UK real estate: political uncertainty clouds the picture

Brexit UK Real estate June 2017

2 minute read

A hung parliament after June’s general election in the UK only added to Brexit-related uncertainty, although there remain pockets of opportunity for investors, says Tom Goodwin*.

Another vote, another period of political turmoil in the UK. In June, the British electorate once again confounded the expectations of markets and pollsters, delivering a hung parliament that only exacerbates the uncertainty surrounding Britain’s negotiations to leave the European Union (EU).

We still anticipate a relatively open trading relationship between the UK and the EU over the medium term, but in the meantime investors in UK commercial real estate face challenges. A further slowdown in rental growth is to be expected, as the lack of clarity over the outcome of the Brexit talks is likely to prove a drag on the economy and lead occupiers to delay decision-making.

There are signs the UK economic slowdown we have anticipated is beginning to take. But the risks do not appear to be fully reflected in valuations; direct real estate still looks overpriced in our view relative to both the listed sector and units in unlisted property funds, which adjusted to the weaker outlook 12 months ago. Such a prolonged disconnect between more liquid forms of real estate investment and the direct market is highly unusual.

It is possible the liquid markets are understating the importance of real estate’s relative pricing; property still offers attractive risk-adjusted returns compared with other asset classes. The real estate yield spread over bonds remains particularly healthy and investor demand is robust. We continue to find pockets of opportunity, and expert investors should be well placed to add value through actively managing their portfolios and careful asset selection.

Offices: regional assets to outperform

A disconnect between pricing and fundamentals is particularly evident in central London’s office sector. A wave of new development in the capital is coming to completion just as occupier demand begins to falter and Brexit threatens to compromise financial services firms’ access to the European single market.

For now, however, capital from outside of the UK appears to be holding up the top end of the London property market. Many of these investors are looking beyond short-term income growth forecasts and focusing on the city’s longer-term prospects, which remain robust. Whatever the outcome of the Brexit negotiations, London is likely retain its status as a global city, with a deep pool of highly-skilled labor and an unrivalled cultural offering.

Regional office assets are less sensitive to the fallout from Brexit than those in the capital and a dearth of supply in many markets is supportive of rental growth. In fact, we expect this sector to outperform, delivering total returns of 6.4% over the next five years.

Retail: consumer squeeze

The outlook for the UK retail sector is threatened by pressures on consumer spending. The inflation rate rose to 2.9% in May – the highest it has been since June 2013, according to the UK Office for National Statistics (ONS) – but wages are not keeping pace; ONS data shows that average weekly earnings increased by 2.1% over the three months to April.

With stalling or even negative real-income growth, and inflation set to move higher in the coming months, our outlook for UK retail sales growth is poor. Households would usually adjust by borrowing more but there is little scope for them to do so; the savings ratio for UK households has already fallen to an all-time low.

Lower UK consumer spending is likely to accelerate the ongoing polarization of the retail sector. Weaker parts of the market – particularly poor-quality assets in secondary locations, including many out-of-town shopping centers – look particularly challenged.  High-quality assets in “destination” locations should prove much more resilient.

Industrials: strong returns

The weaker economic outlook for Britain is likely to force companies to act with more alacrity to adjust to the structural challenges they face. Retailers may rationalize store portfolios more quickly, becoming more discerning in their location strategies in the face of competition from online retailers. In the office sector, we may see firms bring forward plans to introduce automation to reduce costs, which could in turn reduce demand for office space.

In the industrial sector, the structural changes underway are much more favorable. The rise of e-commerce is fostering demand for warehouses, logistics hubs, and “last-mile” delivery depots, while the post-Brexit devaluation of the pound was a boon to some exporters. We are forecasting total returns of 6.6% on UK industrial property over the next five years to 2021, although some of that will be “in the bank” already; strong competition for the best assets has driven yield compression and the market is beginning to look very expensive.

There may be better risk-adjusted returns on offer through development opportunities in the industrials sector – particularly in Southeast Britain – and in some regional office markets, such as Manchester, which probably offer better value in the current market. Over the medium term and beyond, we continue to believe good-quality property assets in “winning” cities, where people want to live, work, play and learn, will outperform.

Figure 1: Regional offices set to outperform

Source: IPD Annual digest, 2000-’16; Aviva Investors House View Q2 2017. Past performance Is no guarantee of future results. 

Figure 2. Rising prices, falling consumer spending

Source: Thomson Reuters Datastream, Q2 2017. Past performance is no guarantee of future results. 

* Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL").

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