August 2019

UK Real Estate Market OutlookFor Investment Professionals only

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Executive summary• Economic activity expected to remain resilient, despite continued political and

economic risks

• UK pricing offers a discount to other key global markets: City of London office yields trade 100bps+ above yields in major cities like Paris, Frankfurt and Tokyo

• Changing work and living preferences are creating significant, long-term investment opportunities, benefiting CBD offices, logistics, residential and hospitality

• Assets must be future-ready, with amenities and flexibility being key

Economic activity to remain resilientDespite the ongoing Brexit-related uncertainty and political upheaval, we expect economic activity to remain resilient. While business and consumer confidence remains fragile, bright spots do remain for the UK economy.

The labour market continues to thrive, with unemployment falling to its lowest level since 1974, whilst the rate of employment climbs, supporting earnings growth. This is likely to underpin consumer spending in the short term at least.

The prospect of a near-term rise in interest rates has reduced, owing to the relatively benign nature of price growth. Inflation now stands at its 2% target (CPI) therefore there is no immediate pressure on the Bank of England to raise rates, and any future hikes are likely to be small and gradual, enabling the economy, and the property markets, to absorb them relatively easily.

Figure 1: Economic activity continues to advance despite Brexit uncertainty

Source: Macrobond, May 2019.

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Investment picks • The Living sectors: new, flexible housing solutions are set

to be a crucial area of growth

• Leisure and hotels: backed by growing consumer demand for ‘experiences’

• Central London offices: selectively, given an improved occupier outlook and comparative yield advantage globally

• Multi-let industrial: tapping into increasing demand, particularly through build-to-core

Economy remains resilient despite uncertainty

Flexibility, wellbeing and ESG at forefront of investors’ minds

Continued growth expected for Living sectors driven by

demographic and lifestyle shifts

Outlook for Central London offices cautiously optimistic

Demand strong for industrial space, though new supply to

moderate rental growth

‘Experience’ and destination appeal are key for the retail sector

UK Real Estate at a glance

UK Outlook | August 2019 3

Income returns offset modest capital declineInvestment activity has been dampened by the turbulent political landscape, with investors exercising more caution. However, occupiers are still largely taking a ‘business as usual’ approach to taking space (except in the retail sector).

Once greater clarity emerges on the UK’s future relationship with the EU, assuming a deal is agreed, we see potential upside to property performance. All Property returns remain positive, but only because income returns have more than offset modest capital decline. A more certain political outlook will likely tempt investors back from the sidelines, with more buying activity leading to an improvement in investment performance.

Figure 2: UK property returns showing early signs of stabilisation

Source: MSCI, data to May 2019.

However, polarisation remains between the main sectors, principally driven by weakness in the retail market. In contrast, the office and industrial sectors continue to deliver respectable total returns, boosted by rising rents. There is closer convergence between the two in performance terms, largely as the significant recent outperformance of the industrial sector starts to moderate.

Figure 3: Continued sector polarisation led by retail

Source: MSCI, data to May 2019.

Alternatives grow in popularity, backed by structural trendsInvestors continue to pile into alternative property types, ahead of almost all mainstream property, as they diversify their portfolios. This trend is backed by a strong long-term supply and demand imbalance, notably within the Living sectors, and growing consumer demand for experiences over ‘things’, supporting leisure and hotels.

Part of this demand can be explained by investors implementing a late-cycle strategy, but we believe this trend is likely to be long-term and represents a compelling opportunity to capture undeniable structural change.

Figure 4: Alternatives attract an increasing proportion of investment flows

Source: PropertyData, May 2019.

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UK Outlook | August 20194

Demand to drive growth in the Living sectorsInstitutional capital continues to target the Private Rented Sector (PRS), as it becomes more established, reaching £3.1 bn in 2018 – a rise of one third compared to the previous year.

Supported by the significant housing supply and demand imbalance and long-term rental growth prospects, the PRS investment opportunity is enhanced by the emerging trend of buy-to-let landlords starting to leave the market due to a raft of recent legislative changes.

Given this reduction in rental supply and rising tenant demand, PRS rents in London are starting to rebound after a period of weakness. The regional cities are generally seeing stronger rental growth currently, although rising development pipelines in some markets like Manchester could restrict the pace of rental rises in the medium term.

Figure 5: Rents in London’s PRS turn a corner

Source: Macrobond, May 2019.

While there is still a significant desire for home ownership, deposit requirements remain a major barrier for would-be first time buyers. As such, new, flexible living solutions are likely to grow in locations where house prices are least affordable. Supported by the government, we expect to see Shared Ownership increase both from a tenant and investor perspective, with the latter attracted to the sector’s stable, index-linked income streams.

The student housing sector continues to see healthy rental growth, reflecting strong and increasingly international occupier demand against ongoing undersupply of accommodation. We expect to see increasing polarisation within the student sector, driven by the quality of Higher Education (HE) institutions. This is driving demand for

accommodation, with those locations, like London, that have several high-quality HE institutions likely to see stronger, sustainable occupier demand in the future.

The ongoing attraction that London holds as a tourist destination has helped to underpin the demand for hotel beds in the Capital. Although London’s development pipeline remains relatively significant, resilient occupier demand is expected to support Revenue per Available Room (RevPAR) going forward. Meanwhile, some regional cities are expected to see slower RevPAR growth as supply increases, although locations with strong fundamentals and land constraints will fare better.

