FULL REPORT
For the first time since the early 1990s, the UK economy is faced with the prospects of rising prices. Earlier in the year, inflation doubled largely because of increases in energy prices, marking the highest level before COVID-19. Latest data shows the rate surpassed the 2% inflation target in May, with prices rising by 2.1% (the consensus forecast was 1.8%). This is the first time inflation has surpassed the BoE's 2% target since July 2019. In May, core inflation which excludes the price of food and energy increased to 2% up from 1.3%, suggesting businesses are now raising prices to recuperate the losses occurred during lockdowns. This raises questions, firstly, on how long the post-lockdown effect will continue to boost inflation, and, secondly, whether changes to consumption habits are potentially misrepresenting true inflation. The latest increase has taken many by surprise, including the Bank of England (BoE), fuelling debate on what the likely course of inflation will be and implications for monetary policy. Not only that, but differing approaches by Central Banks across the world is adding further fuel to the debate on what approach is best.
In the past, interest rates have been set based on inflation forecasts, ensuring the rate remains close to the target of 2%. Post COVID-19 the focus of Central Banks has changed. The European Central Bank has said they will continue the pace of bond purchases despite upgrades to growth and inflation. The BoE have stated they are expecting a temporary period of 'modestly above‑target inflation' focusing on the medium‑term prospects instead, and therefore are unlikely to make a change to monetary policy in the short-term. The US Federal Reserve has now become more accommodating to any rise in prices and are more concerned about employment. Despite US inflation reaching 5%, markets still expect the BoE to begin raising rates before the US Federal Reserve.
There are two causes of inflation, demand-pull and cost-push, both of which will impact real estate returns. Demand-pull inflation occurs when demand is greater than supply, pushing prices up, also causing demand for real estate to go up, driving property values. Cost-push inflation occurs when there is an increase in the costs to manufacture goods or provide services. When caused by rising costs, this could result in lower demand for newly constructed buildings as developers would require rental growth to offset the increased costs. Alternatively the more it costs to build/repair a property, the higher the buyer is willing to pay in order to avoid construction/repair costs.
Overall investment volumes remain subdued; preliminary data suggests £8.6bn transacted in Q2, comfortably beating the £5.0bn recorded in Q2 last year, but still 14% down on Q2 2019. On a year-to-date basis, UK volume currently stands at £20.0bn, in line with the same period last year, while Central London volume, currently standing at £3.3bn, is down 25% on last year.
Trends established last year are continuing to play out. The logistics sector has so far accounted for 29% of total UK investment volume in 2021, which, if maintained for the rest of the year, would represent a record market share. Red-hot demand continues to drive down yields; Aviva Investors’ recent sale of a Royal Mail sorting centre in central Manchester, at £45m / 2.75% NIY, represents a record low yield for a regional industrial asset. While not necessarily reflective of the wider market, this confirms our view that logistics yields continue to trend downwards in the face of consistently-high demand and strong rental growth projections.
However, yield compression is by no means restricted to core logistics. Bids have just been received on 50 New Bond Street, London W1, which comprises prime luxury retail and Grade A offices let to Mulberry, Delvaux and Ralph Lauren with a weighted average unexpired lease term of 10.2 years. Pricing has reportedly exceeded the £230m guide price, which reflects a yield of 3.25%. The latest MSCI benchmark data also suggests Central London office yields are falling. The average City net initial yield currently stands at 3.5%, down from 4.3% in January.
This evidence should encourage further disposals in the coming months. Moreover, bond yields are still very low by historic standards, and with interest rates unlikely to be raised for at least another 18 months, the immediate impact of any inflationary pressures on financing costs will be minimal. It is also important to remember that rising inflation is a product of improving economic conditions, which will in turn improve investor attitudes to real estate income risk. With UK real estate still offering a healthy risk premium to fixed-income, and still offering value relative to European markets, this will mitigate any upward pressure on yields.
Inflation is likely to continue its upward trend, remaining above target at least until the end of 2022. BNP Paribas expect the BoE to raise rates in the final quarter of 2022 by 15bps to 0.25%.
As more evidence of hardening prime yields emerges, we expect liquidity to continue to build, fuelling a c. 20% uptick in investment volume this year. In the retail sector, investors are already capitalising on rebased values and a rebound in consumer spending. While coming off a very low base, retail warehouse transaction volume so far this year is up 54% y-o-y, while Shopping Centre volume is up 44%. As the last of lockdown restrictions are eased and international investors can travel more freely, investors' risk appetite will improve.