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Market Comment - A Year of Transition

Tuesday, January 03, 2017

By James Routledge.

Six months on from the EU Referendum vote to leave the European Union, Brexit still haunts many Boards as they review investment, operational, property and people strategies.

In January 2016 we predicted property investment yields would stagnate, purchasers would be more discerning and some markets would reach a cyclical peak, with an upward drift in yields for secondary assets with questionable fundamentals.

We finished 2016 with moderated activity in commercial property markets, some elements having reached a cyclical peak and with a generally slow growth outlook - albeit economic activity is currently more buoyant than could have been anticipated back in June.

Whereas in Q4 2015 some commercial fund managers reported neutral capital flows, going negative immediately after the EU Referendum, 2017 starts with robust demand for properties with strong fundamentals and good quality sustainable income streams – not just a fillip for overseas investors taking advantage of a currency play, as property can still provide a yield margin to cope with a modest upward trend in interest rates (relative to bonds and equities).

Comparative 2016 Performance

In a reversal of fortunes, average capital values for UK commercial property investments have fallen by a predicted 4.1%, based on November IPF consensus forecasts at November, relative to a 12% increase as measured by IPD in 2015, meaning total returns around 0.6%.

However, buyers have driven prices up for long lease and defensive property, with prime income yields for 15 to 20 year leases with open market rent reviews now below 5%, relative to 6% in 2014.       

UK house price growth was 4.5% according to Nationwide’s latest Index, although recording little upward movement since September.

The residential averages hide a slump in volumes and fall in value for Prime Central London residential property, a market largely the preserve of overseas buyers, which is in the deep freeze due to George Osborne’s SDLT increases.

Government gilt prices (5-15 years) recorded a total return of 7.3% (2015:1.08%; 2014: 11.86%).

The above compare to a rise in the FTSE All Share Index of 12.5% (preceded by a decline of over 4.5% between 2014 and 2016), with the FTSE 100 up 14.4% driven by international / dollar earnings, and the FTSE 250 recording an increase of 3.7% which is a more reliable guide to UK plc.

Seeking a Mix of Security and Inflation-Linked growth – in a Risk-Off Environment

There is a widely held belief that the UK economic performance must be evaluated against the lethargic growth and political uncertainty across Euroland and the deflationary impact of a likely downturn in China’s economy.

UK inflation (CPI) is firmly predicted to rise, from a 2016 level of 1% to the Bank of England’s current 2017 projections of 2.7%. However, the higher RPI measure could exceed 3.5 % and maybe 4% by 2018.

Therefore, the driver at least in the first half of 2017 will be annuity-style investing, with widening interest in specialist properties providing secure long term income (such as pubs and restaurants, hotels, schools, car showrooms and primary healthcare).  

Developers and owners will be challenged to engineer more RPI-linked rental clauses to satisfy a growing appetite for inflation-linked income.

But Mind the Gap

Prices for secondary assets without long-term income certainty and limited value-add opportunity will adjust downwards, increasing the yield gap between prime and secondary assets.

It will become more difficult to source debt at the speculative end of markets, whilst opportunistic buyers, especially in Central London markets, will wait for perhaps longer than not as there will be few forced sellers.

We may well see a structural change in Central London market pricing, which could leave London out of step with other, potentially more stable, parts of the UK.

London Offices – A Footloose Market

There are major influences on the future of the office market (e.g. changing attitudes to ‘Presenteeism’, the growing attraction of remote working, collaborative working, etc.) and issues over affordability which have already forced many businesses to start reconsidering their working practices, thereby accelerating the growth in demand for serviced offices. It is also good news for London satellite locations and the major regional centres.

There will however be rent deflation exceptions - smaller and flexible businesses will place increasing value on landlord service provision, collaboration and working in clusters with like-minded people, as part of the workspace revolution.

In Central London, 2017 will therefore be a tenant’s market. Increased incentives offered to tenants have already reduced net effective rents in some sub markets by £2.50 per sq ft. Expect prime headline rents to reduce by some £10 per sq ft to £110 over the next two months in St James’s and Mayfair (a market dominated by hedge funds who are re-assessing their business models), whilst City fringe locations such as Clerkenwell, Old Street and South Bank look toppy at levels around £70 per sq ft, relative to the more stable core City rents of £65 per sq ft.

A Growing Grey Market

Tenants looking to release surplus space, discreetly and directly to the market, especially in the financial services industry, will increasingly compete with new space being promoted directly by landlords, potentially offering somewhat better rental terms on a short term basis, bringing an extra layer of complexity to the market.

The Threat of Mass Exodus to Euroland is a Red Herring

There is currently much talk about the UK’s future relationship with the European Union andthe possible move off-shore of major high net worth employers, especially if London loses passporting rights to do business in Europe.

A mass exodus of highly paid US bankers to Frankfurt or Paris looks unlikely, given the pull of London for them and their families – in terms of shopping and education, to personal security and culture. Probably more relevant is that they can’t replicate the professional support infrastructure of lawyers, accountants, inter dealer brokers and all the rest of the support network that makes the market tick. Even where access to European markets is required, leveraging technology might prove the answer with the banking and asset management world going through evolution in automation. Ultimately though, if barriers are too high and support networks are replicated satisfactorily in the US, London itself could become irrelevant.

Whilst financial services, which currently accounts for about 12% of UK GDP, may be set to diminish in influence, tech and creative industries have become important players in the occupational market – with Apple planning to move to Battersea Power Station, Google building its presence at Kings Cross and Facebook heading for Tottenham Court Road. It is interesting to note that over the last five years, office take up in Central London was 55% higher for TMT firms than finance companies.

