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Economic and Market Commentary – Q3 2020

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Brexit news

 

Just a few days ago, Prime Minister Johnson apparently ended negotiations with the EU saying that there was no point carrying on unless the EU fundamentally changed its position. Perhaps a week is indeed a long time in politics as talks are very much back on and it appears that the UK and the EU could now be inching towards a deal. It has been reported that compromises from both sides on one of the thorny issues, that of post-Brexit fishing rights, could kick start discussions that would enable a trade deal to be unveiled before the year end.

The compromise would allow the UK to regain control of its territorial waters while also allowing EU fishing boats access. It is reported that the protagonists are looking at a plan which uses the concept of ‘zonal attachment’ where quotas are determined by the amount of fish stocks on either side’s waters. If a deal is reached, it would allow British fishermen to catch significantly more fish than at present and it would also defer the decision on the amount of the EU quota until after the wider trade deal is signed.

Talks are continuing with both sides accepting that the clock is ticking with some tough negotiations still to come. But the fact that discussions are still ongoing is a welcome development.

Meanwhile the UK and Japan have signed a trade agreement, Britain’s first post-Brexit trade deal. It means that virtually all of Britain’s exports will be tariff free while tariffs of Japanese cars entering Britain will be tariff-free from 2026.

While symbolic, the trade agreement would boost trade between the two countries by about £15 bn – adding less than 0.1 percentage point to the UK’s GDP – a tiny fraction of the trade that could be lost were no deal with the EU be agreed.

 

Global economy

It is fair to say that we are all experiencing difficult times, perhaps the most challenging since the Second World War; challenges where economic policy alone is insufficient. Many countries are experiencing a ‘second wave’ of Covid-19 cases, testing has been ramped up across the globe and social restrictions are being reimposed; still the death toll rises, still we await a suitable vaccine and governmental spending still spirals relentlessly upward.

Despite this gloomy environment, economic forecasts for 2020 are generally better than those predicted three months ago, following on from slightly less damaging contractions in the second quarter, but these minor upgrades have been counterbalanced by the expectation of a weaker recovery next year.

The relatively stronger Q2 outturn has been helped by the sizeable, quick and unprecedented fiscal, monetary and regulatory responses that has helped maintain disposable income for many affected households and protected cash flow for businesses. Collectively, these actions have so far prevented a recurrence of the financial meltdown of 2008-10. How governments are going to pay for this largesse is a tetchy question for the future. At least, the probability of low interest rates for a longer period together with the anticipated recovery next year alleviates the debt service burdens in many countries.

While the worst in terms of economic fallout is now, hopefully, behind us, the pace of recovery is likely to be lengthy, uneven and uncertain. Many countries are now facing a second wave of infections, once again putting severe strain on health services and any hope that the illness and its economic impact would be confined to 2020 now seems unlikely. Indeed, the number of new cases in many countries is currently rising at a faster rate than during the initial February – April phase although one has to bear in mind the number being tested now is significantly greater than six or seven months ago. This has caused a further downgrading of the economic outlook for many countries in the near term compared to pre-pandemic expectations. 

 

 

Our global economic forecast for 2020 has improved from -4.9% three months ago to -4.4% with upgrades to our forecasts for the US (by 3.7 percentage points), the eurozone (by 1.9 pp) and Japan (0.5 pp). All these upgrades are followed by slight downgrades next year. The risks remain very much skewed to the downside, most visibly seen in the sudden falls in global stock markets at the end of October when markets started factoring in a much worse economic consequence of the ‘second wave’.

After a partial recovery next year, global growth is forecast to gradually slow to around 3.5% pa in the medium term, somewhat short of the c 4.0% – 4.5% pa anticipated pre-pandemic. The reduction in the growth outlook will hit average living standards and the pandemic will reverse the near three decades of progress in reducing global poverty and will increase inequality, particularly hitting those working outside the formal safety nets. 

Nonetheless, the interminable US circus called the election is over – bar the shouting! – for another four years. While not quite overshadowed by Covid news, the election of Jon Biden (subject to potential litigation by Trump) is likely to change many of Trump’s policies, including tax increases for both high earners and corporations. Only time will tell, as will dissecting ex-President Trump’s tenure. Staying in America, though with global ramifications, the Federal Reserve indicated that there would be no interest rate increases until at least the end of 2023 adding that it would not tighten policy until inflation has been “moderately above” 2% “for some time”. Its Chair, Jerome Powell said the statement meant “rates will remain highly accommodative until the economy is far along its recovery from the Covid-19 pandemic”.

 

 

 

The EU economy

The eurozone and EU recorded a stronger than anticipated recovery in the third quarter, the former posting growth of 12.7%, fully three percentage points ahead of expectations. This followed two quarters of decline which in total had left the zone 15% lower than at the start of the year. But any hope that the single currency bloc could build on this recovery in Q4 have been derailed by new lockdowns or circuit breakers which have been imposed in many countries in recent weeks.

Expectations for Q4 are being reduced with some commentators believing that a double dip – i.e. further contractions in activity – could be on the cards. Certainly, the restrictions re-introduced will have an adverse effect but a slowdown was already being seen. France’s finance minister is on record saying that the French economy will contract by a worse than expected 11% this year. Meanwhile, German consumers are tightening their belts. The boost from the cut in VAT is fading, pushing retail sales down 2.2% in September. 

 

Meanwhile, owing to the job retention schemes that were introduced earlier this year as Covid-19 became established, the rise in unemployment has so far been limited. Over the third quarter, the euro area’s unemployment rate was 8.3%, 30 bps higher than that three months earlier and 80 bps above the rate 12 months ago.

Inflation turned negative in August and at -0.3% in September remains well below the ECB’s target of ‘close to but below 2 percent’. Oil prices have been particularly weak recently as markets consider the financial and economic impact of further lockdowns, and they are likely to remain weak for the foreseeable future putting further downward pressure on inflation.

Our forecasts have been increased slightly for this year but reduced by a small amount next year for most countries. However, with many European countries now in the midst of a tightening of restrictions, there is a real fear that Q4 growth (and consequently for 2020 as a whole) will be significantly lower than that expected.

 

 

 

 

The UK economy

A 20% contraction in the second quarter was not part of Boris Johnson’s manifesto a year ago, but then, the terms coronavirus and Covid-19 had not yet become part of everyday conversation. Not only was the fall the worst quarterly result in UK history, it was the worst performance by any G7 country, and one of the worst posted in the developed world. With the UK’s record on the number of Covid-related cases also one of the worst, it has not been a 2020 to remember for the government.

Predictably, Q3 saw a major recovery, but momentum has since stalled as the virus reasserts itself in the community forcing significant tightening of the economy. The magnitude of the recovery remains uncertain, with the first, flash estimate expected later in the November. Expectations for Q3 growth range from 13% to 18%.  Hopes for Q4 have been lowered in line with other European countries and another contraction cannot be ruled out. It is likely that the full year outcome will be a decline of around 10%, by far the worst outcome seen since the immediate aftermath of the Great War but similar to other countries in the continent.

Meanwhile, the furlough scheme, which pays workers affected by the forced, temporary closure of businesses, and which was due to end on 31 October and be replaced by a less generous job support scheme, has been extended until March 2021, meaning that the scheme will have been in place for 12 months. Around 9.6 million workers have benefited from the scheme since its start this March at a cost to taxpayers of £40bn.

Unemployment has also risen to its highest level in over three years as the pandemic continues to hit the economy. The unemployment rate increased to 4.5% in the quarter, up from 4.1% in the previous quarter. Similarly, the number of redundancies in the last three months increased to 227,000, the highest since 2009 in the midst of the financial crash. These statistics are not as bad as were initially feared at the start of the hiatus when talk of an increase to an unemployment rate of 9% was rife. But with the second wave of infections now upon us, further and significant job losses are likely.

