FULL REPORT
We are in challenging times, especially for the least well off in society, and the Chancellor responded at the end of May, with a welcome fiscal package that is equivalent to 1% of household disposable income. However, while this supports households with the cost of their energy bills, it does little to address the general increase in the cost of living.
The high level of inflation and its implication for the standard of living will continue to be the defining economic story over the rest of the year. We see the inflation rate peaking by the end of 2022, however the price level will remain elevated throughout to the end of 2023. This means household purchasing power will continue to decline, with implications for growth in a consumer-led economy such as the UK. As such, our latest forecast is for a slowdown in GDP growth to 3.8% in 2022, but the bulk of the slowdown will occur in 2023, where we expect 1% growth.
At the moment, this segment of the economy remains robust. Key indicators such as employment, unemployment, wages and labour demand continues to head in the right direction. Last month we alluded to the strength of the UK labour market, with the unemployment rate at the lowest point that we have seen for decades. The latest data shows that for the first time in over 40 years the number of job vacancies has surpassed the number of people actively looking for work.
When we looked in detail at where the vacancies are concentrated, a large proportion are naturally in the services sector. Moreover, a good proportion of this is in office-based employment, which is encouraging for office real estate demand. The high number of vacancies is likely to translate into employment growth in this sector over the coming years.
In short, the read across to this is that, despite the changing working habits and increased desire for working from home, the real estate occupier market will continue to be supported by a strong labour market.
“With the number of people activity looking for work outpacing vacancies for the first time, the UK labour market remains robust. Employment growth is office-based sectors should continue to support real estate demand for the foreseeable future.“
UK property returns remain at multi-decade highs; MSCI's rolling 3-month all property total return increased in April to bring the rolling annual figure to 24.9%, with London industrial reaching a huge 52.8%. However, hidden in the detail are some hints of a slowdown. Equivalent yield impact – capital growth coming from yield shift - has started to drop in some key segments, notably London industrial - which (on a rolling 3-month basis) has halved since reaching 10.1% in December - and Central London retail, which has turned negative. Also, MSCI's average London City offices net initial yield has been on an upward trend since the start of the year, moving out c. 60 bps.
Even so, despite real concerns over stagflation, prime yields remain firm. While global investor demand remains strong, lack of stock is being exacerbated by a narrowing definition of ‘true prime’ due to stricter ESG requirements and evolving lease preferences. According to Costar, the percentage of London office stock meeting the highest ESG credentials amounts to the low single-digits, while the majority of occupier demand is focused around this segment.
Moreover, the flurry of big-ticket deals so far this year masks the fact that overall deal flow remains suppressed. The total number of UK investment transactions in Q1 2022 was 587, the lowest number of deals in Q1 since 2013, and just 28 office deals transacted in Central London, almost half that of Q1 2016 and the lowest Q1 since 2009 (Source: Property Data).
In this context, it is difficult to see a sharp rise in prime yields on the horizon, but rental growth forecasts are crucial. The era of perpetually-low interest rates is over and risk-free rates are rising, so investors will have to underwrite strong rental uplifts to achieve appropriate risk-adjusted returns. The 10.1% industrial rental growth achieved last year is unlikely to continue, but even if warehouse take-up comes off recent highs, it should still trend higher than pre-pandemic given record-low vacancy. Offices are harder to call. On the one hand, a resilient jobs market, record levels of VC investment in life sciences and tech, and acute lack of supply versus demand will ensure continued prime rental growth and justify the yields being paid. On the other hand, with footfall in London workplaces still c.30% below baseline and ESG-conscious businesses keen to attract talent, it is easy to conclude that a value correction in the value of older offices is looming.
As investors absorb higher borrowing costs, our outlook for the rest of 2022 assumes a 2.2% decrease in UK investment volume to £67bn. This would still represent the second-highest annual volume since 2015, and ensure the UK remains the largest CRE investment market in Europe.