London Residential – Watch the Bubble Rating

A recent report by UBS wealth management puts London just behind Vancouver in its “bubble risk” rating, following 25% price growth since 2014, meaning London is the second most over-priced residential market globally.

Linking this to top levels of SDLT at 15%, likely to stay at least through 2017, sales volumes and prices are likely to subside other than in sub £1,000 per sq ft locations in outer London areas, with opportunities in relatively more affordable commuter belt locations.

However, a weak currency coupled with economic and political stability and a well-regulated market still makes investing in London a very attractive option.

The Regions Hold Steady

With markets increasingly less London centric, the focus is on proposed infrastructure projects, devolution for Regional cities and the investment required to drive the Government’s Northern Powerhouse and Midlands Engine strategy.

Inward investors have noticed this, and there will be further bypassing of London in search of higher yields and secure income streams in the regions.

The “next level” office centres such as Liverpool (£21.50 per sq ft) and Newcastle upon Tyne (£23 per sq ft) with strong local infrastructure and communications, seem set to benefit from “north-shoring” with an ongoing positive case for both occupation and investment purposes, with prime rent rises exceeding 5% in 2016 and tenant incentives reducing 12%.

Small Number of Stronger Cities

Although regional markets are less affected by Brexit uncertainty, with low vacancy levels in most office markets for quality stock, and employment growth in professional services, scientific and technical industries, continued decline in manufacturing and public administration will surely be a negative factor for outlying locations.

Therefore, stronger cities such as Manchester are starting to experience greater economic and employment growth than the wider North West.

From a property perspective, prime Manchester office rents of £34 per sq ft whilst currently holding steady amidst an increasing Grade A supply, could ultimately push ahead of South East centres such as Staines and Reading at £34 per sq ft. A more affordable Birmingham market which has edged up to £32 per sq ft in 2016, should see a value spin-off from relocations such as HSBC, but also the West Midlands is more widely set to benefit from increased “on-shoring” of technical industries and evolution of ever-more automated manufacturing.

Retail and Logistics – Ongoing Structural Change

The online revolution has been firmly harnessed by successful retailers, such as John Lewis reporting close to 35% of total sales from online purchases, and some parts of society buying more than 65% online.

Thus it should come as no surprise that Primark sales are faltering (no on-line platform), whilst House of Fraser and Debenhams operating models are under the spotlight (behind the curve on e-tailing), with speculation that either one may suffer the same fate as BHS.

Amazon’s purely online entry into the grocery sector will challenge the big four supermarket groups, with faster deliveries and teaming up with local suppliers to offer wider ranges. This is also challenging Waitrose who have scaled down their roll-out programme to a handful of stores, whilst discounters Aldi and Lidl are stepping up their own online delivery platforms.

The growing click-and-collect model will have a profound impact on the sector’s transactional model, as the greater footfall will need to be ‘entertained’ – giving rise to greater “experiential” retailing.

This is further good news for the re-shaping logistics industry – more same day deliveries, a further integrated approach to logistics, with an explosion in “last mile” and “returns” facilities as an integral element of retail operations.

Private Rental Sector (PRS) Residential – Tackling the Housing Crisis

A sector which remains at the top of many investors agenda, fueled by urban population growth, affordability issues for owner occupation and a systemic undersupply.

The compelling investment case is underwritten by recent research which estimates that by 2025, 25% of UK households will be renting in the PRS, up from around 20% (close to 5 million households) now, with steady income returns of 5% per annum.

However, delivery levels will be frustrated with likely stand-offs between developers and authorities, with paper thin profits resulting from increased affordable housing elements. Local authorities are however now appreciating that the Build to Rent model is different from Build to Sell, from the different amenities required, to integration of differing types of occupier.

Student Housing – Hitting the Buffers due to Changing Demographics?

Alongside PRS, student housing was seen as a one way bet over the past couple of years – but with demand factors changing, this is an increasingly complex sector – a short term diminishing number of school leavers, possible restriction on the number of overseas students allowed into the UK post Brexit, the evolving government policy on apprenticeships and other school leaver programmes.

The growth in population of wealthy overseas students which sparked the demand for high end studios is now over – bring back the concept of clusters and shared facilities, not only for students, but also young professionals especially in London; Get Living London structured a deal with Deloitte to accommodate 600 graduate employees on preferential rental terms at a managed scheme at Stratford; Capital Living specialize in flat shares for professionals.

The Prospect Beyond 2017

2017 is set to be a transitional year, with early 2018 potentially a “low point” of heightened uncertainty, with the outcome of Brexit still an unknown, and the USA’s potentially combative international relations policy in play.

The pace of rebalancing the UK economy to make a success of leaving the EU will most likely only pick up beyond 2018, ultimately driven by our relationship with Euroland over the next 20-odd years.

A continued period of low but steady growth is anticipated – IPF consensus forecasts point towards further negative capital growth in 2017 and 2018, with modest growth in capital values in later years. However, relative highlights are the private rental residential sector, and logistics markets, where longer term transformational changes in both of these sectors should provide more stable returns.

Deferment of development in core office markets, whilst countering prospects of over-build in parts of London, will ultimately lead to a shortage of Grade A accommodation, which together with a period of higher inflation, may lead to higher construction costs, potentially higher yields, but generally upward pressure by the end of the decade.

Higher input costs resulting from weak sterling, feeding on to consumers, may ultimately temper consumer spending and have a calming effect on the residential markets.

We may yet be thankful for a Trump establishment’s expansionary and inflationary outlook, which may stimulate UK growth.

For more information, please contact James Routledge.