After performance weakness in the immediate aftermath of the Brexit referendum, UK property delivered a strong return in 2017. In the first of two guest posts looking at the property environment in different parts of the world, Tony Brown, CIO of M&G Real Estate, discusses where this leaves us in terms of the key themes in UK property in the period ahead, both from a cyclical and a longer term structural perspective.
After the Brexit headwinds that caused a short-lived dip in performance in 2016, UK real estate delivered a surprisingly attractive double digit total return in 2017, broadly in line with the average return since 1982 (see figure 1).
Where does this leave us in terms of prospective returns? From a shorter term perspective the rising market tide that floated all boats from 2010 to 2015 (including a falling rate environment) no longer applies and we are seeing a polarisation in demand for different types of asset. Over the longer term, technology is having profound effects on the structure of the UK economy, which is likely to have implications for property investors.
Brexit and the nearer term outlook: increased polarisation
Since the Brexit vote, there has been intensification in the polarisation of investor demand for prime (higher quality) versus secondary property. A flight to low risk assets in a risk-off environment, driven by Brexit uncertainty, has depressed the pricing of secondary assets that are perceived to be higher risk. This is possibly one of the key aspects of the UK that distinguish it from every other major global market.
This dislocation is likely to make selectivity increasingly important for property investors. Particularly notable has been the divide between the Central London office market (where the most obvious impact of exiting the EU will emerge) and other parts of the UK. Even before the Brexit vote, Central London had appeared overpriced for some time, and there are now risks that development cycle has become stretched.
The chart below shows that office completions, or new supply of space, in 2018 look high relative to the average between 1988 and 2017, while those for the UK’s ‘Big 6’ markets (Birmingham, Bristol, Edinburgh, Glasgow, Leeds and Manchester) remain below average, despite strong activity in 2017.
This would suggest that, other things being equal, rents potentially have some way to fall over the next 12 months in London, but this risk is not currently reflected in capital values. By contrast, cities such as Birmingham, Manchester, Leeds, Glasgow and Edinburgh have more modest levels of new supply and also offer more compelling valuations. They are major conurbations in a European context, supported by improved infrastructure, amenities, political support through devolution as well as young and growing workforces.
Equally important to the shape of the sector are the structural changes to office demand owing to consolidation of financial services companies, attraction of regional office markets and the rise of shared service, or ‘co-working’, model.
The changing economy: logistics and e-tailing
Bucking the general trend of falling secondary asset prices, logistics secondary property has shown capital growth since the referendum, as buoyed by positive supply and demand dynamics and the structural changes initiated by e-tailing.
Logistics seems to have become the darling of investors worldwide, as the profound impact of e-tailing takes hold. The UK leads the way in this regard, second only to South Korea in internet sales penetration in the developed world, and the proportion of online sales expected to continue to grow (see figure 4). We are a small island with many people concentrated in big cities, perfect for e-tailing.
To take a real life example, at my family home in suburban London, I have a button I can press next to my washing machine that orders new washing tablets, which will be delivered the next day. As we become used to that level of service, there’s no going back. This goes some way in explaining the exponential growth in e-tailing.
E-fulfilment is a challenge for retailers, particularly last mile delivery. It’s quite possible multi-storey logistics warehouses will become commonplace in London, just as they are in parts of Asia which has tackled the challenge of urbanisation through better design. In the UK, there is still much progress to be made in the design and development of buildings and this is where asset managers can make a difference by investing capital through forward funding assets to high quality specification.
Conclusion: UK Real Estate from a global perspective
The UK continues to rank first globally for transparency (a measure of which countries provide the most favourable operating environments). This combined with the size of its real estate market – the third largest in the G7 – alongside the high quality of stock and large lot sizes make the UK attractive for investors from a longer term perspective.
In the shorter term, the question is whether capital controls in China or the introduction of capital gains tax for overseas investors on property sales in 2019 may lead to a softening in demand this year. Another area up for debate is whether the division of investment and retail banking business may impact debt pricing and availability, and, unsurprisingly, the ultimate impacts from Brexit.
The most recent (Winter 2017-18) consensus total return forecasts from the Investment Property Forum point to a moderation in, but still positive, returns for property in 2018 to 2021. Critically, rental growth rather than capital gains is anticipated to do much of the heavy lifting in this respect and against this background, both selectivity and active management are likely to be increasingly important.