Research Paper Q3 2015 – Economic and Real Estate Market Commentary
The Global Economy
Global focus over the summer switched away from Greece to a potentially greater threat to global financial stability – that of China’s economic slowdown and transformation from one majored in manufacturing and investment led growth to one more aligned on consumption and services. The consequential managed depreciation of the Chinese renminbi heralded the start of significant external analysing of China’s economy with each release of economic data being heavily scrutinised.
The slowing of the Chinese economy, which was particularly marked in lower imports, has hit prices of many commodities which already had been hit by the fall in energy prices over the preceding year. This coupled with the constant worry of the apparently imminent rises in US interest rates (which would in all likelihood prompt interest rate increases elsewhere) is impacting the economies of the developing world.
Lower commodity and energy prices are benefiting the advanced economies to the detriment of many emerging ones. Growth in the advanced countries, according to the IMF’s latest “World Economic Outlook”, is forecast in aggregate to rise from 1.8% last year to 2.0% this year to 2.2% in 2016, although growth for both 2015 and 2016 has been trimmed by 10 basis points since the release of their previous Outlook three months ago. However, the emerging economies, particularly those with close trading links to China, have been hit much harder. The IMF expect growth for these countries to fall from last year’s 4.6% to 4.0% this year, which would mark the fifth straight year of slowing growth in aggregate for the group.
Risks to global growth are now more skewed to the downside. The risks of China’s slowdown being more acute than expected, the negative impact on the emerging markets of lower commodity prices and the risks to debt burdens through higher borrowing costs together with the likely continued appreciation of the US dollar could be quite concerning for many economies.
The Eurozone Economy
While the trials and tribulations of the Greek economy have all but disappeared from the financial headlines, the drama and uncertainty is still present. Agreement within the Eurozone that debt relief for Greece is necessary has been reached and should be achieved by capping its annual debt service costs at 15% of its GDP (which is still a very high amount).
But Greece has lost it centre stage position in the Eurozone to Germany which has had a particularly worrying summer. Not only have German exports fallen sharply as demand from China and other emerging markets declined, but the country has been rocked by Volkswagen’s diesel emissions scandal and where recent revelations indicate that petrol-fuelled cars may also be affected. The car manufacturer is Germany’s biggest exporter – last year it accounted for almost 18% of the country’s exports – and concern lies over the damage done to its (previously good) reputation. On top of that, Germany has been the location of choice for hundreds of thousands of refugees which is putting additional strain on both its infrastructure and finances.
Germany aside, much of the single currency bloc has been making positive strides forward, albeit very small ones. Some of the previously weakened peripheral states have been improving competitiveness although the gap between most of these countries and the best performing (northern) countries remains quite large. Low oil prices and a weaker euro are stimulating growth within the Eurozone, but export markets remain challenging. However unemployment continues to fall – it is now below 11% – and inflation remains around zero. Consumer spending is benefiting from real wage rises. Our medium term forecasts for the Eurozone are broadly similar to those reported three months ago. GDP forecasts for Germany have been trimmed by 10 basis points this year and next, while our GDP forecasts for Italy have been increased by a similar amount.
The UK Economy
The first estimate of the performance of the UK economy in Q3 came in below expectations at 0.5%. While it was fully expected that the most recent quarter would mark a slowdown from Q2, the outturn was 10 basis points lower than had been anticipated.
The dominant services sector, which accounts for almost 80% of the national economy, posted a second successive quarter of 0.7% growth. But once again, manufacturing contracted over the three months while construction, particularly in London, contracted by a much larger than expected 2.2% in the quarter.
In its latest “Quarterly Inflation Report”, the Bank of England has pushed out the widely expected date for the first increase in interest rates. Citing a weaker outlook for global growth which was depressing the risks of inflation in the short term, the Bank stated that the risks to inflation ‘lie slightly to the downside’. Economists now believe that the first rise in interest rates will not now occur until the summer of 2016.
Consumer spending is a clear beneficiary of low inflation, but exporters are struggling with a relatively high exchange rate which combined with dull export markets limit growth opportunities. Despite the exhortations of Government, the UK seems as far away as ever from rebalancing its economy from one totally dependent on the consumer to one focussed on manufacturing and exports.
Our short team forecasts are broadly unchanged for the UK, although the more favourable outlook for consumer spending has prompted increases there this year and next.
