Real Assets Insights - February 2017

The investment landscape changes continuously. By sharing our knowledge, we aim to ensure our clients understand how best to evolve their strategies.

In this edition of Insights, Rob Martin, Head of Research and Strategy at LGIM Real Assets, looks at the prospects for UK real estate in light of continued political uncertainty.

We start the year with a surprisingly resilient economic backdrop, with the UK confirmed as the fastest growing G7 economy in 2016. Against that, political uncertainty continues to challenge investors; the unknowns around the triggering of Article 50 and the extent to which Prime Minister Theresa May will be able to negotiate her ‘Hard Brexit’, have dented business confidence.

How will the leasing environment for UK real estate respond? What are the implications for investment performance and what tools can investors use to maximise returns in a low yield / low growth environment?

The sector view

Headline GDP figures indicate that economic activity held up surprisingly well in H2 2016, but demand for real estate depends on firms having sufficient confidence to maintain or grow their physical footprint. Here, the findings are more concerning; there has been a sharp deterioration in firms’ intentions with regard to both investment and taking on new staff. We expect this to convert into more challenging leasing conditions. This is not a view on the long-term implications of Brexit or any of the other political uncertainties affecting the outlook – it is a view on the effects of uncertainty.

 

We expect open market rental growth to average around 1% p.a. over the next five years. This compares to an expectation of 2-3% p.a this time a year ago. Open market rents will, in aggregate, lag inflation, which we expect to average 2% for CPI and 3% for RPI over the next five years. It is set to be another relatively strong performance for leases where the income is indexed to inflation.

UK real estate continues to benefit from a relatively high yield versus a number of other asset classes, particularly fixed income. This was squeezed, to a degree, towards the end of 2016 as investors started to factor higher near term inflation into bond yields. LGIM identifies a number of structural factors that are likely to bear down on risk free rates into the longer term, keeping them lower than historic averages. Our analysis indicates that property yields can absorb the degree of rate normalisation envisaged by most forecasters and we see them as currently around their long-term ‘neutral’ level.

Our central case expectation is for all property total returns to average around 5% p.a. between 2017 and 2021. The vast majority of this return will be founded on income; the modest rates of rental growth envisaged will be essentially offset by depreciation, leaving capital values little changed. Given the focus on income, ‘bond-style’ assets are likely to prove resilient over the next 1-2 years. Conversely, growth sensitive assets are likely to be subject to greater downward pressure on capital value and investment return.

Occupational themes

Demand for office space is typically more sensitive to the economic cycle, a pattern we expect to see repeated. This is especially true in London where there are uncertainties over the implications of a ‘Hard Brexit’ for the financial sector and the internationally mobile talent that are important drivers of demand. Office markets outside of London are less exposed and benefit from having seen less construction activity in recent years, hence fewer additions of new supply. Nonetheless, weaker employment growth across the UK will bear down on the rates of rental growth that can be expected.

The occupier trends for light industrial space are more positive than for offices. Demand is being supported by GDP growth and expansion in the ‘trade’ sector, which uses cost effective industrial space to service retail and SME customers. A lack of development activity, alongside increasing levels of residential conversion, has also led to restricted supply which helps to support rental growth. While demand for logistics space continues to benefit from the reorientation of supply chains to respond to ecommerce, there is set to be widening differentiation between newer, purpose-built facilities and dated, poorly located assets.

Consumer spending held up well in 2016. But weaker employment growth and rising inflation is expected to bear down on disposable income growth in 2017. The devaluation of sterling is already boosting import costs, which is likely to be felt in renewed pressure on retailer profit margins from H2 2017. We remain cautious on rental growth for the retail sector as a whole. However, the very limited development activity in recent years means that in locations where retailers can trade profitably, there is now sufficient competition to give upward pressure to rents. The leisure sector continues to benefit from capturing an increasing share of consumer spending.

Sector rankings (5 years)

 

Within the core, ‘traditional’ real estate sectors, industrial space benefits from a relatively higher income return and sufficient rental growth to offset depreciation. The retail sector is showing more strongly in our projections than for a number of years, which partly reflects a rerating to other areas of the market, that has seen a relative improvement in the income return. The office sector is expected to underperform on average, with income returns held back by high levels of vacancy in some markets and rental growth at a level that is not strong enough to offset depreciation, leading to downward pressure on values. This is likely to be seen most strongly in the City of London.

As we have been guiding for a number of years, our view is that a number of ‘alternative’ sectors are set to deliver medium and long-term outperformance. Residential property, both mainstream Build-to-Rent and purpose-built Student Accommodation, are seen as providing steady levels of income, relatively strong rental growth and lower rates of depreciation, adding up to robust total returns. Leisure benefits from a favourable income return and is also delivering rental growth. Other, more specialist forms of real estate, for instance Care Homes, can provide attractive income streams but require expertise to underwrite the risks that are associated with complex operational and regulatory environments.

Implications of a low yield/low growth rate

In a low yield / low growth environment, factors that do not always attract as much attention from investors become increasingly important. At current pricing, income may account for as much as 90% of the total return from the ‘average’ property. Ensuring sustainability of income has become a key differentiator. This extends also to minimising acquisition and maintenance costs. As we have highlighted throughout this piece, depreciation can be a very significant drag on returns. Recent increases in stamp duty have also reinforced the benefits to acquiring assets with good fundamentals that can be held for the long-term, reducing the need for trading and the associated costs.

This encourages a focus on a different set of factors; the underlying economic prospects for a particular town or city, the supply environment, the potential for surrounding infrastructure investment to enhance or detract from tenant demand and the capacity for the asset to meet changing occupier requirements. It is with these ingredients that portfolios need to be positioned to perform for the long-term.