Aviva Investors’ Jonathan Bayfield discusses the outlook for real estate.
3 minute read
UK real estate markets face potential headwinds in 2019 as Brexit, trade talks and rising interest rates threaten to weigh on demand. But there are grounds for optimism. There may yet be favourable resolutions to both the Brexit talks and the US-China trade dispute. Furthermore, rate hikes are likely to be gradual, supporting continued appetite for real estate among institutional investors. And while appropriate strategies will be needed to mitigate late-cycle risks, there remain pockets of value in certain sectors:
1. Manchester, Birmingham and Cambridge offices to offer growth
As capital values are hit across the board, rental growth is likely to be the only source of outsized returns in 2019 and beyond. Over the next five years, we believe offices in the largest UK cities will offer the most attractive returns, thanks to strong economic growth in these locations. Prime property assets will remain in demand and are less likely to experience significant repricing.
The most successful cities will be those able to act as a crucible of ideas, generating agglomeration effects through the sharing of information. Manchester, Birmingham and Cambridge have these characteristics; they also benefit from established knowledge networks and good transport connections.
2. Real estate debt and REITs offer more value than direct investments
As direct investments become more expensive in some markets, the case for real estate debt and real estate investment trusts (REITs) is becoming more compelling in both the UK and Europe. Investors in real estate debt can expect to receive income and – provided capital is sensibly lent – little capital value risk.
REITs continue to offer good value. In the UK, many REITs are trading at significant discounts to their net asset values, some as high as 45 per cent, despite strong portfolios and proven asset-management expertise. Discounts are not quite as attractive on the continent, but European REITs still traded at an average discount of 10.3 per cent to net asset value in the third quarter. On this basis, REITs are likely to offer a better entry point than direct investments next year if the direct market remains expensive.
3. Alternative sectors offer attractive risk-adjusted returns
Over recent years, accommodative monetary policies by global central banks have stimulated a search for yield. Real assets have benefited from this trend, as investors sought an illiquidity premium. With global monetary policy now set to tighten, the search for yield appears to be easing.
At this stage in the cycle, real estate investors in the UK are relatively poorly compensated for taking on extra risk. Positioning defensively makes sense in this environment. Sectors that may offer long leases and attractive risk-adjusted returns include supermarkets, student housing, senior living, hotels and also private rented residential (outside of London).
… and two areas that look less attractive in the medium term:
4. Housing market to keep cooling
From the 1980s to the Global Financial Crisis, it became easier to obtain a mortgage at higher loan-to-value rates in the UK – up to 100 per cent in some cases. Since the crisis there has been greater regulation of lending standards; nevertheless, quantitative easing has brought borrowing costs to very low levels.
As interest rates rise and credit becomes more expensive, the market will continue to cool, particularly in London. A sharper correction in house prices is possible in the event of a disorderly Brexit in 2019 – the Bank of England forecasts a 30 per cent drop in a ‘no deal’ scenario – but it is important to note that this is not our base case.
5. UK retail to come under further pressure
The structural challenges facing UK retail will become even more apparent in 2019, as real estate investors are forced to face up to the increasing pace at which people are changing their shopping habits. The UK is at the forefront of the disruption due to the disproportionate reach of e-commerce (see figure 1). Brexit-related economic uncertainty is likely to compound these structural challenges. Recent UK consumption levels have been supported by households reducing their savings and taking on more debt; neither approach is sustainable.
As retailers target smaller footprints, a downward re-rating for rents is likely. Average and lower-quality retail property is most vulnerable, particularly shopping centres and retail warehouses in secondary locations, where values could drop 5 per cent. Both equity and debt investors will need to position their portfolios with the deteriorating outlook for secondary retail property in mind. The outlook is more robust for better shopping locations which accommodate ‘high-engagement’ retailing, along with those that offer an experience online retail cannot match.