The UK economy was characterised by political turbulence through the final quarter of 2019, as the country underwent a second Brexit extension and a general election.
Q4 has traditionally been the most active period for investors, however Q4 2019 proved to be defined by a lack of stock as investors held back sales in the run up to the Brexit deadline. That said, a large proportion of deals carried forward from the summer completed before the year end, with 19 deals (c. £522m) completing in December once clarification on the general election was provided. Total transaction volume for 2019 totalled £3.16bn, reflecting a 16% drop on 2018. The total transaction volume for the quarter was £1.224bn, which exceeded Q3 volumes by 35% and by 17% on its respective quarter last year. Furthermore, the outcome of the general election has provided greater political clarity and with a clearer direction for the UK, investors appear more optimistic for 2020.
Amid the uncertainty, the deployment of capital remained focused on well-positioned core assets with strong tenant covenants. Institutions competitively targeted core prime opportunities providing security of income and liquidity and prime net initial yields held stable at 5.00%. The ‘flight to quality’ by institutions was a prominent trend for Q4, as they recorded £405m of acquisitions, establishing themselves as the most active investor by a notable margin.
The south east office occupational market has shown good levels of take-up and a fall in availability for the submarkets offering the best quality and most flexible stock in core town centre locations. This has provided a compelling opportunity for investors and developers targeting value add/repositioning assets.
Looking ahead we expect there to be a good appetite for Grade A south east offices as new opportunities are launched to the market and the more evergreen capital selectively returns in search of value and growth. The greater degree of political certainty will improve liquidity positions and in turn translate into higher transaction volumes for 2020.
Local Authorities
Despite a rebound in investment activity in Q3, local authorities significantly reduced their total volumes in Q4, accounting for £97m of acquisitions. This has been a likely outcome from a combination of factors including; a refocused investment strategy on mainly ‘in-borough’ opportunities, a more critical selection approach following a run of negative press, general election, and the absence of lot sizes up to £20m offering security of income in excess of five years. Furthermore, in October 2019 the Government announced a 1% hike on the interest rate for new loans from the PWLB to commence with immediate effect. Despite a notable dip in volumes, local authorities were the second most active investor by number of deals, as they remained competitive for smaller lot sizes of c. £10m. We anticipate local authority activity to increase in H1 2020 as requirement parameters are moved and new opportunities are sourced.
Institutions
UK institutions were net vendors at the end of the year as they continued to experience volatility from redemptions on their open-ended retail funds. The largest outflows in 2019 were reported in the run-up to the election in December and the announcement by M&G that they were gating their fund. This placed increasing pressure on a number of other retail funds including those run by Aberdeen Standard Investments, Nuveen Real Estate, Aviva Investors and Columbia Threadneedle. Institutions had retrenched investment activity for much of the year, however significantly increased their activity in Q4. Institutions bolstered their position as the most active investor in Q4, accounting for £405m of acquisitions. The challenge for institutions remains sourcing opportunities, as off-market approaches will require premium pricing to tempt vendors into selling. Gerald Eve South East Office Investment January 2020.
Property Companies
Property companies increased their activity from the previous quarter and accounted for a total of £180m over 13 deals, making them the most active investor by number of deals. Property companies have continued to capitalise on the market uncertainty and the withdrawal of institutional interest for core plus 6% + opportunities. CLS Holdings completing on four acquisitions in Q4 alone is a case in point. Property companies have also been very competitive bidders for value-add town centre repositioning/redevelopment opportunities, where rental growth and an undersupply in the market is evident.
Overseas Investors
Whilst the value of sterling jumped to its highest level for three years against the euro following the election result, the UK remains attractive to international buyers. Overseas investors were the third largest purchaser of south east offices during Q4, accounting for 18% of total transactions volumes. Despite transacting over £214m, overseas investors accounted for just four deals as they remain focused on larger, defensive, income-led deals that can generate attractive cash-on-cash returns. Recent political instability in Iran and Hong Kong coupled with the retrenchment of local authorities to an in-borough focus should see overseas investment increase in 2020.
Private Equity
Despite the rise in demand from institutions and property companies, private equity interest for south east offices proved very strong, accounting for £222m of acquisitions. Private equity investors established themselves as the second most active purchaser of the quarter following the completions of two significant asset management opportunities. We expect this to continue as some of the larger multi-let assets that have come to the market, such as Reading International, have attracted bids from several private equity houses.
Outlook and Market Insight
- At the end of Q4 c. £840 million of south east offices were under offer, across 29 deals.
- We expect 2020 investment volumes to surpass 2019 levels due to the more optimistic outlook. However, with Britain’s exit from the EU scheduled for 31st January 2020 and trade negotiations due to conclude before 31st December 2020, this may mean H2 2020 could experience some volatility.
- We expect property company and private equity investors to take advantage of pricing for secondary assets in good locations.
- Open market deals are expected to return, as new opportunities get formally launched to the market and the depth of buyers grows.
- The underlying fundamentals in the occupational market are expected to continue to drive rental growth.
- Prime yields are likely to remain firm at 5.00%.
- Institutions will continue to buy selectively in core markets.
- Fluctuations in sterling will continue to make the UK attractive to overseas investors.
- South east offices will remain attractive to investors compared to other asset classes and fixed income assets.
Gerald Eve Corporate Finance
The Christmas period provided a much-needed pause for breath, with the uncertainty of the election behind us and a Government with a clear mandate to govern and an appropriate parliamentary majority in place. Brexit concerns exist, however it is felt that a lot of this uncertainty has been priced into the market.
The year has started with a flurry of transactions and lenders are back in the market with clear mandates to lend albeit, lenders are being very specific on asset classes with a reluctance to lend in certain areas, such as retail and a preference for pre-let commercial or residential (with pre-sales in Gerald Eve South East Office Investment January 2020 place for larger schemes). Operating assets such as hotels, student and care/retirement homes remain fundable as well.
We believe that lenders will continue to exercise caution with their loan-to-value and interest cover ratios, but the large number of specialist funds in the market will continue to provide higher levels of leverage, albeit at a commensurate cost.
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