With the pandemic no nearer to its conclusion and its financial impact no nearer being finalised, the Chancellor has taken the sensible step of postponing this year’s Autumn Budget. ‘… now is not the right time to outline long-term plans – people want to see us focused on the here and now,’ the Treasury said. That means that the difficult decisions on how the cost of fighting Covid is to be financed has been deferred into the new year.

On the day lockdown restrictions were imposed in England, the Bank of England announced another £150bn of quantitative easing, taking the total employed this year to £895m, dwarfing the amounts utilised in the past decade. The Bank acted as it was concerned that the UK would enter another downturn as the new restriction hinder the recovery. Interest rates were kept at their record low levels, 0.1%.

 

 

This second period of lockdown in England should not be as damaging to the economy as the spring one was for several reasons: presently, the period of lockdown indicated is only four weeks as opposed to the uncertain period when the first lockdown was announced in March; unlike the previous period, manufacturing, construction, real estate, schools and universities, nurseries and garden centres are allowed to open. The four-week lockdown is due to end on 2 December, and that therefore affords the possibility of a re-opening in the run-up to Christmas which would obviously be of major benefit to retailers. Additionally, lessons have been learned both from communications and working from home. All that should point to a less damaging impact to the economy in December than what happened earlier in the year.

Summing up, the economy has made a strong recovery in Q3 but momentum has slowed in recent weeks pointing to a weak Q4. As the Covid case numbers remain elevated, a fresh lockdown across much of the UK will further hinder growth while it is likely that the economy will not reach its pre-Covid level until 2022. Meanwhile, the cost to the Treasury keeps mounting. How the Chancellor tells us how we are paying for the unprecedented measures introduced over the last eight months has been deferred until next year. 

 

 

Market Commentary

A 1% fall in average property values over Q3 took the cumulative fall in values to 10%. This period of declining property values started two years ago, making this decline of similar length of time to that over which values fell during the global financial crash. Perhaps the same duration, but thankfully, not the same magnitude, as average values fell a whopping 44% a decade ago. But whereas property values started to rise two years after the decline started in 2007, there are few signs of respite in the current collapse. However, the 1% fall in Q3 was significantly less severe than in the two previous quarters and gives hope to the belief that the end of the decline may be near. Much will depend on the strength of the economy in the coming months.

 

 

While most areas of the market are witnessing falls, it is the retail sector which is bearing the brunt. Once again, the shopping centre segment was the worst performing over the quarter, falling in value by 6.6% for a cumulative fall of 24% this year alone. The fate of standard shops was not much better, seeing a 3% fall in the quarter. Neither segment was helped by the news that the number of shop units closing in the first six months of the year hit an all-time high with 6,001 closures, up from 3,509 in the corresponding period last year.

It is not all doom and gloom on the high street, though. There are a few bright spots too, as there is a steady flow of openings. For example, consumers are rediscovering their local retailers while there has been a mini boom in takeaway and pizza delivery shops. Additionally, there is rising demand for services such as tradesmen’s outlets, building products and locksmiths. These new units, welcome though they are, however, are dwarfed by the numbers closing. There is still a lot of pain to come for the retail sector; a lot of corporate restructuring and many more redundancies to come, despite the Chancellor’s laudable efforts on job protection.

From a performance measurement point of view, institutions, which are most likely to favour investment in city centre retailing units, are often not represented in neighbourhood shops and parades and so it is debateable whether valuation upticks in these local shops will work its way into the MSCI (IPD) indices.

One of the success stories this year has been the growth of internet sales, though that of course has had negative implications for the high street. As retailers have been augmenting their online presence, there has been significant growth in retailer interest in distribution warehouses and also investment by these retailers in the final part of the supply chain known as the ‘last mile’. This is fuelling growth in these smaller distribution warehouses in suitable locations nearer the customer. It is no surprise that these parts of the commercial property market are presently the strongest. Average industrial values bucked the recent trend in Q3, posting an increase of 1.0%, the only sector to show an increase, with the sector back in growth after six months of decline. 

 

 

From success stories to failure! Business recovery firm Begbies Traynor claims that there are now over half a million firms in ‘significant distress’. Needless to say, the biggest increases in struggling companies came in food retailers, construction and real estate and property sectors. And that number could be even higher if courts were operating normally, as the number of county court judgments and winding up provisions are lower as winding-up petitions for Covid-related debts are currently banned. That has led to concerns that, once these restrictions are lifted and Government support is removed, the number of firms going bust could surge as a ‘brutal reality check’ hits the UK economy. Many of these companies are surviving only through the availability of Government loans and employee cost subsidies, but once these come to an end, there will be little hope for many of them.

Investment transactions were notably higher in Q3 than in the depressed second quarter. Total deals in the country totalled £6.5bn (source: LSH), almost 50% higher than in Q2 but still 50% lower than the five year quarterly average. September accounted for over 40% of Q3 deals, perhaps indicating that the market is now beginning to pick up after weakness over the spring and summer.

Surprisingly, investment activity was driven not by London but by provincial deals, where the volume of deals was down only 28% from its quarterly average. This compares with a 50% reduction in central London office transactions. Offices were the most favoured sector in the quarter where deals amounted to £2bn were recorded: industrial properties also remained in vogue with deals worth £1.9bn transacted in the three months while retail assets were again out of favour with less than £1bn transacted for the fourth quarter in a row.

Although activity was relatively muted in London, it was home to the quarter’s largest transaction, the purchase of Morgan Stanley’s headquarters in Cabot Square, Canary Wharf for £380m. The purchaser was a Hong Kong-based REIT. The next two biggest transactions in the quarter were also offices – Sun Ventures purchase of 1 New Oxford Street for £174m and Tristan Capital’s £120m purchase of Reading International Business Park. As debate continues as to the future of offices in the post-Covid world, these purchases are major statements by the purchasing funds concerned. 

Summing up, the property market enters the winter season in much better shape than at any time since the outbreak of the pandemic earlier this year. Take-up and investment statistics remain dull, but are on an upward trend following extremely weak figures over the summer. Anecdotal evidence of the amount of lettings and investment transactions also points to an improvement in the final quarter of the year. But perhaps the most positive feature to emerge over the course of Q3 was the sudden slowdown in the rate at which average property values are declining. The rate of decline in property values had been accelerating for four successive quarters. The outturn for Q3 was significantly better than those recorded over the previous two quarters and gives a glimmer of hope that the two-year decline in property values may be near an end. Whether that is the case will largely depend on the state of the economy, whose outlook is as confusing as ever. Not only do we have potential lockdown-induced weakness but we also have the ‘deal / no-deal’ discussions with the EU. It will be an interesting couple of months. 

Central London offices

With the economy struggling to regain momentum, it comes as no surprise that take up of central London office space currently remains muted, although Q3 was stronger than in the almost moribund second quarter. Vacancy rates have been rising over the course of the summer for three reasons: below average take up, the fact that new Q1 2021 completions now come into the equation and from a significant increase in tenant marketed space.

 

 

In the City and West End combined, the amount of tenant released space available for sub-leasing increased by over 1m sq ft to almost 4.9m sq ft over the course of the quarter. This amount is three times that available before lockdown and now accounts for one-third of the total amount of space available in central London. With many businesses facing unprecedented uncertainty over their futures, it can be expected that this space will continue to grow in the coming months. 

Overall take up is recovering from its earlier slumbers with September figures for the City and West End showing welcome improvement from recent months. That said, though, cumulative take up for both Q3 and for the first nine months of the year remain well below recent comparables. At just over 500,000 sq ft, the City take up in Q3 was the lowest Q3 for 16 years, while the West End take up, at just under 400,000 sq ft, was the lowest third quarter lettings this century. 

