Market Comment - Looking Beyond the Headlines

Backdrop

Despite political uncertainty, engendered by Brexit and Faction Politics, the business community has carried on with the business of business - at home and in Europe.

2017 proved to be a year of divergence in property markets, with some standout trends set to continue into 2018:

A risk-averse environment continues to fuel insatiable demand for secure long-term income streams, with growing numbers of far eastern investors ‘trophy hunting’ which will continue to support prime commercial property values.

Amidst economic uncertainty and weakening occupier fundamentals in many quarters, the themes of infrastructure, e-commerce, technological and demographic change are beginning to redefine 'location.

Investor client strategies are becoming less sector specific, influenced more by structural change. Asset-level decisions are returning to the explosive growth of co-working and flexible offices; to the structural changes that e-commerce is bringing to retailing models, logistics warehousing and last mile delivery; and the need to deliver private rental sector and retirement residential stock.

Although commercial property markets have reached a cyclical peak with limited short-term capital growth prospects, there are huge variations in prospects across the country and within sectors, and pockets of growth in regional markets benefitting from a diversion of activity away from London.

Whilst the first half of 2018 is likely to see a peak in Brexit uncertainties and political ‘noise’, this could be short lived, and barring unforeseen geo-political crises, a benign economic environment and ongoing low interest rates could provide a platform for an economic bounce.

Comparative 2017 Performance

A predicted 6% rise in UK commercial property investment values (2016: decline of 4%), meaning total returns at around 10.5%, has surprised many in the property industry who misread Brexit, the strength of investment from overseas and ongoing low cost of debt.

The standout sector for performance was industrial, with predicted rise in values of over 12%. However, logistics units, bulky goods retail warehousing and specialist (Alternatives) assets which are secured on long leases are likely to have recorded capital appreciation closer to 18%, reflecting yield hardening of around 75 basis points.

The outlook for 2018 is for values to be flat overall, however prime yields approaching 3% and below look stretched - especially within parts of the industrial and long-lease markets. Stable assets yielding 6% to 7% with asset management potential look to be a comparatively safer bet in 2018.

2017 UK house price growth is predicted to be around 2 .5% according to Nationwide’s latest Index, albeit with significant regional variations - brisk activity and value growth of around 6% in the East Midlands and East of England contrast with a slump in volumes and fall in value for Prime Central London residential property.

The above compares to a rise in the FTSE All Share Index of 9% (2016 delivered 12 .5%, preceded by a decline of over 4.5% between 2014 and 2016), with the FTSE 100 up 7.6% and the FTSE 250 (which represents an increasingly complex mix of UK and overseas earnings) was up 14.7%.

10-year UK Government gilts have been trading at yields of between 1.5% and 1% over 2017, finishing at 1.19%, with some financial markets forecasters predicting a similar range in pricing through 2018 - presuming a benign economic outlook and inflation does not rise further.

Seeking a Mix of Security and Inflation-Linked Growth

As predicted last year, UK inflation (CPI) has risen to over 3% from a 2016 level of 1%, although anticipated by the Bank of England to have peaked and will gradually fall to the 2% target.

With many investors remaining cautious, the search for annuity-style opportunities is set to continue into 2018. However, a shortage of mainstream stock will fuel demand for specialist properties providing secure long-term income from ‘accommodation’ and ‘social’ uses (such as leisure facilities, hotels, schools and primary healthcare).

Looking Beyond Prime and London

With a scarce pool of prime and long lease stock in mainstream sectors, development funding and shorter lease assets, let off sustainable rents and with asset management potential, will provide the bulk of buying opportunities. This will predominantly be in locations away from Central London and especially in emerging intellectual and business ‘hubs’.

Whilst London is re-shaping in terms of new infrastructure and working practices, which are providing opportunities in emerging hub locations such as White City and across East London, for now Central London commercial property remains the preserve of overseas ‘trophy hunters’ and seekers of headquarters.

London Offices – A Footloose Market

On face value, London office markets are experiencing take-up which is dramatically stronger than predictions at the start of 2017. Technology companies are leading the way, with around 25% more tech/creative workers today than there are financial services workers.

However, with almost 20% of lease transactions involving flexible office providers (and at 11% over half of this is down to the rapid expansion of WeWork, who state they will double their footprint in 2018), there are wider structural changes ahead.

A growing bubble effect created by WeWork is surely stoking the risk of owners losing smaller footloose occupiers to the operators of serviced offices, potentially providing a buying opportunity a few years out, after a downward rental correction. In the meantime, rent free periods for new leases of offices suites below 5,000 sq ft have pushed out by ten weeks to ten months on a typical five-year lease, as landlords seek to prop up headline rentals.

Regional Centres Steal a March

The recent take-up of circa 100,000 sq ft by Regus in Birmingham responds to a combination of banking, outsourcing and infrastructure businesses seeking flexible solutions connected to major moves to the city by groups such as HSBC and HS2.

Many investors continue to focus on Manchester where office rentals currently hold firm at circa £34 per sq ft, however we can foresee headline rentals push upwards by 2019. Set against a backdrop of tight supply in the central core, the city offers a credible north-shoring story and a likely growing presence of serviced office providers are set to make an impact. In addition to growing demand (mainly from TMT and Financial and Legal occupiers) and tight supply in central areas creating a push factor, infrastructure changes - both physical and tech - are carving new locations and creating micro hub demand, and will draw occupiers to consider fringe city locations, thereby providing refurbishment opportunities.