Optimism resurfaces on Central London office marketThe Central London market has been held back by Brexit uncertainty in recent years. That said, the market has proved more resilient than expected, having seen only relatively small falls in rents since the 2016 Referendum as occupiers have continued to take space. Indeed, prime rents in both the City and West End saw a return to growth in Q1 2019 and, despite the current uncertainty driven by the Brexit ‘stalemate’, the outlook for the office market is becoming increasingly positive.

While large numbers of cranes still dominate the London skyline, the supply that is coming through is gradually being absorbed and future supply is expected to be matched by demand. This is underpinned by businesses’ belief in London’s post-Brexit potential given the talent, infrastructure and commercial credentials on offer. As a result, Central London could experience upward pressure on headline rents, particularly once progress is made around Brexit.

Figure 6: Central London office pipeline looks digestible in the near term

Source: PMA, Q1 2019.

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UK Outlook | August 2019 5

Increasingly, what tenants require in terms of their space is changing and, while this is true of office buildings everywhere, it is most evident in the Capital. We continue to see rising occupier demand for high spec, flexible space, designed with employees’ wellbeing in mind, as part of a progressive shift towards Environmental, Social and Governance (ESG) best practice. Tenants’ growing desire for green credentials means they are increasingly willing to pay a rental premium for space that provides this. Meanwhile, Central London office yields are now looking relatively attractive on a global basis. Prime yields have either held firm or edged up slightly at a time when yields in other major global markets have seen further yield compression.

Figure 7: Prime London office yields look attractive globally

Source: PMA, Q1 2019.

An improved occupier outlook coupled with a comparative yield advantage suggests that now could be the time to invest in Central London offices, albeit selectively and with a strong focus on, and understanding of, local market fundamentals.

Demand for flexible office space continues in the regional marketsBeyond Central London, rental growth has been strengthening, particularly in the regional markets, underpinned by resilient occupier demand. With the drive towards flexibility, both in terms of leases and space, flexible office providers have become an important source of take-up and this trend is likely to strengthen going forward.

However, supply hasn’t been able to satisfy demand: a trend that is most acute at the prime end of the market.

Development, particularly speculative, remains limited, which is likely to promote rental growth going forward.

Strong demand for industrial space, though growth rate to moderateOccupier appetite for industrial property remains extremely buoyant, largely driven by the e-commerce dynamic that is affecting retail. This demand, amidst limited supply, continues to put upwards pressure on multi-let rents, particularly in London and the South East.

As a result of this imbalance, we see significant potential for build-to-core developments in these markets as a way to both capture the strength of short-term cyclical demand as well as creating assets that can benefit from long-term fundamentals.

The level of speculative supply coming onto the market in the Big Box logistics sector is, however, becoming a cause for concern. Although strong demand is generally expected to continue to drive rent rises, we could see a marked deceleration in rental growth in those locations where the greatest speculative development is focused.

Figure 8: Industrial speculative starts look elevated

Source: PMA, Q1 2019.

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UK Outlook | August 20196

Retail market continues to adjustRetailers continue to rationalise their portfolios in response to the impact of e-tailing and rising costs, with stores in more secondary and tertiary locations being hit to the greatest degree. However, parts of the market like Central London shops and out-of-town shopping centres are holding up better, as they have more ‘destination appeal’ and are more suited to shoppers looking for a retail ‘experience’. Supermarkets have also been more resilient recently, reflecting the fact that their core products are consumer essentials as well as their appeal to investors seeking secure income characteristics, thanks to long inflation-linked leases.

Future-proofing vital to long-term asset performanceThe structural shift in occupier requirements is an overriding theme across all sectors, with occupiers seeking ever increasing benefits from their space: from amenities that support customers’ desire for ‘experiences’ and convenience, to building design that promotes employees’ wellbeing. In addition, the continued drive towards urban living means a stronger focus on property location as a crucial factor driving performance.

Ultimately, investors need to be able to embrace this shift to ensure that both new and existing assets are future-proofed. This can be achieved by integrating new, smart technologies into assets, making space truly flexible and incorporating the sustainability agenda into building strategies, for example.

Now, more than ever, outperformance requires cutting-edge thinking, with occupier demand likely to become polarised between those buildings that commit to meeting changing standards and those that are unable to satisfy occupiers’ enhanced requirements.

Value-add strategies offer potential to outperformAlongside the need to future-proof, there is the opportunity for investors to capitalise on the short-term mispricing of assets created by Brexit-related uncertainty, as well as cyclical trends.

This strategy could involve selectively targeting stock in core locations which could benefit from significant asset management, with a view to being redeveloped and future-proofed or repurposed.

Figure 9: The discount available on non-core property values continues to widen

Source: CBRE, April 2019.

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Optimising UK real estateConsider cyclical opportunities• Tap into attractive UK pricing versus other global markets

• Look to acquire selectively in the Central London office market

• Take on more risk, albeit focused on core locations

Future-proof portfolios• Make assets resilient by responding to changing

occupier needs

• Position the ESG agenda at the heart of investment strategies

• Redevelop or reposition properties for the long term

Benefit from diversification• Buy into the structurally-growing Living sectors

• Tune into consumers’ rising demand for ‘experiences’ through hotels and leisure

• Ensure portfolios are balanced across both mainstream and alternative sectors

UK Outlook | August 2019 7

ContactEmma Grew Associate Director, Property Research +44 (0)20 3977 0951 emma.grew@mandg.com

Richard Gwilliam Head of Property Research +44 (0)20 3977 0980 richard.gwilliam@mandg.com

www.mandgrealestate.com

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