The UK Property Market
UK commercial property delivered another solid quarter of total returns over the third quarter of 2015. According to the IPD Quarterly Index, Q3 returns of 3.2% were only a little down from the 3.5% recorded the previous quarter. This time, offices were replaced by industrials as the best performing sector, with a total return of 4.4%, just ahead of offices which recorded a 4.1% with long term laggards the retail sector again generating returns only half those of industrials.
Over the twelve months to the end of September 2015, average property has delivered an impressive total return of 14.4%. That the retail environment continues to be under pressure from structural change can be seen from recent publications of the Quarterly Index. Over the most recent twelve month period, average office and industrial properties have recorded total returns in excess of 19%, more than twice that for average retail properties.
These total returns are still being aided by firming property yields, in part due to the low and often negative rates of inflation which is further delaying the start of policy tightening and increases in bond yields. However, rental growth is now playing a greater part in increasing capital values, although less so in the retail sector.
The immediate outlook for total returns remains positive. Prime yields are still under downward pressure across most of the market, but given the keen yields now evident, most of the future downward yield movement is likely to come in well specified and well located secondary properties. Indeed, Savills have reported in their latest “UK Commercial Market” report that average prime yields are now below their 2007 historic lows.
As reported in previous quarterly reports, development continues to increase, but being accompanied by ever decreasing vacancy rates, such new stock is not at present threatening the ongoing recovery in commercial property.
It is highly unlikely that the UK property market, at least in its attitude to development, will return to the excesses of the early to mid 2000s, the period which prompted the credit crunch, the global financial recession and the collapse of property values. Many funds are now acutely aware of development risk, many of them having been so damaged by the events of 2007 – 09. These funds which tended to utilise gearing are unlikely to employ such high levels of borrowings, if any, in the immediate future. Bank lending remains at modest levels but it has to be pointed out that at least one major bank has sanctioned the lending on UK property at ‘pre-crash’ levels of 90% loan to values.
The immediate outlook for yields and rents across the market remains favourable, as is the strength of the occupier markets. The one issue that has altered over the summer has been the increasing number of properties coming to the market. Much of this may be down to asset class rebalancing following property’s strong performance over recent years and the equity market’s weak showing over the summer.
But whatever the reason, stock being brought to the market for sale is nearing historically high levels. If this was to continue into 2016, that would surely put a dampener on performance.
One of brighter spots in a dismal retail world over the last few years has been the performance of retail warehousing. That relative strength may now be about to be tested. A report over the summer indicated that over the next 3-5 years, some of the major retail park tenants – including B&Q, Homebase and Curry’s are wishing to reduce their floor space by a cumulative 9.5m sq. ft. Not even the expanding new entrants to that market – B&M, Poundland, Dunelm and the like – will be able to absorb that amount of vacated space.
For 2015, we remain confident that total return for the commercial property market will be around 13% with 9-10% indicative for 2016.
The Central London Office Market
While yields remain on a downward trajectory and rents of prime and good secondary properties are still rising, the main story over the summer is the increasing number and value of office properties coming to the market.
It has been reported that over £3bn of office properties in the capital are up for sale. Much of that will be opportunistic sales following stellar recent performance; much will be brought about by strategic asset re-allocation: and some, though less easy to predict, like a far eastern pension fund, will have been instructed to sell overseas assets, and repatriate the capital in order to support its weakening currency.
Take up across the central London market remains buoyant. Up to the end of August, City take up in 2015 was 5.24m sq. ft., an increase of 11% on the similar period last year, while take up in the West End totalled 2.7m sq. ft., over 20% above last year’s (source: Savills). By far the most of this take up has been in Grade A space, which together with limited development completions, is keeping Grade A vacancy rates at extremely low levels.
According to Savills, total supply of available space in the City stood at 5.6m sq. ft. at the end of August, equivalent to a vacancy rate of 5.3%. Of that total, over a quarter was at that point under offer. The position is even tighter in the West End. Available supply of 3.3m sq. ft. or a vacancy rate of 2.7% is exceptionally low by historic standards, even for the West End. Top rents of £90 past in the City and £147.50 psf in the West End are still under upward pressure (source: Savills) while prime yields are still falling, although quarterly falls are now measured only in basis points.
While economists now do not expect interest rates to rise until next summer, this would normally be positive news for commercial property. However, the weight of property coming to the market (described by one stockbroker as a ‘tsunami’) may have a more immediate impact on property yields.
Author: Stewart Cowe 09/11/2015