By James Routledge at PAI member Matthews & Goodman
Despite being in a “bleak midwinter” in a geopolitical and Brexit sense, we still need to consider our prospects for 2019 within the context of:
- A slowing world economy: with China and the US expected to lose economic momentum and a Sino-US trade war likely to have a profound impact on all global trade
- A weaker sterling: which will enhance our export opportunities (almost £550bn is earned through exports), but impact our import bill
- A rebalancing of the UK economy towards our major regional cities: especially Manchester, Leeds, Birmingham and Liverpool
- An ongoing environment of relatively low interest rates and gilt-edged bonds: presuming a Brexit deal can finally be agreed - the demand for secure long-term income streams should continue to support prime commercial property values
- Modest base rate increases: keeping RPI inflation in check at a little over 3%, edging back from recent peaks and low employment rate of c. 4% will benefit the lower paid
- An ongoing redefinition of “location” and “sustainability” through infrastructure, e-commerce, technological and demographic change. The pace of evolution will quicken – capital values in the commercial property markets will therefore continue to move in the opposite direction.
Comparative 2018 performance
A predicted 2% rise in institutionally held UK commercial property investment values (2017: rise of 6%), resulting in total returns at around 6.5% (2017: 12%), will mask extremes.
The standout sector for performance was industrial/warehousing, with a predicted rise in values of around 12% - close to 2017 levels - set to level off in 2019.
Demand for specialist (Alternatives) assets, especially with social, health-related and accommodation uses, ideally secured on long leases with index-linked rentals is strengthening, with mainstream Funds reducing their retail holdings. Despite the Brexit turmoil, in the run up to Christmas 2018, we witnessed pension funds bidding down to yields of around 3%, some 75 basis points stronger than twelve months ago.
The outlook for 2019 is for an overall decline in commercial property values, predominantly in the retail sector where average declines could be in the range of 5% to 10%, together with assets across all sectors adversely affected from structural change. Low trading volumes are likely in Q1 whilst many investors and occupiers await political guidance, however some direction and stability thereafter should lead to a bounce back in activity.
2018 London house price falls of between 1.5% and 2% were reported from various sources, compared to an overall (slight) increase across the UK. These figures mask small increases in some outer east London areas, balanced by double digit drops in local markets more closely linked to London’s financial districts - which are clearly affected by economic and political uncertainty. Whilst Mark Carney’s comments on 35% reductions across the market look far-fetched, the divide between London and the rest of the country is set to narrow over the next five years.
The above compares to a decline in the FTSE All Share Index of 13% (2017 delivered a 9% rise), with the FTSE 100 down 12% and the FTSE 250, which represents an increasingly complex mix of UK and overseas earnings, was down 15%.
10-year UK Government gilts have been trading at yields of between 1.65% and 1.05% over 2018, opening the year at 1.29% and finishing at 1.145%. Whilst financial market forecasters predict interest rates and gilt yields to gradually edge upwards, perhaps we will witness a similar spread in pricing through 2019.
Brexit weighing most heavily on residential market in London
The prospect of a ‘bad’ Brexit is weighing on markets across London to varying degrees, however the longer term (the next 20 years), according to Oxford Economics, is for east and north-east London to attract a third to half of net migration to London, driven by improved public transport (Crossrail).
Low levels of affordability in London, falling real wages for middle and upper management and economic and political uncertainty will translate into weak buyer demand and modest price falls. This is contrasted by stronger activity in the more affordable and now faster growing technology and life science-led economies, such as the Cambridge-Oxford growth corridor, where prices should continue to rise.
The long-term growth of the build-to-rent market and the necessity of providing affordable housing is a clear ongoing trend, with many fund managers citing predictability of income and low correlation of the more cyclical commercial markets.
There should also remain a weight of money from debt providers looking for a home, which is increasingly amongst unregulated (i.e. family office type) lenders, as well as challenger banks and private equity backed funds.
London versus regional offices – differing fundamentals
Many regional office markets have a well-balanced supply and demand equation, with an outlook of relatively stable rental levels over the next 12 – 18 months.
The growth of the knowledge sector and adoption of a north-shoring strategy by London’s professional services firms should continue to be a catalyst for areas such as Cambridge, Manchester, Leeds and the Oxford corridor. Technology, communications and media entrepreneurs seek cheaper accommodation, talent and a better lifestyle and this they find in the regions.
