FULL REPORT
An already complex recovery situation for the UK economy became more so over March, with an elevated geopolitical uncertainty and the cost of energy in Europe. The UK sources much of its hydrocarbon requirements from the global markets. Increased competition for energy sources is likely to mean further magnification of already high energy costs as we emerge from the pandemic. The most likely outcome is substantial cost of living challenges in the short term. The Office for Budgetary Responsibility estimates that real living standards are set to fall by 2.2 per cent in 2022-23, one of the largest falls ever recorded, with living standards not recovering until 2024-25.
The significant reduction in consumptive potential has implications for demand for retail space as well as the overall economic outlook. The Consensus Forecasts for UK GDP in 2022 have been reduced from around 4.3% in February to 3.9% in April and may reduce further as the year proceeds. Forecast GDP growth for 2023 is also lower at 1.4%, down from 2.1%.
The rise in the cost of living is likely to be the defining economic story of the year, but although challenging, the UK economy remains very far from repeating the stagflation period of the 1970s. The UK went into the pandemic with a jobs boom, and though jobs were lost, employment levels remain high. In April, the employment rate stood at 75.5%, unchanged over the quarter, although still below pre-coronavirus (COVID-19) pandemic levels.
The number of job vacancies in Q1 2022 rose to a new record of 1,288,000 with the largest increase found in health and social work. Though the rate of growth is slowing down, which is not surprising, it is not indicative of a deteriorating labour market. Consequently, the consensus forecast for unemployment in 2022 is around 4.1% rising to 4.2% by 2023. The Q1 CFO Survey from Deloitte indicates that hiring managers are looking to increase hiring over the next few years. This underpins the solid state of the job market, which will continue to provide a floor for consumption over the next two years and support the real estate occupier market across all sectors.
“Though the rate of jobs growth is slowing, it is not indicative of a deteriorating labour market. A recent CFO Survey from Deloitte indicates that hiring managers plan to increase hiring over the next few years. This underpins the solid state of the job market, which will provide a floor for consumption and support the real estate occupier market across all sectors.“
The positive momentum from last year has continued into 2022, with UK commercial property investment volume in Q1 reaching £13.7bn. This was up 14% y/y and 5% above the 10-year Q1 average. The standout performer was the office sector, which saw c. £6.0bn change hands - a 128% y/y increase and the highest Q1 since 2006.
Much of this uptick was down to strong demand in Central London, where £4.9bn of office assets transacted - over 50% above the 10-year Q1 average. The market was dominated by a series of large transactions which pushed the average lot size to record levels.
We expect this trend to continue for the rest of the year. Capital raising for strategies targeting core markets - seen as resilient to rising inflation, geopolitical tensions and ESG-related obsolescence risk – reached record levels last year, and recent survey data from INREV has highlighted improving sentiment towards the UK market. For example, 100% of the non-European investors surveyed for INREV’s 2022 Investor Intentions Survey indicated the UK as their most preferred location, and London offices regained the top spot for city/sector combinations.
This is helping to ensure yield compression continues across the board. MSCI data showed the All Property net initial yield dropped to 4.30% in March, the lowest level since their records began. The last time it was anywhere near this level was late-2007. The challenges today are of course very different, but rising inflation and interest rates mean the future trajectory of pricing is uncertain. Compared with "risk-free" income such as UK government bonds, prime commercial property still offers value and remains attractive when recovering occupational demand, low supply and robust rental growth forecasts are factored in, but at the same time gilt yields are rising sharply and the 10-year benchmark has reached 2.00% far ahead of forecasts.
Should bond yields continue to rise, this will undoubtedly put upward pressure on yields. How much pressure depends on how leasing markets and the economy overall fare as we navigate the rest of the year.
Despite the challenging context, the outlook for real estate remains positive. Surveys indicate businesses remain focused on growth despite surging operating costs and tightening credit conditions, while rising construction costs and looming ESG regulation are helping to keep the supply of truly core offices low. Therefore both supply and demand-side factors are driving prime rental growth. All eyes, however, will be on the trajectory of inflation and interest rate rises for the rest of the year and the ensuing impact on pricing and risk appetite.