Strong foundations: The outlook for UK property

Guy Glover and Emma Gullifer assess the outlook for the UK property market in 2020.
January 2020

Risk Disclaimer 

Past performance is not a guide to future performance.

The value of your investments and any income from them can go down as well as up and you may not get back the original amount invested.

The value of directly-held property reflects the opinion of valuers and is reviewed periodically. These assets can also be illiquid and significant or persistent redemptions may require the manager to sell properties at a lower market value adversely affecting the value of your investment.

In this note, we explain why we remain confident in UK property (excluding the majority of retail!), focusing on the fundamentals and capital flows as pointers of future performance.

The headlines for the UK have been dominated by Brexit and political uncertainty for the past three and a half years, sapping confidence from UK businesses. This has been reflected in investment volumes for commercial real estate transactions, which were down by around 25% in 2019 compared with a year earlier, and more in line with volumes in 2012 and 2013 rather than the past 5 years.

This has been partly due to a sellers’ hiatus; why sell your asset in this uncertain environment? But the fears of a rush for the exit in the wake of the Referendum result have proved unfounded, and the third and provisional fourth quarter data shows some revival in activity. With the political clouds having lifted with the decisive election result and a path set out for Brexit, it is worth reviewing the prospects for property for 2020 and beyond.

Risk Disclaimer 

Past performance is not a guide to future performance.

The value of your investments and any income from them can go down as well as up and you may not get back the original amount invested.

The value of directly-held property reflects the opinion of valuers and is reviewed periodically. These assets can also be illiquid and significant or persistent redemptions may require the manager to sell properties at a lower market value adversely affecting the value of your investment.

Chart 1 – UK Real Estate Investment volumes

Chart 1 – UK Real Estate Investment volumes

Source: Property Data, Jan-20

Retail woes

Investment volumes are perhaps not the best indicator of the health of the property market which has faced huge headwinds over the past 12 months. These headwinds have been focused on the retail space with double digits falls in valuations of standing investments and very large losses being crystallised on some sales. The significant falls in investment volumes relate mainly to the retail sector – the collapse in shopping centre investment activity indicates the extent of this correction.

Chart 2 – Shopping Centre Investment Transactions – £ Million

2014


£5,555

2019


£514

Source: Property Data, Jan-20

 

With the retail sector comprising around 30 per cent of the overall MSCI Monthly Property index, it is no wonder performance from other sectors has been hidden from view, making the 2019 all-property performance look fairly muted. The other sectors would have had to have delivered an exceptional performance for the overall market to have produced more than just a small positive return. In order to truly understand the underlying health of the property market an examination of the individual subsectors is required, as simply looking at the All Property index return can be misleading.

Chart 3 takes a closer look at the performance of the individual sub-sectors over 2019.

Chart 3 – MSCI Annual UK Property Total Returns (%)

Source: MSCI UK Monthly Property Digest Dec-19

On closer inspection, the above paints a healthy picture, bar retail, and is what you would expect from property in a marginally positive economic growth environment. It seems that the market is looking past some of the political noise, focusing instead on the fundamentals of income delivered and some rental growth, even if capital appreciation has been elusive in most sectors.

 

Will pricing remain firm?

Let’s compare property to other asset classes and then look at sub-sector fundamentals. The best way to look at this is to compare income return from property versus that from 10-year gilts and FTSE dividend yields.

Use our handy glossary to look up any technical jargon you are unfamiliar with.

Chart 4 – Property Net Initial Yields Less 10-Year Gilt and Equity Yields (bps)

Chart 4 – Property Net Initial Yields Less 10-Year Gilt and Equity Yields (bps)

Source: Capital Economics, Dec-19

 

It is clear that property values remain cheap compared to fixed income but historically relatively expensive against the FTSE index. The yield premium of around 400 basis points against the gilt yield provides tremendous defence against any macro wobbles, and Chart 4 demonstrates how different the position is to a pre-Global Financial Crisis yield environment. It may be that it is as much a case of an overvalued gilt market than an undervalued property market but the latest survey by the Royal Institution of Chartered Surveyors (RICS) shows most respondents regarding property as fairly priced. Additionally, when ‘fixed income’ is neither fixed nor providing a real ‘income’, it is plausible that a further rotation or an increased allocation of capital into real estate could follow.

With both superannuation and some sovereign wealth funds below their target allocations, this indicates there is an amount of unallocated capital that could be directed to real assets to provide the increasingly elusive income. Dry powder focused on the sector is also at significant levels and worldwide fundraising in 2019 reached record highs at $151bn with a target of capital raising for 2020 of some $281bn (source Prequin). Inevitably the UK will continue to attract its fair share of this allocation.

