Mind the Gap
Key Messages
City offices maybe the best performing with total returns of 13.7% in 2020 generated by the strongest capital growth in the region at 9.8%
City offices lead rental growth at 7.0% in 2020
UK and Dublin offices may experience yield compression in 2020. London offices will see yield inversion with retail
UK logistics yields may remain flat at 4% over 2020
Investors have been contending with uncertainty surrounding Brexit for three years now, which encouraged a more cautious approach to UK real estate. Ireland, to some extent, is the beneficiary of this restraint.
The newly elected Conservative Government with its huge majority has resulted in clarity in policy. Pent up demand for UK commercial real estate is now likely to be realised. The flurry of activity in Q4 2019 following the election result is something we see continuing in 2020. The only deterrent is likely to be the lack of available product.
London in particular looks set to be a big opportunity. Since the 2016 referendum, Central London yields remained flat while European yields compressed. Prime Central London offices are trading at a considerable discount: the City of London yields are on a par with Prague at 4% for example.
We foresee a rebound in investment activity this year and expect yields across Central London to compress by 10bp in 2020. Furthermore, developers have been cautious, leading to limited construction across London. This has led to vacancy rates falling to all-time lows, and rising rents. Prime rents may grow by around 4% on average over the forecast period 2020 to 2024.
On the other end of the spectrum is Dublin, which will witness a surge in development. Approximately 480,000 m2 will be delivered over the next two years, almost four times the average of the last five years. Consequently, we anticipate an increase in vacancy rates to 7% in 2020 alongside little or no prime rental growth across the forecast period.
UK logistics is likely to post the strongest returns in the region led by the South East (7.5%) and Heathrow (7%). Over 2020-24, Heathrow logistics will show the strongest return performance at 5.0% on average.
The weight of capital targeting logistics means yields are stable in the front part of the forecast before limited decompression over 2023 and 2024. Capital growth is likely to stay positive over the period. Lack of supply remains an issue, particularly in the South East and Heathrow prompting the bringing forward of new sites. That means rental growth may ease from the levels seen in recent years resulting in growth rates of around 2% to 3% over the forecast period.
The retail sector continues its structural transformation, where the need for physical stores is diminishing. However, demand is proving resilient in prime central locations such as Oxford Street in London and Manchester city centre that are the focus of our forecast. Here we see total returns gradually strengthening over 2020-2024. London is likely to post negative total return of -3.5% in 2020 move toward 4.7% by 2024. The other UK cities and Dublin will post return over 5% by 2024. What restores growth is recovery in capital values at the end of the forecast, Similarly, rental growth is mostly flat or negative in the UK. Dublin is an exception with prime rental growth around 2%.
Although we do not see a big turnaround in retail over the forecast period, we do foresee developers delivering retail space more fit for purpose that may act to improve performance.
Risk to the Forecast
The Conservative Party’s majority win in the election signals a relatively easier push through on Brexit related issues.
Things rattling on smoothly approaching the Brexit deadlines will provide an upside risk to the UK real estate market. Little or no progress on the next Brexit phase will have the opposite effect.
There is a risk that Dublin’s office market could be oversupplied. If this occurs, we could see a further rise in vacancy rates and rents falling.
Sukhdeep Dhillon