Rental Values (LHS) Distribution sector employment, adv m, (RHS) - - - 99 999 9 - - - - - : RICS Surveyors Reporting a Rise in Industrial Availability and Rental Value Expectations (% Balance) - Availability (LHS, inverted) - Rental value expectations (RHS) - - - - - : Spending on New Supply (Rolling four-quarter total, m) : Real Industrial Rental Values (Index) - Development Development and improvement - Simple trend 9 9 99 99 F'cast - - - - : GDP and Real Industrial Rental Values Real Industrial Rental Values (%y/y, LHS) Real GDP (% y/y, RHS) Forecast 9 9 99 99 : Summary Forecasts for Industrial Property Markets (%y/y) (-9 average) Total Return Capital Values Rental Values - - - Table : CE Industrial Sector Forecasts (%y/y, Year-End) All industrial f f f f 9f Rental value growth...... End yr equiv. yield %.9..... Capital value growth. 9..... Income return...... Total return...... South East industrial % of industrial stock by value Rental value growth...... End yr equiv. yield %...... Capital value growth. 9..... Income return...... Total return..9...9. Rest of UK industrial % of industrial stock by value RoUK All Industrial RoSE Rental value growth...... End yr equiv. yield %...9...9 Capital value growth. 9..... Income return....9..9 Total return......9 Sources IPD, RICS, Thomson Datastream, Capital Economics 9 The UK Commercial Property Analyst Q

Leisure Benefitting from the rise in real wages Hotels Hotel upswing set to moderate in Leisure property yields fell by bps in the Capital value growth in the hotel sector has second quarter of this year to stand at.%. almost doubled over the past year, rising from That left them around bps above the mid-.%y/y in the second quarter of to s low, but around bps below their %y/y on the latest data. own long-run average. (See Chart.) In the past, spending on hotel and restaurant Relative to the rest of the market, that suggests services has been a fairly reliable guide to the that leisure property may be a little cheap. strength of hotel capital value growth. But the After all, all-property yields are bps below latest surge in capital values has run well average and only bps above the lows seen ahead of such economic fundamentals. (See in the last upswing. Therefore, we would not Chart.) be surprised to see leisure yields continue to drift down by bps or so over the next year. That s because investor interest in the sector has soared. In the year to June, the value of After all, the latest signs from the occupier completed hotel deals stood at.bn, up market are good. Spending on leisure services % compared to the same period a year has surged in the past few quarters. In value earlier. That has helped to push yields down terms it grew by more than % in the year to by bps, which in turn explains the bulk of Q. However, we would be wary of assuming the rise in capital values. that this will automatically translate into stronger rental value growth. Over the next few years, we envisage that spending on hotel and restaurant services As we wrote in a Commercial Property Update should perform well, with growth averaging What does the surge in leisure spending mean perhaps % to % per annum in nominal for property on th June, we suspect the data terms. may have been boosted by ticket sales to last year s Commonwealth games and advanced But capital values are already well above the sales of tickets for the Rugby World Cup. level implied by a simple liner trend. (See Chart.) And with the hospitality sector likely Moreover, the relationship between spending to be hit harder than most by the Chancellor s and rental growth is typically fairly loose. (See new living wage, we have stuck with our Chart.) We have therefore penciled in rental previous forecasts, which envisage capital value growth of % this year and.% next. value growth slowing quite sharply over the next two years. Pulling all that together generates forecasts for total returns that are comfortably in double- As a result, we expect hotels to deliver returns digit territory this year and next and an average of over % in and 9% in, before return over the forecast horizon of 9.%, in dropping to around % or % in the later line with the all-property figure. (See Chart.) years of the forecast horizon. (See Chart.). The UK Commercial Property Analyst Q

