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A strong global economy and rising interest rates are shaping the outlook for UK real estate in 2018, says Tom Goodwin.
The landscape for UK real estate investors is beginning to shift. While the uncertainty surrounding the ‘Brexit’ negotiations continues to dominate discussions over Britain’s economic prospects, two factors have changed the outlook for property in 2018: global growth has been strong, and as a direct consequence, interest rates are rising. UK occupier markets have benefitted from the growth environment, and its continued strength bodes well for UK exports, in particular. However, a higher interest rate environment is likely to drag on UK property returns.
Low bond yields have been the primary source of support for real estate pricing in recent years, with income-seeking investors holding up the market (see figure 1). As interest rates begin to rise, bond yields are also likely to tick higher, eroding the relative attractiveness of physical assets.
We expect spread compression to be gradual, but if central banks hike rates more aggressively than anticipated the impact on investor demand for real estate could be dramatic. The Bank of England raised the official bank rate from 0.25 per cent to 0.5 per cent in November 2017 and UK bond yields have already begun to inch higher.
For the time being, UK real estate still looks attractive for investors focused on income rather than absolute returns. Much of the market remains expensive but there are pockets of risk-adjusted value in regional offices, leisure, and urban logistics.
Figure 1. UK real estate, relative pricing over bonds
Occupier markets: signal and noise
On the occupier side, rental growth was slightly stronger than expected in 2017, at 1.7 per cent across all UK real estate. But investors need to be cautious and tune out the market noise if they are to identify sectors where demand is likely to be sustained.
There has been much talk about demand for central London offices, for example, but take-up is concentrated at the top end of the market. We expect lower-quality assets will struggle to maintain current rental levels and suffer increasing obsolescence, particularly given the quantity of new development being brought onto the market. As such, our forecasts for rental growth for the office market as a whole are for negative rental growth in 2018 and 2019, though we expect a recovery from 2020 onwards.
With this in mind, fund managers should consider reducing their exposure to offices in the centre of the capital and look either at emerging submarkets with reduced supply risks, or opportunities elsewhere in the UK. The development pipeline for regional offices looks relatively constrained over this year and next, and demand for good-quality space remains robust.
Industrials look expensive
While fundamentals across the industrials sector are strong, pricing has tightened considerably over the last year to levels now well beyond expectations. High prices may be justified in areas such as urban logistics – as occupiers need to pay for last-mile delivery hubs in inner-city locations to be close to their end customers, at least until the advent of delivery drones – but elsewhere valuations look high.
Some investors risk succumbing to a herd mentality as they seek exposure to industrials as a proxy for the secular trend towards e-commerce; price-blind investments appear to have become increasingly common. 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. As industrial assets become ever more expensive, investor attention is likely to shift towards higher-yielding alternatives, such as retail warehouses.
High-street retail continues to struggle as consumer spending is squeezed amid falling real wages and high inflation. However, we expect inflation to fall this year, which may support a degree of recovery in consumption towards the end of 2018. We recommend investors focus on ‘destination’ retail – schemes based on the provision of an experience and where people choose to spend their time, such as outlet centres. These assets appear best placed to fend off competition from e-commerce. Retail parks in suburban locations that could be converted to residential property over the longer term could also offer value.
Investors should continue to position their portfolios defensively and focus on income security. Real estate debt remains more attractive than equity on a risk-adjusted basis; although prime equity and debt offer similar income returns, debt is protected from capital declines. Despite a rally in real estate investment trust (REIT) pricing since last quarter, the listed sector remains a better entry point for funds that have to deploy capital.
Regional offices continue to offer the best risk-adjusted returns in the current environment; occupier fundamentals in Manchester and Cambridge make these markets look particularly compelling at present. Investors should also consider development projects, which are likely to offer better value than standing assets. Leisure schemes – particularly those in good locations with well-let retail space anchored by cinemas – and larger mixed-use regeneration schemes may also offer opportunity.
Figure 2: Under/over pricing analysis1
- The relative pricing analysis compares the difference between real estate yields and the yields from other asset classes in a specific quarter with the long-term average difference. A standardised score is thereby created for each quarter and the standardised scores for each asset class are separated into quintiles, with the top (bottom) quintile indicating that property is very cheap (very expensive) compared to the other asset class.
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