 

 

Confidence in the investment market is also slowly but surely improving. Total investment deals across the two central London office markets in Q3 amounted to £1.27bn, double that of the previous quarter, although it is still way below pre-Covid levels. The acquisition of 1 New Oxford Street at a yield of 4.2% has already been referred to, but that was eclipsed as the largest deal in the quarter by the purchase of the Morgan Stanley headquarters in Canary Wharf for £380m. Both strong statements as to the future of the office post Covid.

 

 

Capital values are still under downward pressure, but the rate of decline in Q3 was less than in the two previous quarters. Average City values fell 0.5% while those in the West End by 1.1%, bringing the cumulative fall this year to 1.8% in the City and 3.6% in the West End. Rents, though, are faltering. Prime City rents, at £77 per square foot in September are 4.6% lower than three months earlier and 12% lower than 12months ago. West End prime rents remain around £100 psf.

Summing up, the central London office market has weathered the recent storms relatively well.  Take-up and investment transactions are recovering though still well short of recent levels. While many of the statistics are moving in the right direction, the increasing amount of tenant marketed space is a worrying development. Central London offices are still vulnerable to the failure of the Brexit discussions and to the debate over the future role of offices versus home working. In the short term, further weakness in rents is likely.

All investment and take up data and statistics from Savills, unless stated; all performance statistics from MSCI; all graphs by the author.

Stewart Cowe, November 2020

Economic and Market Commentary – Q2 2020

By | News

Brexit news

Little progress has been made in recent months. Presently, there remains a few key sticking points between the protagonists, such as European access to the UK’s fishing waters and ensuring a level playing field is maintained. But given the UK’s threat to walk away from talks if no progress was visible by the end of June, the fact that discussions are still ongoing can only be regarded as encouraging.

Businesses on both sides of the Channel have been preparing for a ‘no deal’ outcome for some time and such preparations have been rendered even more complex given the equally pressing Covid related matters that are currently taking much of their attention.

Meanwhile, Michel Barnier, the EU’s chief Brexit negotiator, has issued a dossier of preparations EU businesses and citizens need to make before the end of the year.  The report advises all businesses to revisit the existing plans for a ‘no deal’ Brexit.

It has to repeated that the risks surrounding economic forecasts – predominantly on the downside -are particularly heightened at present, both on account of Brexit and Covid related matters. The threat of a ‘second wave’ of infections, or even a resumption of greater lockdown measures renders any forecasting extremely challenging.

Global economy

We closed our commentary of the global economy three months ago with the comments of the head of the IMF, Kristalina Georgieva, that her organisation’s then forecasts may well be “too optimistic”. That certainly was so, with the latest forecasts for this year and next being cut virtually across the board.

Forecasts for global growth have been cut from the -3.0% expected in April 2020 to -4.9% now while next year’s growth has been reduced from 5.8% to 5.4%.  These reductions are the result of a greater than expected hit to activity over the first half of 2020 and a slower path of recovery.

It is sobering to realise that cumulative global growth over 2020 and 2021 together is now forecast to be over six percentage points worse than forecasts made six months ago, before the coronavirus took hold. For all bar a few countries, first quarter growth was generally poorer than expected while flash data point to a more severe contraction in Q2 than had initially been anticipated – China being the exception as most of the country had emerged from lockdown by early April.

The economic crisis caused by the pandemic is often described as “unique” and in many ways it is. But in some ways, this crisis has triggered different patterns. Normally, recessions are characterised by consumers using savings to tide themselves over, meaning that consumption is less affected than investment. This time, though, both consumption and output have dropped significantly. Businesses have reduced investment owing to sharp falls in demand, interruptions to supply chains and uncertainties of future prospects. This all leads to a broad-based demand shock which compounds the near-term supply disruption caused by lockdown.

One of the key restraints to economic activity is the fact that mobility remains depressed. Lockdowns generally were at their most intense and widespread in the period from mid-March to mid-May. As economies have gradually reopened, mobility has picked up in some areas but it still remains low compared to pre-virus levels. Data from mobile phone tracking, for example, indicate that activity in retail, recreation and workplaces remains depressed in most countries, although it appears to be returning to normal levels in some areas.

Unsurprisingly, the sharp decline in activity comes with a huge hit to the global labour market. While some countries have contained the fallout with effective short-term pay schemes, the International Labour Organization have estimated that the global decline in work hours in the first quarter of this year compared to the previous quarter is equivalent to the loss of 130 million full-time jobs: the decline in the second quarter could be equivalent to more than 300 million full-time jobs.

However, there is some light at the end of the Covid tunnel. Financial conditions have eased recently and coupled with temporary furlough measures and financial support to firms, these have prevented even greater economic pain. This has been accompanied by further quantitative easing measures (and through the central banks of some emerging markets initiating QE programmes for the first time) which have improved liquidity provision and crucially limited the rise in borrowing costs.

The EU economy

Once again, Brexit negotiations have been largely overshadowed by politicians and public alike as Covid-19 dominated the headlines. Predictably, economic activity plummeted in the second quarter of the year, pushing many countries into a technical recession. For the EU as a whole, the first estimate for the Q2 GDP was a contraction of 11.9%, following on from Q1’s downwardly revised decline of 3.2%.

Like many other regions, the sharp decline in the EU economy so far has been deeper than originally expected and the forecast bounce back in the second half of the year is likely to be less pronounced. The EU is unlikely to return to its pre-Covid activity level until 2022 at the earliest and for some countries, that prospect is even further into the future.

The sorry state of European economies

Tied in with the deep cuts in economic activity has been news of the EU’s ground-breaking €750 bn package to assist countries in addressing the economic malaise caused by the virus. Agreeing the deal, though, was not straightforward. There were deep divisions between the likely beneficiaries of the package – particularly Italy and Spain – and the so-called ‘frugal four’ of the Netherlands, Austria, Sweden and Denmark. The rift between the ‘spendthrift southerners’ and the ‘frugal four’ was not simply one of money but one of potential European fiscal integration to which the four are opposed. At times heated, agreement was finally reached after four days of negotiations when a compromise was struck – limiting the amount of grants to €390 bn with the rest being provided as low-interest loans. The four also retained their budget rebates. The proposal now reverts to individual countries for ratification.

Our 2020 forecast for the EU as a whole has been cut by 2.7 percentage points from those of three months ago. The recovery next year has been raised by 1.3 percentage points, implying an overall decline since the last report of 1.4% over this year and next. Nations which are expected to fare worse over the two-year period, namely, France, Italy and Spain, have seen their forecasts cut the most.

The UK economy

The bond markets have taken the strain across the globe as countries have raised billions in order to pay for the damage to the economies wreaked by hurricane Covid-19. And few countries have borrowed quite as much as the UK. By the end of June, the cost of the outbreak had soared to £190 bn, that figure inflated by a staggering £55 bn borrowed in the month of May alone. Economists are factoring in a total borrowing requirement of around £300 bn this financial year. Before the crisis erupted, the government deficit was expected to be a mere £55 bn.

The Office for National Statistics (ONS) stated that at the end of June, the ratio of debt to GDP had increased to 100%, the highest since 1961, although it recognised that calculations are “subject to greater than usual uncertainty”.

It is still unclear how the economy performed in Q2. The monthly estimates of activity indicate that activity plummeted by 20% in April (the first full month of lockdown) with a modest 1.8% uptick in May as some lockdown measures were relaxed. The jury is at present out on how June (and hence the quarter) performed. While much hard data continues to suggest a weak recovery, some point to a much stronger pickup. Prominent amongst the optimists is the Bank of England economist, Andy Haldane, who said in late July that the economy had already recouped about half the 25% decline it saw in March and April.

