While the outlook for UK real estate assets is positive, sinking oil prices and a vote on EU membership are among risks worth watching this year, warns Richard Levis.
- Good-quality, higher-yielding assets are likely to do well this year under our central scenario, but there a several key risks
- London offices, and the City in particular, appears to be the occupier sector at most risk if the UK exits the EU
- A re-run of the 2011/12 euro debt crisis could have significant impacts on returns to UK real estate
- On the upside, we may experience surprisingly strong rental growth in some parts of the market, with the biggest upside potential likely to be found in industrial assets
After seven years of growth in UK commercial real estate in the aftermath of the financial crisis, the upswing seems to be running out of momentum. London has continued to lead the way with strong capital growth seen in 2015 as yields fell to record lows across the offices, retail and industrial sectors. But optimism has markedly strengthened towards the main regional markets too. Warehouse, distribution and top-tier offices performed particularly well last year. While retail underperformed, returns varied widely by location and building type.
Domestic institutional and overseas investors remain the main net buyers of UK real estate, which is typical of this phase of the cycle. Overseas investors have been highly active, continuing to increase their presence in the market with most focus on large London assets. By contrast, private property companies were the main net-sellers of real estate in 2015. With yields plumbing new depths in many areas, finding value in traditional, ‘prime’ assets is increasingly difficult.
Prospects for UK real estate remain positive this year. Although returns are likely to be significantly lower than those seen in 2015 they should remain around historical norms. We expect healthy occupier demand and a broader recovery in the rental market to drive capital appreciation in coming months. Good-quality, higher-yielding assets are likely to do particularly well this year.
This favourable outlook is our central scenario but, as always, there are several risks worth bearing in mind which could have both negative and positive impacts on real estate returns. We believe the following ones will be worth watching out for in 2016.
Potential downside risks
While we doubt the UK electorate will vote to leave the EU this year, it remains a distinct possibility. Short of a clear mandate to remain in the EU, potential risks arising from ‘Brexit’ in the aftermath of the vote include unusually high currency volatility, higher gilt yields, capital flight, weaker economic growth and another Scottish referendum. All of these would have the potential to drain liquidity and harm investment performance of UK real estate in the short term.
But even in the event of Brexit, the UK will probably retain extremely close economic and political ties with the EU. So, the longer-term impacts would depend on the outcome of trade negotiations between the two. Nevertheless, Brexit could be expected to lead to lower net migration to the UK, which would likely reduce demand for housing and weaken prospective labour-force demographics. The central London office market appears to be the commercial occupier sector at most risk from a UK exit, in particular the City, due to the potential drop in demand for buildings from the financial services sector.
Euro-zone debt crisis
The fragile political situation in Greece could lead to a re-run of the 2011/12 debt crisis and renewed fears that the euro project will be derailed. The impact on UK real estate would vary according to how the crisis unfolded but the economic outlook would almost certainly weaken and confidence in the market would fall.
Amid a severe financial crisis most sectors would suffer, although as sentiment worsened very high quality assets, those with secure income streams and strategies targeting debt-related ‘distressed’ assets would be likely to outperform.
Faster-than-expected rate rises
Our central view is for UK interest rates to remain extremely low in 2016, rising at a gentle pace in coming years and peaking below their pre-2008 historical norms. However, unexpectedly rapid policy tightening is a potential risk scenario that may savage real estate returns if property yields also rise rapidly. While the speed and magnitude of any rate increases would likely dictate its effect on the market, much would also depend on the causes of the increase.
If rates rose surprisingly quickly in response to, say, a pick-up in inflation against a backdrop of strong economic output and real wage growth, then real estate rental growth is likely. In turn, property yields could rise gently without significant capital loss.
A sell-off in UK real estate would be far more likely were the Bank of England forced to raise rates in response to, say, surging inflation within a stagnant economy or a currency crisis (perhaps triggered by Brexit). In such circumstances, higher rates would likely coincide with worsening prospects for rental growth. In turn, a loss of confidence may trigger lower liquidity, higher yields and capital losses.
Potential upside risks
Stronger-than-expected rental growth
Rental growth in UK real estate is at levels not seen since the last cyclical peak. At a more granular level, industrial rents are growing more than three times faster than they were in 2007. Meanwhile, office rents are climbing at close to the rate reached at their previous peak, led by central London.
We expect rental growth to cool in 2016 as momentum in the central London office market slows. But there is a possibility rents will surge due to a combination of restrained supply, low vacancy rates, a lack of new development and steady economic expansion. We believe the biggest upside potential is in the industrial sector, which has not had much real terms rental growth since the late 1990s.
Overseas net investment grows even further
International investors have steadily increased their presence in UK real estate in recent years. Indeed, overseas net investment has been positive each year since 2000 according to Propertydata.com, with 2015 almost equalling the previous record peak set in 2007. This year we expect overseas net investment to ease amid slowing emerging economies, heightened geopolitical tensions and low oil prices. But we can also envisage an upside scenario where net investment is surprisingly strong, with repercussions for the wider market.
Firstly, as yields for the best assets fall, demand for lower-quality, ‘secondary’ assets and strategies will also rise, fuelling a further ‘re-rating’ of secondary yields. Secondly, investors may increase exposure to non-core real estate assets such as infrastructure, residential, healthcare, care homes and leisure. Finally, new development will become more attractive as a means of deploying capital, easing supply constraints.
Debt availability escalates
Less likely, but possible, is a surge in real estate lending. Eight years on from the financial crisis, the process of debt deleveraging in UK commercial real estate appears nearly complete. Under our central scenario we expect credit conditions to be restrained for some time, largely owing to regulatory pressures. But, traditional bank lenders may return to a market where ‘alternative’ lenders and debt funds are already competing fiercely for business. And, as credit conditions ease further, real estate yields would likely compress as the competition for assets increased.