Part of the M&G Group

Real Estate Market Outlook UK

Janu

ary

2017

For investment professionals only

Front cover photo: Hardman Square, Manchester.

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Executive summary• Economy shrugs off initial Brexit-related hit to confidence, sentiment rebounds

• Demand/supply imbalance to support a healthy industrial occupier market

• Investor concerns abating after turbulent summer

• Moderate outlook for performance although downside risks remain

• Defensive investments likely to hold investors in good stead over the short term

Although economic conditions remain healthy for the

time being, the consensus view continues to be that we

shall see a slowdown in 2017’s activity. However, the

expected slowdown is relatively modest, with economic

activity seen to be easing to levels more akin to the UK’s

larger European neighbours.

There remains little conviction around what sort of

relationship the UK will eventually have with the EU,

although with the government seemingly taking a

hard line against the free movement of EU citizens

to the UK the probability of a “soft Brexit” may be

more limited than previously anticipated. That said,

negotiations are yet to begin and speculation is

constantly evolving. So with the only certainty in this

process being uncertainty there is still significant hope

that a mutually beneficial agreement will be reached.

Whatever does happen, both the UK government

and the Bank of England have made it clear that

their primary focus throughout will be to maintain

the stability of the British economy, whether through

accommodative monetary or fiscal policy. The Bank’s

policy interest rate, for example, has already been cut

to a new historic low of 0.25% and is likely to remain

at that level for the foreseeable future, something that

will be supportive of the country’s underlying economy

and real estate markets.

Economy proves resilient in face of Brexit uncertainty

Initial fears of a sharp uncertainty-driven slowdown

in the economy have, as yet, proved unfounded, with

GDP continuing to grow at a healthy 0.5% pace in the

third quarter of 2016. This healthier-than-expected

picture of growth has echoed across various economic

indicators. Sentiment in particular has bounced back

after slumping initially in July 2016, following the June

vote to leave the European Union, so it would seem that

British consumers and businesses are looking to carry

on pretty much as usual despite the Brexit vote. At the

same time unemployment has continued to fall and in

October 2016 retail sales grew at their fastest annual

rate for 14 years.

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USA Canada Germany UK France Japan Italy

Fig. 2: UK expected to see similar growth to many other G7 countries

Source: Consensus Economics, December 2016.

Fig. 1: Sentiment rebounds from Brexit falls

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Service sector Manufacturing sector

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Source: Bloomberg, December 2016.

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Occupier demand remains resilient…Fundamentally, nothing has really changed in the

property occupier market since the EU referendum vote.

IPD All Property rental growth has shown some signs

of moderating, from 3.3% p.a. to 2.6% p.a. in 2016, but

remains healthy. There is also significant divergence

across different parts of the property market: much of

the slowdown to date, for example, reflects the weaker

Central London office market, something that was

anticipated well ahead of the referendum due to more

market-specific factors.

… although some caution evident in the Central London office marketCentral London offices, and the City in particular, are

likely to be at the epicentre of any more significant

weakness in the overall occupier market. With the

City likely to suffer the most from the impact of

Brexit on EU-related trade in the financial and business

sectors (particularly if passporting rights are lost), we

expect occupiers to hold off from taking space in the

short term. Indeed, post-referendum take-up is already

relatively subdued, with Brexit, affordability concerns,

and rising supply all placing pressure on the occupier

market. We think this may lead to falls in rents, or at

least rising incentives, but we expect these falls to be

relatively limited (in the region of only c. 5-6%) thanks

to the wider economy’s continued growth, which should

underpin general demand for space, and a scaling back

of the development pipeline.

The regional UK office market appears more resilient

given grade-A availability is very low and there is limited

new supply coming on line in the short-term. Take-up here

is driven more by domestic demand (which has proven

surprisingly buoyant) than by international financial

services. That said, the market is becoming increasingly

bifurcated with the likes of Manchester, Birmingham,

Edinburgh and some South East towns such as Reading

and Maidenhead moving ahead of the rest, helped by

strong and improving transport infrastructure, young

educated workforces, and government support.

Continued support for industrial rentsDespite the recent political uncertainty, occupier

sentiment for the industrial sector has remained

upbeat. This reflects, at least in part, the fact that

a large share of current and expected demand is

from companies such as e-tailing giant Amazon,

which are looking to take advantage of the ongoing

structural change in the sector. This race for space

shows no sign of slowing as yet, so demand continues

to exceed supply even though it has encouraged some

speculative development as investors and developers

try to meet the need for new space.