Irrespective of which Brexit deal we finally end up with, London will continue to be a leading global financial centre and the epicentre for this sector in the UK. However central London, especially the City has challenges ahead – whilst we recently heard from Tom Sharman, head of research and estate strategy, real estate finance at NatWest/RBS that there will probably not be a mass exodus from the City, perhaps only 5,000-10,000 jobs lost, equivalent to 0.5 – 1m sq ft of office space, the total amount of office space will increase over the next two to three years. Combine the increase in space with the growth of the Serviced Office market (now second only to the government as the largest owner/occupier group in the office sector), this is likely to result in occupiers vacating second-hand space, with resultant falls in office rentals perhaps by 10% over the next two years.
Ultimately core locations such as the City could benefit, as occupiers move out of some fringe locations, having only recently herded into them and creating record rentals.
Regional centres coming of age vs London
There is a growing school of thought which believes that it is misleading to use London as a benchmark to evaluate the performance and potential of our regional centres.
Looking ahead, it would be more accurate to compare the growth in Manchester, Leeds, Birmingham and Liverpool with similar regions such as Hamburg and Munich. A transformation in our regional centres is already in place, resulting from the impact of growth of urban living, employment growth in professional services, scientific and technical industries. However, a decline in manufacturing and public administration will surely be an increasing negative factor for outlying locations.
Retail – structural change brings winning locations and players
With Amazon now a top ten UK retailer by turnover, rubbing shoulders with John Lewis and Aldi, and with only the “top four” grocers ahead, the ongoing theme for others will be to reshape, adapt, reduce costs, and consider CVAs.
Whilst e-tailing is set to grow from the current level of just under 20% of the total market, to a predicted 30% over the next 5-10 years, the ‘offer’ of Amazon and other online retailers will broaden. Expect them to build presence with physical stores and service hubs – rather than increase the demand for space, it will quicken the demise of groups such as M&S and Debenhams, whilst investors will seek to grow exposure to the successful value retailers such as Aldi, Lidl, Home Bargains, B&M and Wilko - retailers which sell a narrower range of products will increasingly shape the out of town retail scene.
Despite the re-purposing of redundant retail space to residential and other alternative uses, occupancy levels should remain high in locations able to deliver a mixed use, experience-led destination. Inbound tourism will continue to benefit central London and destination/luxury retailers, with the top ten successful high street locations having clear USPs. For example, expanding local economies such as Cambridge and Oxford; Chichester and Guildford attracting the grey pound; and concentrated local catchments such as Brighton and Kingston upon Thames.
Last Mile – where to next?
A cocktail of strong investor demand for urban logistics, rapid evolution of online retailers and distributors concepts and delivery models, with an ever more complex puzzle involving pick-up pods and stores and utilization of surplus space within retailer’s estates makes for a complex outlook.
Time will tell, but the rental trends point towards prime logistics rentals becoming more expensive than some retail rentals – ailing retail parks and superstores could come into focus as potentially viable for logistics and fulfillment-related activities.
Private Equity – waiting in the wings
Central London offices, retail parks and shopping centres are all in the line of sight of private equity groups, waiting for a significant downward adjustment in prices - seeking opportunities to re-model assets (will it come later in 2019 or 2020)?
The Prospect Beyond 2019
2019 is set to be a year of extremes, with local knowledge and asset management key ingredients to provide guidance in a changing market, but with an industry increasingly focused on delivering “service” in a fast-changing world.
The pace of rebalancing the UK economy will pick up, with the longer-term trend of London’s economic performance no longer outperforming the regions. The outflow of London’s population from the professional classes, will be balanced by an increasingly younger international mix, the City retaining its No1 mantle for financial services and London continuing to be a favoured destination for overseas investment.
No predictions for 2019 and beyond can ignore the relentless march of technology and its potential impact on what we do, how we do it and the skills we will need in the future. Blockchain, virtual reality, artificial intelligence and cyber risks will no doubt feed into an increasingly process-driven approach to business.
It would be inappropriate to conjecture about the impact of Brexit on the property sector (in the absence of even an inkling of the terms of our exit), however a no-deal exit looks set to most impact on short term trade, with consequences for foreign direct investments, regulation, tax and individual sectors. However, an increased possibility of an extreme socialist government is more likely to blow any 2019 predictions even further off course.