UK commercial property overview and outlook
The main upfront economic interruption from the country-wide coronavirus lockdown has been quantified and UK output is estimated to have fallen by 20.4% in Q2. The UK is officially in recession – the deepest one in the G7. Despite a 2021 bounceback there will be some significant sustained output losses and the economy will not return to its pre-pandemic level of output until 2022. The manufacturing sector is set to be hit much harder and take many years longer to recover.
Q2 also marks a low point for commercial property investment transactions, with the total down 70% quarter-on-quarter to just over £4 billion. Investors were risk-off in Q2 and trading centred on operational assets such as logistics, supermarkets and residential build-to-rent. The high residual land values of London assets also attracted interest and SEGRO’s £203 million purchase of Perivale Park in London was the largest deal of Q2.
A fall in the equity dividend yield in line with the summer stock market recovery has meant that the commercial property sector looks increasingly expensive to income investors. However, as bond yields have fallen to new lows, and the spreads with property are relatively high, there is still a helpful risk premium cushion for commercial property over the medium term.
Property yields moved out sharply at the end of Q2, notably for Retail and Leisure, where business operations have been hardest and most directly hit by the lockdown. For 2020 as a whole we expect rents to fall 3.2% and yields to soften by 60 basis points – driven very much by the beleaguered retail sector. Higher yields will weigh on capital values and we forecast a 12% fall in capital values and a total return of -9%, the first negative annual return since 2009, before stabilising in 2021 without a significant bounceback.
The industrial segment continues to fare better than other property segments, notably larger logistics that have benefitted from the increase in online shopping and working. There is multi-dimensional investor appetite for logistics, with big-ticket opportunities attracting fierce bidding. Smaller multi-let units with a greater proportion of direct-trading SME tenants have been more vulnerable. Defaults and voids are forecast to rise from late 2020 but new supply is tight and future rental growth, put in the context of the other property segments, is quite favourable. A relatively modest 30bps outward yield shift is expected by the year-end.
Office investment is weak as workplaces, particularly in city centres, remain underutilised. Investor debate has moved to how offices will be used post-Covid and future-proofing assets against the expected growth in agile working. The impact of the coronavirus on capital values has been felt more in UK regional markets, with core London assets showing more resilience. Notably, pension funds have sought to secure prime London assets through retailer sale and leasebacks in Q2. Prime and secondary capital values have diverged, with sharp declines across all regions in secondary assets. We have downgraded our 2020 forecast for annual total return to -5.9%.
Retail property has been hit particularly hard due to the direct lockdown measures on trading units, coupled with the accelerated ongoing trend to online. Shopping centres fared particularly badly in Q2, with Intu’s collapse into administration further denting investor confidence. Following the recovery that never really materialised after the global financial crisis, all capital gains made in the retail sector since June 2009 have now been wiped out. Select pockets of the market are more resilient, including supermarkets, convenience retail, urban retail parks for their repurposing potential and long income assets in general. Nonetheless, we expect Retail capital values to decline by over a quarter in 2020, resembling the fall seen during the GFC.
If the growth of e-commerce has been the defining economic trend of the past decade, it is industrial property, and multi-let in particular, that has been the biggest beneficiary of this shift. Stronger fundamentals have driven increased investor appetite, and this in turn has driven yields to record lows. The flipside, of course, has been the flight from retail space, and the opposite directions of travel for capital values in the respective sectors has seen the traditional hierarchy reversed.
Nick Ogden, Partner, Capital Markets