Recent events have led to a slowdown in new starts,

particularly in the case of distribution warehouse

developments. Those that are in the pipeline remain

firmly focused on core hub locations, where the supply of

existing quality stock is particularly acute and demand

for space remains strong, such as London and the South

East. Meanwhile, availability for multi-let units is at

record lows, adding to the pressures in the sector. As a

result, we expect rental growth to remain strong in the

short term.

Mixed outlook for retailThe recent recovery in the retail property sector and

strong retail sales are likely to be curtailed by a number of

headwinds that are expected to impact the sector over

the next couple of years. These include higher inflation,

the introduction of the national living wage, business

rate revaluations, and an increasingly competitive retail

environment. These headwinds are set to occur during

a period in which retailers have continued investing in

supply chain and omni-channel capabilities. However,

different retail types and geographies are expected to

be impacted by these headwinds to differing degrees.

We expect the polarisation between prime and

secondary schemes and locations, which is already

evident within the retail sector, to become more

palpable in the near term. Occupier demand is likely

to remain focussed on the best retail pitches, while

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Central London Take-up 10-year average

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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

(Jan-Nov)

Fig. 3: Central London office take-up slows

Source: CBRE (December 2016).

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PAS Industrial – South East PAS Industrial – Rest of UK

Fig. 4: Strong demand and limited supply continue to boost industrial rents

Source: IPD (November 2016).

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increased retailer consolidation and a withdrawal from

weaker towns looks likely to lead to more secondary

space coming back onto the market.

That said, the return of a more cautious approach to

development, given the uncertain political and economic

backdrop, is likely to apply to the food store and retail

warehouse sectors – which should lend support to rents.

Indeed, we expect supermarkets to hold up better, given

the defensive nature of their occupier base and the

prevalence of long inflation-linked leases.

Higher house prices underpin demand for private rentingIn contrast, rental growth in the private rented sector

(PRS) has been strengthening in recent months, albeit

gradually. Tenant demand has continued to improve

across much of the country as the Brexit uncertainty

reduces people’s willingness to buy and high house

prices affect their ability to do so. In addition, the supply

of rented property has actually weakened, adding to

pressure on rents.

The picture in London is more mixed. Activity in Outer

London and the main commuter areas, driven by young

professionals and families, remains healthy, underpinned

again by a lack of affordability for would-be first-time

buyers and the Brexit uncertainty. In contrast, the more

prime, inner areas of the city are seeing increased

supply coming onto the market at a time when demand

is being tempered, leading to falls in rents.

On balance though, away from Central London, the

PRS remains, and should continue to remain, relatively

resilient in the face of economic headwinds.

Initial investor Brexit concerns abatingUnsurprisingly, the EU Referendum result led to some

unease amongst investors: retail investor funds saw net

outflows of c.£2.3 billion in 2016, triggering property

sales as those funds looked to meet these redemptions.

This selling pressure and the uncertainty generally led

to capital values slipping over the summer months.

Nevertheless, the declines were seemingly over before

they began, with values falling by a limited 2.4% at the

All-Property level (IPD) in 2016. Indeed, capital values

have already started to rise again, albeit tentatively, as

renewed confidence and the desire to keep calm and

carry on has allowed stability to return to the market.

UK property yields have risen by about 25 basis points in

2016, leaving the spread above 10-year UK government

bond yields at around 500 basis points, above where it

started 2015 and well above its historic average. That

will continue to provide a healthy cushion for pricing in

the short- to medium-term.

There are other reasons to be relatively positive about

the UK property market. Capital values are, on average,

almost 25% below where they were at their 2007

peak, before the global financial crisis. Debt is also at

considerably lower levels whilst the number of forced

sellers in the market is still relatively low.

One additional and important factor is that overseas

investors do not seem to have been deterred by the

idea of Brexit and its potential implications for the

UK. If anything, the post-referendum depreciation of

sterling has made UK property look more attractive

from an international perspective. Property in London,

in particular, now looks more attractive on a relative

basis, given that prime London yields have risen by

c.25bps, while yields elsewhere in the world have stayed

the same or even compressed over the same period.

the post-referendum depreciation of sterling has made UK property

look more attractive from an international perspective.

