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UK real estate outlook: three predictions for 2018

The UK real estate market continues to look expensive, but there are a few pockets of value in certain sectors, says Tom Goodwin.

3 minute read

Pricing has tightened across the UK real estate market in recent months despite the deteriorating economic outlook. High inflation is weighing on consumer spending and the uncertainty surrounding the Brexit negotiations is contributing to low levels of business investment. Yet the long-anticipated correction in property prices has yet to occur.

The primary reason for this is that real estate’s income yield continues to look attractive compared with other asset classes. The weight of capital from yield-hungry investors is holding up the market. For now, investors would be well-advised to implement defensive strategies and reduce risk. For expert investors who have deep knowledge of local markets and the ability to source and structure transactions creatively, there remain some pockets of risk-adjusted value in regional offices, well located multi-let industrials and urban logistics.

Here are three predictions for the trends that will shape UK real estate markets in 2018:

1.  Foreign buyers will continue to invest in the UK – but there will be fewer blockbuster deals

Overseas capital has been a key feature of the UK property market in 2017. This year has seen two of the biggest British real estate deals on record: London office towers The Leadenhall Building (the ‘Cheesegrater’) and 20 Fenchurch Street (the ‘Walkie-talkie’) were sold to Chinese institutions for more than £1 billion each, in March and July respectively, reflecting sub-four per cent yields.

The appetite for trophy assets among investors from East Asia is still strong, but we are unlikely to see a repeat of such eye-watering pricing next year. Other foreign buyers will remain active in the market, notably German open-ended property funds – which have been targeting UK acquisitions following fund inflows in the face of aggressive pricing on the continent – and, further up the risk curve, US private equity funds.

In total, overseas buyers have accounted for more than half of total investment in British commercial property this year, and in London that figure is higher than 80 per cent. We expect continued overseas interest in 2018, but investors should keep an eye on these capital flows as any reversal would have an adverse effect on pricing.

2.  Herd mentality will skew pricing in certain sectors

As the market becomes more expensive, many investors in UK property have started to focus on ‘thematic’ strategies. Industrial assets have benefited from the conviction that the growth in e-commerce will stoke demand for warehouses and delivery hubs; similarly, the healthcare sector and senior-living properties have been targeted by investors mindful of the implications of the UK’s ageing population.

Of course, allocating capital based on supportive long-term structural trends is sensible, but investors need to keep an eye on pricing. Yields in parts of the industrial sector have now compressed to a point that implies investors are expecting long-term rental growth of between four and five per cent per annum. This is inconsistent with historical trends in the sector, which has historically struggled to generate positive rental value growth in real terms; in most locations the barriers to new development are simply too low for warehouse rents to sustain growth at such rates. The alternative is that investors are speculating on expectations of further yield compression – which is a high risk strategy at this stage in the market cycle.

Investors would do well to take a more granular view and focus on pockets of potential outperformance within these sectors. The structural changes underway in urban logistics, for example, may mean the excitement surrounding this sub-sector is justified. Until the advent of delivery drones, occupiers will need to pay for last-mile delivery hubs in inner-city locations to be close to their end customers. With strong occupier demand and constraints on supply, urban logistics assets are likely to continue to deliver capital growth.

3.  REITs will offer a better entry point than direct investments

As real estate prices rise, the case for rotating out of direct property and into real estate investment trusts (REITs) becomes more compelling. Many REITs are trading at deep discounts to their net asset values, some as high as 30 or 40 per cent, despite excellent portfolios and proven asset-management expertise. Such vehicles are likely to offer a better entry point than direct investments over 2018 if the direct market remains expensive.

…and two risks to the outlook

1.  Hard Brexit

We continue to anticipate a relatively favourable end trading relationship between the UK and the European Union, with a transition period after the UK’s exit from the bloc in 2019, although the risk that Britain could leave without a trade deal should not be discounted. The outlook should become clearer next year; in the event that the future trading relationship includes barriers to trade, the UK economy – and real estate occupier market – is likely to struggle. We would intensify our focus on defensive assets in this scenario.

2.  Higher interest rates

Our base case is that pricing will weaken gradually as rental growth slows and bond yields slowly edge out, favouring long-income strategies. However, there is a risk a sharper rise in bond yields might be ‘imported’ from the US should the Federal Reserve’s ongoing rate hikes lead to higher yields across global bond markets. In that event, low-yielding property sectors would be hit particularly badly.

Figure 1. Share of the UK real estate investment market that looks attractively priced
Figure 2. Under/over pricing analysis, five-year view from end-20171


The scale represents our forecast excess return (total return forecast over the outlook period minus the hurdle rate), expressed as a percentage of the hurdle rate for each sector.


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