Leisure charts Hotel charts 9 : Leisure Sector Initial Yields (%) : Hotel Capital Values and Spending Hotels and Restaurant Services (% y/y) Average =.9% F'cast 9 9 99 99 9 - - - - - - Hotel capital values (LHS) Spending on hotels and restaurants (RHS) Forecast - - : Spending on Leisure Services and Leisure Rental Values (%y/y) Leisure services, avg of prev qtrs (LHS) Leisure rental values (RHS) - - - F'cast - - - : Hotel Capital Values (Index) Forecast Simple linear trend 9 9 9 9 : Leisure Returns and the All-Property Average (%) : Hotel Returns and the All-Property Average (%) Forecasts All-property Leisure Forecasts All-property Hotels 9 9 Table : CE Leisure Sector Forecasts (%y/y, Year-End) All leisure f f f f 9f Rental value growth...... End yr equiv. yield %..9.... Capital value growth 9. 9... -.. Income return...9... Total return...... Table : CE Hotels Sector Forecasts (%y/y, Year-End) All hotels f f f f 9f Rental value growth...... End yr equiv. yield %...... Capital value growth...... Income return.....9.9 Total return.. 9..9.. Sources IPD, Thomson Datastream, Capital Economics The UK Commercial Property Analyst Q

Sectoral Rankings : CE Forecasts for Rental Value Growth in (%y/y) : CE Forecasts for Average Rental Value Growth in to 9 (%y/y) All-property average =.% All-property average =.% : CE Forecasts for Capital Value Growth in (%y/y) : CE Forecasts for Average Capital Value Growth in to 9 (%y/y) All-property average =.% All-property average =.% : Equivalent Yields, Q (%) : CE Forecasts for Equivalent Yields, Q 9 (%) 9 All-property average =.% 9 9 All-property average =.% 9 : CE Forecasts for Total Returns in (%y/y) : CE Forecasts for Average Total Returns in to 9 (%y/y) All-property average = % All-property average = 9.% Source Capital Economics The UK Commercial Property Analyst Q

Capital Economics Ltd Capital Economics is an independent economic consultancy based in London, Toronto and Singapore. We specialise in macro-economic analysis and the relationship between the macro economy and individual business sectors. We are retained by both financial and industrial & commercial companies to provide regular analysis and advice on the state of the world s leading economies and the economic prospects facing business sectors. Our clients range from some of the world's largest banks to boutique property investors. They include retailers, pension funds, insurance companies, fund managers, merchant banks, stockbrokers, housebuilders, property developers, construction companies, building societies and specialist lenders. In addition to our retained relationships we also undertake research projects commissioned by companies, government agencies, and trade associations. Recent research projects have included studies on personal finances in an era of low inflation and low interest rates, VAT and the construction industry, the use of property in business, the impact of the euro on the UK savings market and the impact of deflation on pensions and pension funds. If you would like more information about Capital Economics and what we could do for you, then please contact us at the addresses given overleaf. About Roger Bootle, Managing Director One of the City of London s best-known economists, Roger Bootle runs the consultancy, Capital Economics, one of the world s largest independent economics consultancies, which he founded in 999. Roger is also a Specialist Adviser to the House of Commons Treasury Committee and an Honorary Fellow of the Institute of Actuaries. He was formerly Group Chief Economist of HSBC and, under the previous Conservative government, he was appointed one of the Chancellor s panel of Independent Economic Advisers, the so-called Wise Men. In July, it was announced that Roger and a team from Capital Economics had won the Wolfson Prize, the second biggest prize in Economics after the Nobel. Roger Bootle studied at Oxford University and then became a Lecturer in Economics at St Anne s College, Oxford. Most of his subsequent career has been spent in the City of London. Roger has written many articles and several books on monetary economics. His latest book, The Trouble with Markets, analyses the deep causes of the recent financial crisis and discusses the threats to capitalism arising from it. Like his previous book, Money for Nothing, which correctly anticipated the financial crisis, it has been widely acclaimed. This follows the success of The Death of Inflation, published in 99, which became a best-seller and was subsequently translated into nine languages. Roger is also joint author of the book Theory of Money, and author of Index-Linked Gilts. Roger appears frequently on television and radio and is also a regular columnist for The Daily Telegraph. In The Comment Awards he was named Economics Commentator of the year.

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