“ “

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Property yield minus bond yield

Fig. 5: Property retains a healthy risk premium above bonds

Source: IPD, Bloomberg (November 2016).

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Fig. 6: Prime London yields more attractive on a relative basis than previously

Source: CBRE (December 2016).

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lead to a deceleration in the housing (sales) market,

the PRS is likely to benefit as would-be buyers instead

choose, or are forced, to remain in an already supply-

constrained rental market. This should maintain, or

even strengthen, rental growth, helping to offset any

weakness in the owner-occupier market.

• Quality over quantity In times of unease, well-located property with secure

income streams tend to prove most attractive to

investors looking to minimise risk. As such, focusing

on prime and good secondary property should

provide the potential to outperform in the short

term.

• Central London at greater risk Overall, we believe that central London offices will

be affected to a greater degree, as this is where the

change in our relationship with the EU will be most

visible, as well as being the area where pricing looks

most expensive relative to fair value. This is also

the part of the market where we see the greatest

probability of falls in rental values. Similarly, we

expect Central London residential to underperform,

reflecting the fact that, alongside the potential

impacts from Brexit, the sector is also seeing high

levels of supply and weak investor demand in the

face of significant stamp duty changes introduced

in early-2016.

• Maintain a balanced, diversified portfolio With uncertainty likely to be the watchword of

2017, if not for the next few years as Brexit unfolds,

investors should look to limit risk by maintaining

a portfolio that is balanced and well-diversified in

terms of both geography and market segment.

Conclusion

On balance, the UK property market appears to be in

a much better position than we were expecting in the

summer, shortly after the EU referendum. We now look

to be entering 2017 from a position of relative strength

and with a modicum of optimism. However, it is clear

that there are definite and significant headwinds in

place that may affect the market over the next two

years. As such, taking a defensive stance in terms of

portfolio strategy should prove beneficial.

All of that means that the UK property market as it

enters 2017 looks set to face the challenges of Brexit

from a position of relative strength. Certainly, conditions

are much stronger than the industry was previously

anticipating. As a result, while we may see further falls

in capital values due to of the Brexit uncertainty, these

are likely to remain relatively modest and more focussed

at the secondary end of the market.

There are, however, significant differences. Offices and

residential in Central London are likely to feel the

greatest impact from Brexit, while the more defensive

industrial and private rented sectors are likely to be

affected to a lesser degree. Meanwhile, the impact on

the retail sector may be more mixed as uncertainty

leads to slower consumption growth but with prime

schemes with destination appeal likely to be bolstered

by international tourism.

Caution remains an important themeAlthough our base-case scenario suggests that the

market will remain relatively resilient in the short term

there are significant downside risks on the horizon, not

just associated with Brexit but also reflecting other

geopolitical and economic events. Therefore, we believe

that it is important to remain cautious and thus for

investors to position their portfolios to weather any

potential storms that may arise.

• Uncertainty to continue drive towards defensive sectors

The industrial sector, already seen as a defensive

investment from a cyclical perspective but also from

a structural perspective since it is benefiting from

e-commerce-driven change, should hold up well.

Industrial property should continue to see positive

rental growth and only limited upward pressure on

yields.

We anticipate that long lease and inflation-linked property such as supermarkets will also prove

resilient, with its low-risk, bond-like characteristics

always demonstrating significant appeal during

periods of uncertainty.

Away from the property mainstream, the residential sector is likely to be impacted the least by any

ongoing uncertainty: while a weaker economy may

“ “... the UK property market as it enters 2017 looks set to face the challenges of Brexit from a

position of relative strength.

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Emma Grew Research Manager

+44 (0)20 7548 6676

emma.grew@mandg.com

Richard Gwilliam Head of Property Research

+44 (0)20 7548 6863

richard.gwilliam@mandg.com

Christopher Andrews, CFA Head of Client Relationships and Marketing, Real Estate

+(65) 6436 5331

chris.j.andrews@mandg.com

For more informationLucy Williams Director, Institutional Business UK and Europe, Real Estate

+44 (0)20 7548 6585

lucy.williams@mandg.com

Stefan Cornelissen Director of Institutional Business Benelux, Nordics and Switzerland

+31 (0)20 799 7680

stefan.cornelissen@mandg.co.uk

www.mandg.com/realestate

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