Roughly 9.5 million workers (one-third of the total private sector workforce) were furloughed at the outbreak. Businesses were required to contribute to the furloughing scheme from August and the scheme itself is due to cease completely in October. At that point, not all these workers will be re-employed, despite the further incentives to do so offered by the government. Economists believe that the unemployment rate, so far steady at around 4% could well then rise to around 9% – a rate not seen since the early 1990s. The coming months, therefore, will be crucial for companies and employees alike.

One key factor taking up much of corporate decision makers’ time is that of cash conservation. Even though some businesses have managed to get through the working from home mandate with apparent few difficulties, and even for those companies whose trading was largely unaffected, that has been achieved at some cost. Remote working does not come cheap, particularly given the little notice companies had when the restrictions were announced. Couple that with uncertain prospects in the coming months, it is not surprising that this topic is so critical.

Arguably, companies were in a better financial state at the start of the lockdown than for many years. Corporate debt levels were at a 20-year low, at around 80% of GDP at the start of the year yet even that was concerning to many. In a recent (Q2) Deloitte survey of UK chief financial officers, a net balance of 40% thought that the balance sheets of UK corporates were too highly geared – the highest percentage for a decade.

Almost half of companies have less than six months’ cash reserves

This desire to conserve cash was also demonstrated by the government’s decision to halt dividend payments by the banks, to ensure that they remain as fully reserved as possible during the crisis. Given the interim results of the banking sector announced recently, showing a huge rise in the provision for bad debts, that dictate was very prescient.

But the banks are not the only sector to be feeling the economic chill. Research from the Link Group shows that the likely total amount of dividends paid by UK plc could be halved this year, and Link do not believe that there is any prospect of last year’s record amount of £111 bn paid out to shareholders being reached again until 2026 at the earliest.

 Market Commentary

A further fall in average All Property capital values over the second quarter of 2.95% was not unexpected and this decline takes the cumulative fall over the last seven quarters to 8.8%.  Already, these valuation hits are the longest since the global financial crash, where values tumbled on average by 44% over a two-year spell, but so far, the current rate of decline is less marked.  While there is undoubtedly more softening in valuations to come, we reiterate that we are not in the midst of the same financial meltdown that we witnessed a decade ago – the more limited use of debt now and consequential less pressing need for owners to sell being one reason. The fact that the economy is expected to return to its pre-crash level quicker than during the GFC is another important factor.

Where valuations are under the greatest downward pressure remains the retail sector. The travails of retailers and the retail property sector have been constant themes in this report over the last couple of years and we foresee valuation declines for many retail assets for some time to come. The restructuring of the retail industry has been ongoing for the best part of a decade and lockdown has merely accelerated these trends. Since lockdown measures were eased, a raft of retailers has announced plans to reduce the size of their estates – even well-run companies such as John Lewis have decided to close some stores – and many more chains will announce plans to trim their portfolios in the coming months.

The worst performing segment – in property performance terms – has been shopping centres: a feature neatly captured by the fate of INTU, one of the largest real estate investment trusts (REITs) and the owner of some of the largest shopping centres in the UK.  Just 30 months ago, its share price was 250p and it had entered discussions with Hammerson with a view to merging their businesses. That merger was eventually called off and since then, INTU’s share price has continued to fall just as the values of its assets have fallen. It formally went into administration in June with its shares suspended – and probably worthless.

The one bright spark in the retail has been the performance of supermarkets. While average capital values there too have fallen this quarter, it was by a minor 0.1%. As well as the buoyant trading many enjoyed during the full lockdown phase, these assets have benefited from their long long leases.

Rents are falling in all three sectors, but while retail is seeing marked reductions in rents and a sharp rise in yields, the twin effects are less damaging in the office and retail sectors.  Average All Property capital values fell 2.95% in Q2 for a 5.5% decline over the first six months. Capital falls for the market as a whole have been on a downward trend now for seven quarters, during which average capital values have fallen 8.8%.

These market falls have been exacerbated by the collapse in the value of many retail assets which have fallen by 11% on average this year and by no less than 25% over the last 2½ years. The performance of offices and industrials has been better: both sectors have only so far experienced six months of falling values amounting to just 2.8% and 1.5% respectively.

With the second quarter encompassing the lockdown in its entirety, it is not surprising that the number of investment transactions have fallen substantially. March had seen a distinct slowing from the healthy number in the two previous months, but April and May, in particular was badly affected by investors’ reticence. Although June’s figure was better, deals over the quarter totalled a mere £5.1bn, by far the weakest quarter since the GFC. Bad though this quarter’s figure is, it is worth recalling that during the GFC, total deals then were significantly lower.

Overseas investors still remain keen on UK property

With many businesses in difficulty – whether from a lack of customers, as with many retailers, or those struggling with problematic computer systems that make working from home extremely challenging, landlords have been in the firing line when it comes to rent collection. A survey by Remit Consulting on behalf of Capital Economics has been conducting an analysis of leases across the UK since 2009. Currently, the sample covers 125,000 leases, in total paying an annual rent of £9.4bn.

As would have been expected, rent collection statistics this year are down substantially from previous years.  Whereas almost 80% of rent payable was received on time last year, the equivalent figures for 2020 are much worse: 36% for the March due date and 33% for June. By 21 days after the due date, these collection statistics had improved to virtually 100% during 2019 but only to 67% for March. For the June period, the amount collected within 21 days had dipped to only 59%. Office renters were most timely about payment; almost 81% of the due rent had been collected within 21 days of the June date.  Contrast that with 48% or retailers and 33% of leisure users.

This loss of income – whether permanent or temporary we will have to wait and see – did have an impact on the IPD property market performance in Q2. Normally, when capital values fall, the income return statistic rises (as income return is calculated as [rental income received / capital value] and as the denominator falls, the answer increases). However, for Q2, such was the loss to the numerator (ie the rental income) that the division resulted in a lower answer. This could be a feature over the rest of the year as more and more companies seek to halt or reduce their rental commitments. Even so, commercial property still generates a higher income return than many competing assets, such as bonds and equities.

Summing up, the UK commercial property market has had a rough time since Covid-19 caused so many changes to normal life. Lettings and investment turnover and rent collection statistics are all down.  Industry has a major fight to cope with the ending of the furlough scheme and unemployment is certain to increase in the coming months. It is not an ideal backdrop in which commercial property will thrive. However, looking at the bright side, the economy is expected to recover relatively quickly, there is little development underway, and much of what there is has been deferred owing to working restrictions. Social distancing policies and other health issues in offices are likely to lead to more space requirements than less. But the risks remain elevated – coming from the threat of a second epidemic on the health side – but arguably, the greater risk comes from the chance of greater global trade protectionism and the possibility of a no deal Brexit. Irrespective of these risks, the retail sector will still face challenging times as its restructuring continues apace.

Central London offices

With poor levels of both take up and transactions over Q2, it is easy to regard the central London office market as one in crisis. In take up terms last quarter, both the City of London and West End segments posted the lowest quarterly lettings in a decade, while the value of deals completed has also collapsed. City investment transactions recorded the lowest three months in a quarter of a century, while the West End was buoyed by a much better June at least. In that market, there were only three lettings over 50,000 sq ft in the first six months of the year, two of which occurred in June.

Despite these exceptionally poor statistics, there has been a noticeable improvement in sentiment as we progressed through the quarter. June’s take up figures were markedly better than both those for April and May while it was a not dissimilar story with investment transactions.