Whilst the upward impact of flexible working becomes a growing influencer, with WeWork beginning to focus on the Big 6 city office markets where availability of Grade A space is likely to remain restricted, Regus is set to further expand into mid-size towns and cities with aim of providing a ‘hub’ for small businesses.

Retail – Winners Emerge out of Structural Change

Whilst a perfect storm of declining consumer demand, increased staff costs and growing online retailing channels are affecting retailing models, retail pitches, the re-shaping of shopping centres/retail parks and bleak prospects for the middle ground, there are clear winners emerging.

Primark (voted ‘top requested brand’ (CACI 2017)), JD Sports, B&M Bargains, TK Maxx, ASOS, Farfetch, The Hut Group, Harrods and Burberry are all growing in the current environment, clearly defining their positioning into value or luxury or by single-mindedly pursuing online growth.

Increasingly Primark comes in as anchor tenant, out go the ailing mid-market fashion retailers such as New Look and River Island. Out of town, fashion parks are set to struggle, bulky goods retailers look resilient (think Pets at Home, Wren and Dunelm), whilst expansive Aldi, Lidl, B&M and Home Bargains are anchoring new retail parks at the value and convenience end of the market.

Looking ahead over the next ten years, according to Global Data the 55-plus age group will account for 57.5% of all physical store and online click & collect purchases – this will benefit wealthier towns and cities with good central area facilities and tight retail pitches which will attract upmarket retailers and restaurants.

In the meantime, inbound tourism looks set to continue to benefit destination and luxury retailers, with London cited as a top ten value tourist destination for 2018 – Harrods have reported 23% growth in revenues during 2017 due to overseas customers especially from China, reflected in retailers continuing to pay strong rents in the busiest locations despite some business failures and rising costs.

Leisure – A Bellweather?

A rebalancing of shopping centres to reflect a relative increase in discretionary spending towards leisure, with a focus on attracting cinemas alongside food and beverage operators to help create the wider ‘experience’ and increase dwell time, looks to have reached saturation point and already softening occupier demand may collapse in 2018.

Branded mid-scale restaurant groups appear to have over-expanded in general, into locations which are simply not delivering the volume of business required to justify high base rents which many have paid. Consequently, some operators are now rethinking their location strategy and will attempt to consolidate, with the casual dining sector now overcrowded and clearly feeling the pinch between reduced ‘frequency’ and increased costs. In particular, operators in the ‘expensive burger’ market are looking to offload units.

The recent restaurant market boom contrasts with a decade of decline in the now reshaped pub sector which appears to be stabilizing in terms of number of outlets and is overall leaner, fitter and more sustainable as a result.

The gym market remains resilient as a ‘non-digital’ lifestyle activity with the budget, no frills operators being the most acquisitive and welcomed by landlords. There is now a widening gap between the top-end operators (David Lloyd, Nuffield Health and Virgin Active for example) and the budget operators like Pure Gym which is now recognised as the UKs largest health club operator, having purchased the estate of the former UK operator, LA Fitness.

Last Mile – Finding the Right Concept

Investor focus looks set to remain on urban logistics, with funds under weight and under pressure to increase allocations to the industrial sector. With competition from higher alternative use values in urban areas, further yield compression and capital growth is likely in 2018, regardless of building and location quality.

Strong investor demand comes at a time when many occupiers are uncertain about the outcome of Brexit, and when online retailers and distributors are rapidly evolving their concepts and delivery models, with an ever more complex puzzle involving pick-up pods and stores, and utilization of surplus space within retailer’s estates.

Residential – The Search for Affordability and Supply

Low levels of affordability in London, falling real wages, a cloud of economic uncertainty and political uncertainty will continue to translate into weak buyer demand, and modest price falls (despite limited availability of stock). This is contrasted by stronger activity in the more affordable and now faster growing technology and life science-led economies such as the Cambridge-Oxford-Milton Keynes arc where prices should continue to rise.

The biggest story continues to be the private rental sector, where 98% of rental properties are still in the hands of small landlords, providing ongoing potential for institutional investors to scale their operating platforms. Target markets for investors look to be the more affordable northern cities, including Manchester and Leeds, and historically cheaper but fast emerging East London locations – however supply, already in excess of demand in some parts of the Liverpool markets, is set to significantly increase on the fringes of Manchester City Centre.

The Prospect Beyond 2018

2018 is set to be another transitional year, with the first half of 2018 potentially a ‘low point’ of heightened uncertainty. Local knowledge and asset management will be key ingredients to provide guidance in a changing market, but with an industry increasingly focused on delivering ‘service’ in a fast-changing world.

A period of low growth is anticipated over the next couple of years. The pace of rebalancing the UK economy to make a success of leaving the EU will most likely only pick up beyond 2018, ultimately driven by our relationship with Euroland over the next 20-odd years.

The impact of inward overseas investors could begin to wane beyond 2018 if exchange controls restrain the flow of money from parts of Asia, whilst imposition of CGT on overseas purchasers will negatively impact on their investment returns, benefitting UK-listed REITs.