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The UK government’s negotiating stance on ‘Brexit’ has become clearer, which is good news for real estate investors. But value remains scarce across the market, says Tom Goodwin.
The UK’s vote to leave the European Union in June 2016 continues to dominate the macroeconomic landscape. But at least investors now have more clarity over the potential outcome of the ‘Brexit’ negotiations.
On February 2, Theresa May’s government published a white paper outlining its priorities, including a new customs arrangement with the trading bloc, controls on EU immigration and a border between Northern Ireland and Ireland that is as “seamless and frictionless as possible”. The government looks set to trigger Article 50 of the Lisbon Treaty to formally start the process of exiting the EU this month.
While uncertainty continues to surround the outcome, the government’s transparency over its objectives for the negotiations has been positive for business confidence. We have upgraded our 2017 GDP growth forecasts and now expect the economy to grow between one and 1.5 per cent this year.
However, UK real estate continues to face significant headwinds that will affect both liquidity and performance over the next five years. We expect the asset class to deliver total returns of 4.5 per cent per annum between 2017 and 2021.
London’s office market is particularly sensitive to the outcome of the Brexit negotiations, with access to the EU market crucial for the city’s financial services sector.
In its Brexit white paper, the government said it would be “aiming for the freest possible trade in financial services between the UK and EU member states”, and the industry has been lobbying hard to protect the ‘passporting’ rules under which British firms currently operate within the single market.
Demand for London office space is likely to weaken as the UK exits the trading bloc, but we believe a favourable outcome – short of untrammelled single-market access – is likely. Our best estimate is that London will see about 10,000 financial-services job losses, which equates to approximately one million sq. ft. of office space.
However, the impact of weaker demand will be mitigated by a stifled development cycle. Despite high-profile projects such as 22 Bishopsgate, a state-of-the-art skyscraper currently under construction in the City, the medium-term supply pipeline in central London is more constrained, which is supportive of rental growth. And London will continue to draw occupier demand thanks to its world-class financial industry, flexible labour market and attractive lifestyle and culture, whatever the outcome of the Brexit process.
Beyond London, supply of high-quality office assets is lagging long-term trends, which should support rental growth. The case is particularly compelling in Manchester and Cambridge, in our view.
Central London office rental growth forecasts
Source: IPD Annual Digest, 2000-2015; Aviva Investors. There is no guarantee forecast rental growth can be achieved.
Retail and industrial
Rising inflation looks set to drag on real wage growth this year, hampering the strength of the consumer economy and impacting the retail sector in particular. However, the rise in inflation is attributable to two short-term factors – the recent rise in energy prices and the devaluation of the pound following the referendum – and it will probably begin to fall again in late 2017.
London retailers benefited from increased tourist spending in 2016, thanks in part to the fall in the value of the pound following the referendum. This helped retail rents in the capital to grow between five and six per cent last year, significantly faster than elsewhere. However, the revision of business rates from next month will have a significant impact on occupancy costs in the capital – on Bond Street and Marylebone High Street, for example, rates are set to double.
Beyond London, we will continue to see a polarisation in the retail sector, with high-quality assets in core locations outperforming and poor-quality assets in secondary locations increasingly threatened by the growth in online retail.
The devaluation of sterling following the referendum improved the prospects of UK-based exporters and boosted demand for industrial property. However, most British manufacturers rely on imported component parts, so the benefits of the fall in the pound may not be fully realised. Nevertheless we expect to see industrial property outperform in 2017; competition among investors in industrial assets is growing intense.
Transaction activity in UK real estate has not fallen as significantly as was expected following the referendum, partly because the decline in bond yields after the vote improved the relative attractiveness of real estate for investors. However, at an aggregate level direct real estate looks overpriced relative to both the listed sector and units in unlisted property funds, which have adjusted to the weaker outlook.
While there may be opportunities in regional offices and the industrial sector, overall value is scarce in the UK real estate market and it has become crucially important for investors to select the right assets. In the office sector, we are focusing our investment activity in key cities where people want to live, work, play and learn, like Birmingham, Manchester and Cambridge, which we expect to outperform over the long term.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at March 14, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.