Given the economic backdrop and these muted property market statistics, there was no surprise that central London office values fell again in the quarter. But the Q2 falls, of 1.1% in the City and 1.8% in the West End, were better than many had feared. Indeed, the overall fall in the All Property values was a relatively modest 2.95%. Central London office values have now been falling for six months, and it is likely that values will continue slipping until the economy picks up. It is worth emphasising that economic activity is not expected to fully recover to pre-Covid levels until 2022 at the earliest so property returns are not likely to bounce back strongly soon.

Very few letting deals in central London offices in Q2

There was little encouragement in the number and value of investment deals in Q2.  Both the City and the West End saw minimal deals in the quarter. Indeed, the volume in both markets were reminiscent of the dark days during the financial crash a decade ago. But perhaps we are turning the corner.

As well as more engagement between buyers and sellers in the quarter, and a substantial rise in properties under offer, the early signs for Q3 are encouraging.  Transactions in both the City and West End totalled over £850m: the City’s £445m in July was 5% bigger than that recorded over the whole of Q2 while the monthly total for the West End’s (£411m) exceed the combined total for the previous four months.

Investment transactions were negligible in Q2 but better times ahead …

Summing up, at first glance, take up and investment transactions were disappointing over the second quarter of the year. However, forward looking indicators such as the number of properties under offer and potential lettings are heading back up, a feature highlighted in July statistics.  Having said that, however, and despite relatively optimistic claims from letting agents and investors, the value of central London offices will remain under pressure for some time until both Covid-19 and Brexit are safely behind us.

All investment and take up statistics from Savills, unless stated; all performance statistics from MSCI.

Stewart Cowe, August 2020

 

Death of the office? We don’t think so..

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They say that necessity is the mother of all invention. Well, the Covid pandemic certainly sparked a wave of innovation created by the sudden vacation of the work place and the mass adoption of home working. Millions of us are now working from our kitchens communicating via video platforms like Zoom which as a result has, in the space of a few months, achieved a market capitalisation larger than the world’s seven biggest airlines – combined! Despite employers’ previous reluctance to fully embrace home working the feedback has, up until now, been fairly positive. The key question for real estate owners is how this experience will shape occupier behaviour in the longer term?

Humans are a resilient bunch. Necessity has required us make home working work, however after a number of months it is starting to show its limits. Many people find homeworking socially isolating, some struggle to separate work from private life and then there are the challenges of working in a cramped home with children.

Of course there are times when focused work requires solitude and few distractions, which can be achieved at home however we are social beasts and we thrive by collaborating with others and in this respect Zoom can only achieve so much.

Central to our productivity is health and wellbeing. It is estimated that more than a third of UK office workers have found working from home mentally challenging and this has affected different people in different ways. The impact of poor mental and physical health has become more apparent and risen up the business agenda in recent years. As a result, it is likely that post pandemic, occupiers will focus heavily on quality in offices in their drive to attract talent and boost productivity. At Cordatus we have seen evidence of this trend in two recent City office refurbishments. More than one new tenant cited the provision of the right amenities as the key factor in deciding to locate in our buildings.

Some commentators have described the post pandemic future of the office as bleak but its not. Its just different. Enforced homeworking has shown that people appreciate the social and collaborative aspects of office life and want flexibility. If a building offers this and boosts wellbeing in the right location it will be very much in demand. After all, you only need to look at the tech giants who have heavily invested in high-quality office buildings when they could have most people working from home. For them, getting people to work under one roof to foster creativity makes good business sense. Much the same can be said of the rest of the business community.

What about the quantum of space required? Well, the need to comply with rules on social distancing means that companies are unlikely to cut their office space as soon as lockdown rules are relaxed. In theory, businesses might actually need more office space per person. However, that assumes that companies can afford to rent additional space, which is debateable in the current economic environment. It also assumes that most staff can travel safely to the office without using public transport. That might be possible in Amsterdam, Copenhagen and Edinburgh where most people either cycle, or drive to work, but is unrealistic in major cities like Berlin, London, Paris, or Milan where traffic congestion and limited parking means that the majority of commuters have no alternative to public transport.

The real issue for most businesses is how many staff they can accommodate safely within their existing office. The answer varies according to the design of the building and whether floors are open-plan, or cellular, but space planners estimate that most offices can probably only safely accommodate between 25% – 40% of staff. It is interesting to note that in many cases this is considerably less than the percentage of staff who now want to return to the office.

In addition to social distancing, businesses also need to install hand sanitisers, remove landline telephones, arrange regular deep cleans and consider other measures such as increasing air humidity, upgrading air filters, adding more bike racks, temperature checks at entrances and mobile apps which track people within the building.

On balance, it certainly appears to be an over-reaction to assume that the office is dead, given its enduring advantages. Some businesses will be tempted to continue with large scale remote working after the pandemic and cut their office space. But we expect that the majority of occupiers will revert to prior working patterns, albeit it more people may work one day a week at home.

In our view, new technologies such as block chain, robotic process automation and voice recognition probably pose a bigger threat to the office, as they reduce the number of people working in call centres and back office administration. However, the demand for offices in city centres and close to universities should continue to increase, driven by the growth in tech, life sciences and professional services.

One thing is for sure whether you are an office occupier or an investor; property selection is now more multi-faceted than ever before and critical to investment performance.

Cordatus Opens The Doors

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Cordatus Property Trust (CPT) is pleased to announce that Leeds based door specialist The Doors Group has signed for c.22,000 sq. ft. at CPT’s Revie Road Industrial Estate, Leeds.

The Doors Group specialise in supplying doors to residential and commercial customers throughout the UK from their Leeds base.

Revie Road Industrial Estate, off Elland Road is a multi-let industrial estate comprising 59,767 sq. ft. of accommodation in 5 units.  The estate is located immediately off Junction 2 of the M621 motorway approximately 3 miles south of Leeds city centre.

Neil Tweedie, Asset Manager for Cordatus Real Estate, said: “We are delighted to be welcoming The Doors Group to Review Road which will provide them with the additional space needed for their business expansion.  CPT’s Review Road estate is now fully occupied as it continues to perform well for our clients.”

Gent Visick and CMS Cameron McKenna Nabarro Olswang LLP acted for CPT.

Cordatus Property Trust rent collection exceeds expectations

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The Cordatus Property Trust has re-instigated income distributions for the period ending 30 June 2020, having collected c87% of the March to June quarter’s rent.

It is also anticipated that overall rent collection for Q3, 2020 is likely to be around the 91% level.

Mike Channing, Fund Manager for CPT commented:

“These numbers are better than we were expecting at the start of the COVID-19 lockdown and I think vindicates our approach from the outset, which has been very much one of seeking to work with our tenants, to understand the specific issues they are facing and if necessary to agree rent payment plans that enable them to manage cash flow through these challenging times. I am pleased to report that the overwhelming approach from the vast majority of our tenants is one of wishing to meet their lease commitments.

What I have found most disappointing however is that some rent is still due from well-known tenants, some of whom have even been open throughout lockdown and who can well afford to pay their rent but have chosen not to. Nor do they deem it appropriate to communicate with us, despite our best efforts to make contact with them”.

Cordatus Property Trust was launched in December 2015 and has a smaller lot sized (£3m to £17.5m) income focus from across all the commercial real estate sectors. As at June 2020, the Trust comprises 51 properties and over 170 tenants, with its portfolio valued at over £160m.

Award-Winning Toy Retailer Signs Up At Lisnagelvin

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Cordatus Property Trust (CPT) is pleased to announce that award-winning and independent family owned retailer, Toytown, is to open a new store at Lisnagelvin Shopping Centre, Derry/Londonderry. The Newtownards based company, which employs approximately 200 staff across 29 stores is aiming to open for trade at Lisnagelvin in September. The company is now one of the largest independent toy and nursery retailers in the UK and Ireland and this store will mark the firm’s eighth outlet in Northern Ireland.

