UK real estate 2018: balancing resilience with growth potential

Returns in 2018 are unlikely to match the pace of 2017 and are set to favour more defensive portfolios. To meet investors’ long-term objectives, we see an ongoing need to build portfolios which balance resilience against weaker economic conditions with sufficient growth potential to deliver in more benign environments.

2017 surprises to the upside

At the start of 2017, views on UK real estate were still being shaped by the short-term fallout from the EU referendum. Cash redemptions from real estate funds serving retail clients in the immediate aftermath of the referendum put pressure on certain managers to sell assets at short notice. Whilst flows into real estate funds serving UK clients have been more stable in recent  months, a number of fund managers are still dealing with the fallout; UK institutional managers have been net sellers of assets since mid-2016. Whilst this was most extreme in the second half of 2016, it has continued at a more modest pace in 2017.

Conversely, demand from overseas investors has been strong. After tapering pre-referendum, their net investment has accelerated once again. That has been linked to a resurgence of investment activity, particularly for assets in London. During the first three quarters of 2017, the value of commercial real estate transactions across the UK was up some 10% relative to the same period in 2016. But within that whole, activity in London, still favoured by overseas investors, was up 30%. Volumes outside London, however, where domestic investors account for a greater share of deals, were down by circa 10%.

Chart 1 Capital values (Dec-15 = 100)

 

The resurgence in investment activity has supported a recovery in prices; capital values for both the market as a whole and for City of London offices (which initially bore the brunt of investor concerns over the impact of EU exit on financial services), have returned to prereferendum levels (chart 1). The mean total return expectation for calendar year 2017, recorded by the Investment Property Forum (IPF) consensus survey, started the year at 1.3%. If the pace of returns up to October is matched for the year as a whole, All Property returns are likely to be close to 10%. Is this pace of returns going to be matched in 2018?

Returns unlikely to be matched in 2018

We don’t think so. Whatever view you take on the eventual implications of EU exit, most forecasters expect a drag on short-term economic activity. Consensus expectations for GDP growth, which has already slowed in 2017, are for a further slowdown in 2018. Investment intentions – both for capital projects and the recruitment of new people – have sagged, feeding into weaker occupier demand.

One useful barometer we track is a survey conducted by the Royal Institution of Chartered Surveyors (RICS) of agents responsible for leasing space to occupiers (chart 2). After reporting strong growth in occupier demand during 2013-2015, they have reported slowing momentum over the past 18 months. There are variations across sectors; demand for industrial space and for private rented housing has continued to rise. But those parts of the market account for only around 25% of institutionally-managed assets. For retail and offices, which account for much of the remaining 75%, demand is reported to have come under downward pressure in 2017. Rental growth expectations have been reduced sharply in response. The IPF consensus survey indicates a mean expectation for rental growth of 0.4% and 0.6% rental growth in 2018 and 2019 respectively; the survey conducted just before the Referendum reported equivalent figures of 1.9% and 1.5%.

Chart 2 - Occupier demand

 

Chart 3 - Valuation dashboard - Q2 2017

 

Income in a low-yield world

The other side of the coin is yields. Chart 3 sets out the dashboard we use to benchmark UK real estate yields. It compares a broad-based measure of yields (i.e.,including all sectors) with historic averages. If yields today are at higher than average levels, the bars are above the line. The data underpinning the chart go back to the early 1970’s.

The results paint a mixed picture. In absolute terms, yields are undeniably low – shown by the bars towards the left hand side of the chart. But the same can be said of other asset classes. For many long-term investors, the task is to make the best of the options available and so the relative position is more important. Based on pure yield arbitrage, the income from real estate remains much more generous than cash or fixed income alternatives. The ex-ante risk premium, which incorporates both growth prospects and yield, is now around average. In the absence of a marked upward shift in interest rate expectations or required risk premia, this has so far proven to be a powerful anchor for yields at current levels, despite the relatively weak rental growth prospects.

Tempering the tail risk

The consensus forecast is for UK All Property Index returns to average 4.7% per annum during 2018-2021. This is founded entirely on income return – capital values are expected to be neutral. In absolute terms that level of return lags a long way behind historic averages. But these figures still imply a significant risk premium against the gilts that most investors still use as their risk-free benchmark.