 

Income and leverage

Although the total return of the All-Property Index has been variable over recent years, the income element has been incredibly stable, as illustrated by Chart 5. This together with the cost of debt being at the cheapest level for a generation, means it would be reasonable to expect the UK property market to be leveraged up to deliver late-cycle exceptional returns.

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Chart 5 – 12 Month All-Property Income Return and Total Return – per cent

Chart 5 – 12 Month All-Property Income Return and Total Return – per cent

Source: MSCI UK Monthly Property Digest Dec-19

In fact, increased gearing has been totally absent from this cycle, as indicated in Chart 6. This restraint shown in the UK property market can only be attributed to the collective memory of what happened in 2008, when so many geared vehicles were forced into emergency rights issues or the banks were simply handed back the keys due to loan defaults.

Will debt feature over the next few years to boost returns? Unlikely at this stage but worth keeping under review, especially as we are seeing increased leverage in European markets.

Chart 6 – UK Property Debt and real Capital Values

Chart 6 – UK Property Debt and real Capital Values

Source: Capital Economics, Dec-19

Offices and industrials – the fundamentals

Offices continue to be resilient across the UK. This is not just due to the relatively constrained supply characteristics but also reflects the continued rise of technology and media adding employment. The move towards agile working across all industries (characterised by co-working offerings) seems to have had limited impact, although this remains an area to watch along with the increased take up of serviced office offerings, which could be skewing the vacancy numbers.

Urban logistics, last mile delivery, mid box logistics – call it what you want, but the rise and rise of on-line shopping means the tailwinds in this area continue to look compelling leading to rental growth in key locations. A softening of the pace of rental growth and total returns may have occurred in 2019 but the sector is still a leading performer.

So, both these sectors remain healthy despite years of political turbulence. Indeed, supply is limited by the increasing cost of construction year-on-year coupled with significant labour shortages which is likely to remain constrained.

Bringing this all together, what does this mean for our forecasts, which we set out below? Outside of retail, a very sensible outlook for the next 5 year period.

Chart 7 – Our Five-year Total Return Forecasts by Sector % per annum to end 2024

Chart 7 – Our Five-year Total Return Forecasts by Sector % per annum to end 2024

Source: BMO REP Jan-20

Forecasts are provided for illustrative purposes; are not a guarantee of future performance; should not be relied upon for investment decisions; and are subject to change without notice.

 
Could the above surprise on the upside?

There are some supportive factors that could, we believe, all act positively on the above forecasts:

1 ‘Lower for longer’ interest rate and economic growth environment potentially providing a near-term boost to capital values;

2 Resolution of uncertainty could see a resurgence of investment into the UK, including property;

3 Fiscal expansion is coming.

 
Let’s review these individually

 

1 ‘Lower for longer’

Chart 8 shows how PMA (Property Market Analysis, a global independent property research consultancy) analyse the lower for longer environment and its impact on UK property. Clearly a nearer term boost to the returns.

Chart 8 – UK All-Property Total Returns

Chart 8 – UK All-Property Total Returns

Source: PMA, Aug-19

2 Improving sentiment could mean more investment

Quantifying the resurgence of investment into UK property is difficult. The latest PMA UK Investor Intentions Survey, which covers UK institutions and overseas buyers, shows that sentiment turned positive, on balance, towards year-end, with most sectors apart from retail seen as attractive. There has been net overseas investment throughout the post-Referendum uncertainty, and as the economic and political situation clarifies, some dry powder may be deployed and the investor universe expanded. This is more than anecdotal with German fund Deka Immobilien buying two UK offices post the general election for around £180m.

 

3 The promise of fiscal expansion

Adding to this, the impact of the fiscal expansion that has been promised by the new Conservative government is likely to provide further support to the market. Regardless of the merits of increasing the UK debt burden and concerns over how quickly any additional spending could be deployed, it is clear that there will be a boost – with resulting economic growth and enhanced property investment opportunities.

 

The UK property market looks well positioned

As long as the wider global markets do not provide any shocks and UK investor confidence picks up, the UK property market could potentially be in for a surprise resurgence in 2020 over and above the income return and consensus property forecasts. If this boost does not materialise, the UK property market still looks to be in a relatively good position to weather any global storm clouds on the horizon, especially given the compelling level and stability return that the sector provides.

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