Lisnagelvin Shopping Centre is a neighbourhood centre of 111,540 sqft with 487 free car parking spaces and anchored by a 24-hour Tesco superstore and petrol filling station.

Andrew Murray, Asset Manager for Cordatus Real Estate, said: “We are delighted to welcome Toytown to Lisnagelvin as a fantastic addition to an already strong line up of retailers. We have long believed the local convenience sector to be resilient in the face of retail headwinds and this letting backs this up. Despite the disruption of the COVID-19 pandemic,  the Centre only saw a drop in footfall during lockdown of around 10% at its worst, which is a testament both to the quality of the Centre and the offering it provides. Positively too, occupational demand for the Centre has remained strong in these challenging times and we are optimistic that we will have some more exciting news to relay shortly on this front. ”

Cushman & Wakefield acted for CPT.

Cordatus partners with Coyote Software

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We are pleased to have partnered with Coyote Software to implement a new investment acquisition platform which will further improve our deal sourcing and acquisition processes. The software will allow us to pull together all the deal data we need – reports, cashflows , notes, site plans onto one platform optimising efficiencies across the team. Additionally the platform has the potential to provide us with a valuable property database for the future.

This technology is undoubtedly the way forward and we are pleased to be at the leading edge of it.

www.coyotesoftware.co.uk

 

2020 Cordatus ESG Awards – The Results!

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To much eager anticipation among team members, the results of the inaugural Cordatus ESG Awards were recently announced. The Award is presented on an annual basis to encourage asset managers to think about ESG in all their activities.

This year, two particular submissions received stood out and it was agreed that this year’s prize would be jointly awarded to two applicants.

So congratulations to Andrew and Douglas for their commitment to improving the ESG credentials of their assets and of Cordatus Real Estate.  Unable this year, for obvious reasons, to present the prize(s) in person, Mike Channing commented:

“I was delighted with the response that this year’s competition produced. The quality of all submissions was high, but the joint winners showed real enthusiasm and initiative in their well thought out and documented projects.

There is growing evidence that ESG factors, when integrated into investment management and portfolio construction, can offer investors potential long-term performance advantages and our aim is to ensure that our team is thinking about these issues as part of their day to day portfolio management”.

Amazon e-vouchers of £75 were awarded to both winners.

Economic and Market Commentary – Q1 2020

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Brexit news

Given the huge amount of column inches that Brexit has commanded over the last four years, and particularly last year, it had to be something quite cataclysmic to take it off the front pages of the media in 2020.  And not only the front pages, but virtually every page.

The coronavirus pandemic has relegated Brexit news to a mere filler in media coverage at a time when the daily ministerial briefings, the number of new infections and deaths, the transmission rate (R0) and news about how and when the lockdown might end are far more important topics and far more pressing issues for a worried population.

However, meetings between the British and EU counterparts are still taking place.  Only now, they are happening online. But that change does not seem to have helped thaw the frosty relations between the two.  Virtual meetings have not altered the impasse that shows no signs of being broken.

Progress this year has been “disappointing” according to the EU’s chief negotiator, Michel Barnier, who also reiterated that “genuine progress” and a decision on whether to extend the transition period were both needed by June. Two further rounds of talks are scheduled before the end of the transition period. Prime Minister Johnson has again reiterated that Britain will not seek an extension to the end of the transition period in December.

May also saw the start of trade negotiations with the United States. One early stumbling block is the US farmers’ desire to increase their share of the UK market. Given the British consumers’ reluctance to accept chlorinated chicken and hormone treated beef, these talks could be just as fractious as the European ones. And with President Trump wishing to go to the electorate at the end of the year with some good news, it is unlikely that the US will easily back down.

Global economy

It is incredible just how much the world has changed over the past three months.  Our previous report did highlight the problems that the coronavirus was then causing, particularly to global supply chains and specifically to the Chinese economy, but we did not anticipate how rapidly the virus would spread and how our daily lives would be impacted.

Our previous report forecast that global output this year would grow by 3.3% – dull by historic standards, but certainly positive. Now red pens have been taken to all such forecasts: instead of growing, world output is now forecast to contract by 3%, significantly worse than at the time of the global financial crash (in the worst year of the crisis, 2009, world output dipped by less than 1%). Such a forecast puts the current global situation on a par with the Great Depression of the 1930s.

It is truly a global pandemic, the like of which has not been seen for over a century when ‘Spanish’ flu was reported to have caused the death of up to 100 million. The United Nations have reported that 81% of the world’s workforce of 3.3 billion has had their place of work fully or partly closed because of the outbreak and on an even more sombre note, the charity Oxfam warned that the economic ramifications from the spread of the virus could force more than 500 million people into poverty.

Countries in the firing line have imposed containment measures which prompted shutdowns of large parts of the economy. Coupled with these measures have been huge fiscal stimuli – which for many countries were substantially greater than those during the GFC – such as providing additional funds for health services and paying part or all of affected workers’ wages. While these measures will help in the short term, this crisis is one without precedent and one of the biggest unknowns is how long any measures designed to limit the spread of the virus will be needed. We also do not know how this situation will pan out over the course of the year.

As we write, we welcome news that some countries are beginning to ease their lockdown strategies – but any easing too soon risk the return of another wave of infections. With every country at different stages of the epidemic and with no clear ending of the crisis, it is virtually impossible to quantify the extent to which economies will be hit, and for how long any particular economy will be affected.

However, and bearing in mind the above caveats, our 2020 forecasts have been slashed across the board. Expectations for the IMF designated ‘advanced economies’ have been cut from +1.6% to -6.1% (a cut of 7.7 percentage points). Few economies will escape moving into negative territory; China, the original epicentre of the virus, is likely to grow this year by only 1.2%, significantly lower than recent trend growth of around 6%. Some of this year’s weakness is expected to be made up next year, but all forecasts – for 2020 and 2021 are subject to a higher than normal degree of risk.

Worrying though these forecasts are, it is chilling to read that the new head of the IMF, Kristalina Georgieva, has admitted that her organisation’s forecasts may well be “too optimistic”.

For what it is worth, official figures show that the US economy contracted by an annualised 4.8% in the first quarter while China, where containment measures were introduced much earlier in the year, saw its output decline by 6.8% – the first quarterly contraction there since records began in 1992.  Data from the major European countries were equally as bleak.

Global Economic Forecasts

% growth pa 2019 (est) 2020 (f) 2021 (f) 2022 (f)
US 2.3 -5.9 4.7 n/a
Eurozone 1.2 -7.5 4.7 n/a
Japan 0.7 -5.2 3.0 n/a
All advanced countries 1.7 -6.1 4.5 n/a
Emerging & developing countries 3.7 -1.0 6.6 n/a
World 2.9 -3.0 5.8 n/a
Source: IMF, April 2020

Note in view of the uncertainties surrounding economic growth in the near term, the IMF has abandoned its forecasts for 2022

The EU economy

Continental Europe has been amongst the hardest hit areas in terms of coronavirus victims and deaths. Once the epidemic spread outside China, Italy and later Spain became the focal points. Italy has been particularly badly hit and the measures taken by the Italian government, similar to those taken elsewhere, of supporting business and workers, is a burden the heavily indebted country can ill afford.

The latest GDP forecasts show that the euro-area is expected to contract by 7.5% this year with a partial rebound of 4.7% growth next year. Cumulatively, the two years imply a contraction of 2.8%, compared to a previously expected aggregate growth of 2.7% over that period. As would be expected, the economies of Italy and Spain, the most affected by the virus, see the greatest forecast contractions this year: Italy by 9.1% and Spain by 8.0%. Even with a modest rebound in 2021, both these economies are forecast to contract in total by roughly 4 percentage points over 2020 and 2021.