Given the costs of investing in real estate, it would not be surprising to see modest new allocations into diversified real estate. But without a high conviction case for a sharp drop in values, we believe many investors will find it difficult to justify tactical sales.

We find little to disagree with in the consensus as a working central case. But it inevitably reflects a particular path for the Brexit process and the broader shape of government economic policy. At different points, this could have both positive and negative effects on real estate markets. We struggle to avoid the conclusion that the range of outcomes for the coming years has widened and our ability to know which path we are on has lessened. To our minds, that argues for a hedging approach.

Chart 4 - Global Corporate Fixed Income Default Rates

 

This is at the heart of our twin themes of resilience and optionality. As we are shaping portfolios, our focus is on building resilience against downside outcomes, whilst retaining sufficient growth potential to deliver in more benign environments. We flag two broad approaches for investors to consider.

Long income; not just for liability matching

Investors have increasingly looked to real estate to explicitly match long-term liabilities. This can involve constructing portfolios of assets supported by long-term contracts (frequently 20 years or more) with occupiers whose rents are indexed to inflation. These assets then generate highly predictable cashflows which can be used to pay pensions.

We argue these assets also have a broader relevance as a hedge against non-consensus economic outcomes. The long lease contract creates a bond-like cashflow that is relatively immune to recessions. The indexing of rents is also key. In a ‘conventional’ economic boom, strong demand leads to upward pressure on inflation, which would then be reflected in higher rents. But this would also be the case in conditions of ‘stagflation’ where the economy is weak but inflation rises nonetheless. Stagflationary conditions are particularly problematic for conventional real estate, which depends on occupier demand to deliver its inflation hedging. So this type of asset has a role to play in hedging both upside and downside economic outcomes.

Important to point out though is the emphasis on credit quality in this strategy. Not all long income is created equal. Moody’s default data, which are based on liquid corporate bonds, demonstrate the point nicely (chart 4). They show that default rates for sub-investment grade counterparties rise significantly during economic downturn. But investment grade counterparties (i.e., with a minimum rating of BBB-) hardly ever default, even in extreme market conditions. Of course, subinvestment grade blends a spectrum of counterparties, many of which retain a low absolute risk of default. But that in itself highlights that a detailed assessment of credit quality is key for downside protection.

Chart 5 - Office vs Residential Rents

 

Fundamentals focus

The second broad approach we highlight is founded on identifying income which is resilient not because of the protections provided by leasing contracts but the fundamentals of the buildings themselves.

One dimension is the asset type. A number of alternatives can be viewed as being needs-based and hence less exposed to the economic cycle. Residential is perhaps one of the best examples. During the global financial crisis, the proportion of housing which was vacant remained in the low single digits, reflecting the tight supply dynamic in the UK; according to UK National Statistics, rents actually rose by 3% between December 2007 and December 2009. Conversely, demand for office space contracted significantly, and rents for the office sector declined by 17% over the same period (chart 5).

But it is not only in needs-based sectors that resilient income is available. In the core Retail, Office and Industrial sectors, there are a cocktail of factors that investors use to understand the resilience of demand; they all start with meeting occupier needs. The layout of buildings, the ability to refit them economically and their location in their locality are all important. Moreover, identifying towns and cities which are positioned to grow their populations and local economies underpins long-term resilience and investment performance. That will be the subject of our next article in early 2018.

Wrapping it up

Real estate returns for calendar 2017 look very likely to surprise on the upside against expectations at the start of the year. The emerging pressure on occupier demand makes it unlikely that the pace will be matched in 2018. The next twelve months are likely to see underperformance for assets which are highly geared to the economic cycle.

More defensively positioned portfolios, and those where managers have been focusing on assets which meet occupier needs, are likely to be the winners in the shortterm. More broadly, to meet investor objectives over the long-term, we believe that investors and their managers increasingly need to focus on the themes of resilience and optionality – resilience against difficult market conditions whilst retaining the growth potential to deliver in more benign environments.

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