Even northern European countries, which so far have escaped the worst of the virus, are not immune to the sharp contractions expected this year. France and Germany are expected to contract by 7.2% and 7.0% respectively although they are both tipped to bounce back stronger and quicker than their southern neighbours.

First estimates of Q1 activity already show the scale of the downturn.  As expected, the economies of Italy and Spain contracted sharply by 4.7% and 5.1% respectively. It was France which suffered the most of all the major economies, declining by 5.8% – the largest fall since the quarterly data was published in 1949. The overall figure for the eurozone was a contraction of 3.8%. These Q1 numbers – bad as they are – are just the aperitif: Q2 declines for all countries will be significantly more negative.

Eurozone Economic Forecasts

% growth pa 2019 (est) 2020 (f) 2021 (f) 2022 (f)
Eurozone 1.2 -7.5 4.7 n/a
   France 1.3 -7.2 4.5 n/a
   Germany 0.6 -7.0 5.2 n/a
   Italy 0.3 -9.1 4.8 n/a
   Spain 2.0 -8.0 4.3 n/a
Source: IMF, April 2020        

The UK economy

The magnitude of the anticipated drop in UK output caused by the coronavirus this year is matched only by that of the huge sums of money pledged by the government to ease the financial pain of business and employees together with the open-ended budget allocated to the NHS to fight the virus.

The first quarter of the year was relatively unaffected as the bulk of the strict lockdown measures were only implemented on 23 March but the collapse of the economy this (April to June) quarter will be on an unprecedented scale, and certainly greater than anything encountered in the last 100 years. Forecasts for Q2, as collated by the BBC, range from a best of -7.5% from JP Morgan to a jaw-dropping -24% from Capital Economics.  And while it may be hoped that there will be some form of recovery in the second half of the year, the initially expected ‘V-shaped’ pattern of the economy – a sharp decline followed by an equally strong recovery – now seems unlikely with more economists favouring a double-dip or ‘W-shaped’ recession involving a second but less deadly spike of infections.

Our in-house forecasts anticipate annual GDP falling by 6.5% this year. That outcome is in the middle of the BBC’s sample (which ranges from a most optimistic -3.6% (JP Morgan) to a worst view decline of 12% (Capital Economics) but such numbers are meaningless when policymakers have so little control over the spread of the virus. Epidemiologists, just as much as economists, are necessary to determine the near-term pattern of the economy.

 There is no consensus of the magnitude of the UK GDP downturn

Some recovery is anticipated next year but it will not fully make up this year’s shortfall and we expect growth of 4.0% in 2021. Taking this year and next together, our current belief is that the UK will contract by a cumulative 2.5 percentage points; three months ago, we expected cumulative growth of 2.9%. Our revised forecasts therefore indicate a cumulative hit to the economy of almost 5½ percentage points – massive in historic terms and not dissimilar to the period of the global financial crash.  Looking at 2020 on its own, the magnitude of the contraction will not have been matched since the combination of the Great War and Spanish flu ravaged the economy over the 1918-20 period.

The drain on the country’s finances will be huge; lower corporate taxes, lower employee income tax (despite the furlough scheme) as well as funds pledged to workers, companies and to the NHS. The Bank of England did cut interest rates to an historic low of 0.1% on the day of the March budget but even so the financing of all these recently announced measures is an unwelcome additional hit to an already stretched UK government debt burden. We will all be paying for this debt for some time, even if a vaccine for coronavirus is found quickly. If a vaccine is not developed soon, the costs for the UK and other countries will become even more astronomical.

 Historic and forecast UK quarterly GDP growth

UK Economic Forecasts

% growth pa 2019 (est) 2020 (f) 2021 (f) 2022 (f)
GDP growth 1.4 -6.5 4.0 n/a
CPI inflation 1.9 1.2 1.5 n/a
Consumer spending 1.2 1.1 1.4 n/a
Base rate (end year) 0.75 0.1 0.5 n/a
Source: IMF, April 2020

As we write, the government is deliberating on the precise means to loosen the lockdown measures, allowing a return to some normality and permitting many more workers to return to gainful employment. Health issues to one side, a return to work is seen as imperative as it is revealed that the government is now paying the wages of nearly a quarter of UK jobs.  As many as 6.3 million workers (23% of the UK workforce) are receiving government money through the job retention scheme.

However, it seems that not everyone believes that the economy will quickly return to normality. A recent poll by YouGov indicates that up to two-thirds of the population would be reluctant to enter gyms, pubs or coffee shops when they reopen.

Not all parts of the economy will recover as quickly

Market Commentary

News that average commercial property valuations fell by just 2.4% over first quarter of the year may have brought some relief to investors, given the extreme volatility in equity, bond, currency and commodity prices recently. But such tranquil movements in property valuations may be short lived, particularly so if the period of lockdown in the UK is longer than initially expected.

The UK announced lockdown measures on 23 March, around the time when the valuers were beginning to issue their end Q1 valuations.  While average valuations for the market as a whole, as measured by the IPD Quarterly Index, showed a further 2.4% fall over the first three months of the year, the more frequent, but less representative, IPD Monthly Index showed that March itself accounted for that magnitude of fall.

The fall in capital values seems to be accelerating

In line with many other indicators, investment interest in UK commercial property appears robust when looking at deals over the first three months of the year. At £13.7bn (source: UK Economic and Real Estate Briefing, BNP Paribas, April 2020), investment turnover was 21% higher than the equivalent figure in 2019 and in line with the 10-year average. But deals were noticeably slower in the latter part of March. It was clear that UK institutions were particularly wary of the market in Q1, being heavy net sellers over the quarter.

 Overseas investors still remain keen on UK property

The art of commercial property valuation is a highly complex and sometimes mysterious process at the best of times, involving as a crucial crutch, the availability of similar properties with which to compare. In these more challenging times, when such comparables are few and far between and when even the previously simple task of inspecting a property is often impossible, these valuations take on a much greater degree of subjectivity. In only the fifth time in the last 150 years, the Royal Institution of Chartered Surveyors have instructed valuers to impose a ‘market valuation uncertainty’ clause, thereby stating that a higher degree of caution should be attached to the valuation of individual properties. By extension, this uncertainty to value can be extended to that of funds; the reason why many unitised property vehicles have suspended trading.

Parallels with the GFC cannot be ruled out; the fall in UK output is expected to be of a not dis-similar magnitude, but we do not foresee falls in property valuation similar to that seen a decade ago. While, arguably, commercial property valuations are stretched, and have been so for some time, the extent of over-valuation is not as bad as it was in the mid-late 2000s while crucially, the industry is not saddled with as much debt, thereby ruling out the necessity of a significant number of forced asset sales. But that is not to say that there will be no distressed sellers. Cash flow problems will surface for many investors.

Share prices of REITs were falling significantly before the lockdown; such moves tend to pre-empt a similar fall in property valuations. We pointed out in our last report that rents were declining across the retail sector while rents were virtually static in the office and industrial sectors. With little tenant demand likely in this uncertain period, it is difficult to see any improvement over the rest of the year at least: consequently, we expect rental declines across most of the market to continue in the coming months.

Average capital values in all three sectors are now declining

The retail sector will continue to see the sharpest valuation markdowns. Already we have seen a slew of retailers wishing to engage in “rent discussions” – a euphemism for at best rent deferrals or in some cases a rent reduction – some have announced further plans to downsize their portfolios of outlets, while some (most publicly and most strikingly, Primark) have revealed they have sold nothing since the lockdown. Some have requested changes to the frequency of rent payments – from quarterly to monthly – and in some cases, further concessions from monthly in advance to monthly in arrear. In an ideal world, the total rent paid under these new arrangements over the term of the lease would be unaffected, even if the timing differs, but the world at present is certainly not ideal, and some businesses will collapse before the lease ends.  It is inconceivable to believe that this sector will not continue its downward repricing over the coming months.

While it is tempting to consider that commercial property is currently competitively priced against other asset classes, given its yield premia, such an argument ignores the risk factor of tenant failure (or the reduction in rent demanded by a struggling business). This risk has never been higher and until business returns to some form of normality, this risk will remain and perhaps increase. Rarely has a portfolio’s covenant strength been so important and rarely will that of a tenant be subject to such rapid change. Businesses with reduced or minimal sales coupled with the ever-present, if perhaps temporarily reduced, overheads are not all going to come through the coming months unscathed and some, at least, will fall by the wayside. Many previously profitable entities will suffer heavy losses and at best may be forced to downsize their operations, or at worst face collapse.

The key question facing investors is how long the current exceptional period will last. If things get back to normal (or near normal) soon, and by that, say over the next three to four months, then hopefully not too many businesses will fail. If it takes much longer, we can expect a significant number of company failures, empty premises and with little demand for that space. That gloomy scenario is a reminder of the deep recession in the early 1990s.  It was initially anticipated that it would be a ‘short-sharp’ recession, one in which most companies could weather the storm; in reality, it proved to be one of the deepest and longest lasting recessions in history, wiping out numerous companies and driving vacancy rates up across the board. That period was exacerbated by a continuing development boom, which thankfully we are spared at present, but those with long memories will not want a repeat of that period.

The portfolio of the future

Much is being written about the possible winners and losers in the commercial property field: will internet/click and collect finally kill off the high street as we know it?; will there be even more demand for distribution warehouses?; what will be the optimum size of office and how should the configuration of the workspace look post crisis? Everyone will have a view about these and a myriad of similar ‘strategic’ questions.

Terry Smith, chief executive of Fundsmith LLP and star equity stock picker cautions on over-analysing the situation. In an article published in the Financial Times at the end of April, Smith believes that needless analysis is conducted on speculating on what will happen – when will the lockdown end?; what will happen to the travel and hospitality industry?; who will be the winners – makers of disinfectant and masks; drug companies? – and so on. This over-analysis sentiment, I believe, can be carried over to the commercial property market. The key question facing property fund managers just now is how secure are the tenants in one’s portfolio? At this stage, no one really knows. Covenant strength analyses are backward looking anyway. This crisis is dynamic in nature and seemingly strong businesses can collapse tomorrow. Even if one could identify potential tenant defaulters, how easy is it to remove that tenant from one’s portfolio? By selling the asset? By engineering a tenant replacement?  In this market, investors are as wary about investing in dodgy tenants as you are.

I believe that fund managers must resist buying into the latest fashion, e.g. buying properties with pharmaceutical tenants or selling those with travel agents on the lease. Rather, seek to maximise one’s income from the existing portfolio – and that may include accepting reductions in rent from certain tenants, particularly if these reductions mean the difference between collapse of the business and survival.

It is easy to predict that the retail sector will remain out of favour with investors.  The current crisis is merely accelerating a process that started over a decade ago and which has manifested in significant valuation declines already. It is also tempting to think that the industrial sector will also continue to benefit from the growth of distribution centres. But here, be wary of the yield; traditionally, industrial assets commanded significant yield discounts to the other sectors – now they stand at premia to the others. It is perhaps the office sector where the biggest debate ensues. What will be the optimum size, configuration and location of tomorrow’s occupiers? Will these discussions go the way of ‘hot desking’ which was thought to be the way forward 10 or 20 years ago but never really crystallised? Or will social distancing rules in the workplace dictate larger floorplates per employee? These are the debates landlords should be planning to have with their tenants, if not now, then when the crisis subsides. These discussions crucially should involve developers, not just at the stage of letting, but during the planning and construction stages too.

Central London offices

Not surprisingly, the short-to-medium term outlook for central London offices has changed dramatically since our last report three months ago.  We had noted the effect of the ‘Boris bounce’ in both business and consumer confidence which suggested that this momentum could well feed through to both occupier and transactional markets this year.

Indeed, there were signs of this happening in January, February and early March, although there were mixed fortunes for the City and West End markets in terms of take-up to that point. Hopes of a strong March were dashed when the full extent of the UK’s lockdown response emerged. In both markets, take up in March collapsed compared to the same month last year: take-up in the City, at just under 500,000 sq ft, was down 22% on March last year while the West End saw an even more dramatic 63% fall. Prior to March, the fortunes of both markets differed: City lettings an impressive 71% increase for the first two months of the year compared to the January and February 2019, the West End down by over one quarter. Part of the West End’s modest take-up figures is simply because there is very limited available stock for interested occupiers with current vacancy rates hovering around the 4-4¼% mark.

Central London office take up – mixed fortunes for the City and West End

There was a clearer picture when it comes to investment turnover. Transactions were already suffering the investment jitters – for example, equity markets were exceptionally volatile for much of that period. The volume of deals was already down even before the lockdown was announced. Transactions in the City and West End office markets over Q1 fell to £1.35bn and £1.05bn, down 38% and 10% respectively on the equivalent figures last year. Caution should be taken with the City figure as last year’s Q1 total included the £1bn Citibank purchase of 25 Canada Square last March.

City investment turnover collapses in March

Most of the March deals had been initiated well before the severity of the lockdown measures became apparent. Consequently, there were few deals started in the closing two weeks of the month. With many investors content just to wait and see how the landscape lies, with the timeframe and severity of the trauma to the economy still unknown, and with widely differing views as to the value of property assets in this environment, it is clear that transactions in Q2 and perhaps over the rest of the year will be severely reduced.

While new lettings may be more challenging to find in the short term, the one benefit brought by the lockdown has been the inevitable delays to the development pipeline, which will produce further constraints on future supply. This will particularly affect occupiers wishing large premises, where current options are extremely limited.

Central London office values fell in Q1, reversing a ten-year upward movement. Bar a sharp pause at the time of the EU-referendum in 2016, values have been on an upward trend since the end of the GFC-induced correction in 2009. Since then, average capital values had risen by 110% in the City and 88% in the West End before the Q1 fall of 0.2% and 0.8% respectively. It seems unlikely that values will pick up again over the course of 2020, but the underlying, if temporarily dormant, demand for space and the limited development ongoing at present should limit any further falls in valuation.

Central London office rents are falling

While the short-term prognosis for central London offices has deteriorated since our last report, particularly on account of the virus (and Brexit uncertainties are not helping), fundamentals remain relatively positive. Underlying tenant demand is strong even if letting deals are quiet just now while the delays to development completions reduces the amount of space available. Nevertheless, office values in London, like most other commercial property markets are going to have to weather some dull quarters before both the investment and occupier markets recover.

All investment and take up statistics from Savills, unless stated; all performance statistics from MSCI.

Stewart Cowe, May 2020

Cordatus Real Estate secures detailed planning permission at Littlehampton

By | News

Cordatus Real Estate on behalf of Cordatus Property Trust (CPT) has secured detailed planning permission from Arun District Council for the development of four new commercial units (Use Class B1, B2 or B8), at their holding at Minster Court, Littlehampton.

The estate currently comprises ten single storey industrial units built in the early 1990s in two terraces, containing five units each, totalling 2,369 sq. m (25,500 sqft). The approval will allow for an extension to the original terraces by a further 1,200 sq. m (c. 13,000 sqft) with two new units to be added to each side.

Andrew Murray, Asset Manager for Cordatus Real Estate, said: “We are delighted to confirm that our proposals have been approved, making it a very positive start to the year. The development is ideally placed to benefit from a lack of suitable industrial stock in the area and we have already received strong interest in the units.”

Stiles Harold Williams (SHW) acted for Cordatus in securing the planning approval.