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An investor’s view on UK commercial real estate

We begin 2021 with the covid-19 vaccine rollout underway and a real prospect of light at the end of the tunnel.

As the vaccination programme works its way through the population, beginning with the elderly and most vulnerable, we can look forward to social distancing restrictions being eased to the point where life starts to resemble a return to normal.

In addition, the long and arduous Brexit process has now concluded.

Pending any major disruption during the initial phase of our separation from the EU, and once the current national lockdown is over, the outlook for the UK economy looks rather brighter, writes Michael Morris, chief executive of Picton Property Income.

Continued government support and household savings point to an economic recovery

The UK government’s furlough scheme will continue to protect jobs until at least April 2021, putting a lid on rising levels of unemployment.

Retail sales have already bounced back to pre-pandemic levels and the UK household savings ratio is at a record high.

After the third lockdown comes to an end, economic recovery is expected to gather pace over the second quarter and into the summer, driven by healthy consumer spending driven by pent-up demand, interest rates staying lower for longer, and low inflation.

Covid-19 accelerated a re-pricing of commercial property sectors during 2020

Low interest rates and low returns from government bond yields make investment into well-let commercial property with a secure income stream, an attractive proposition.

UK commercial property looks competitively priced on a global level, with Brexit uncertainty and retailer distress priced in.

The market has already undergone a period of correction, with capital values at an aggregate level falling 6.0% for all property in 2020.

Polarisation between sectors has never been more pronounced, making sector allocation paramount to performance.

Industrial property rallied in 2020, helped by demand for logistics assets driven by the acceleration in online retail spending.

Office capital values have declined amid the reassessment of requirements and limited short term demand caused by widespread working from home during the pandemic.

Ongoing structural changes continue to adversely affect the retail sector.

Outlook for the industrial sector remains strong

2020 was a bumper year for the industrial sector, which saw strong occupational demand, particularly of logistics units, as retailers and third-party logistics companies invested in fulfilment of online orders.

The proportion of retail spend online reached highs of 36% in the UK during 2020 and is not expected to fully revert to pre-pandemic levels.

Last mile and last hour logistics requirements have sustained upward pressure on rents in urban locations.

The sector is also experiencing strong investor demand, with capital values increasing 4.0% in the year to December 2020.

The outlook for the industrial sector is a continuation of these trends, and outperformance of the all property average.

Office workers will return to the office

There is a widely mooted structural change in motion for the office sector, with office workers proving during the pandemic that working from home is a viable option.

Many companies are likely to incorporate an element of flexible home working post-pandemic, but the office is by no means redundant.

Office workers are looking forward to no longer ‘living at work’ once restrictions are lifted.

Innovation, collaboration and creativity all favour face-to-face interaction, as well as training and mentoring opportunities, introducing new team members, winning business, and starting new projects.

In the future, this is likely to lead to less desk and more collaborative layouts and may enable occupiers to think more about quality rather than quantity of space.

Vacancy rates have risen but remain low by historic standards, and with limited new supply in the pipeline it is not expected that rental values will suffer more than a short-term dip.

Be careful not to lump all retail together into one basket

There is no doubt that 2020 was a defining year for the retail sector, which saw a record level of distress in the form of CVAs and insolvencies.

In the UK, two national lockdowns closed all non-essential retail for a total of over four months during 2020; an extraordinary blow to bricks and mortar retailers already suffering rising costs and increased competition from online.

The sector has already seen a price correction, with capital values down 16.8% in 2020 and rents falling 8.7%.

There is much debate over when the sector will reach the bottom and the pace of recovery.

When considering overall retail sector performance, it is important to draw distinction between the subsectors.

Retail warehouses typically benefit from high carparking ratios and have little reliance on public transport. This coupled with larger floorplates and the ability to configure a more spacious layout lends well to safely operating during the pandemic.

Retail warehouses began to gain momentum in the investment market in the second half of 2020 and we expect investor appetite to increase in the short to medium term.

The outlook is less rosy for town centre retail, where rising vacancy rates following the wave of CVAs and liquidations are more prevalent.

The UK government’s change in use class restrictions during 2020 will gradually allow repurposing of retail space and tackle the demand/supply balance in the longer term.

Until the oversupply of retail space is addressed in town centres, we do not expect to see a strong recovery in capital or rental values.

Notwithstanding, footfall is set to improve as the vaccine rollout allows social distancing restrictions to be eased, hopefully relieving the pressure on the retailers who manage to weather the storm.

2021: Continued divergence of returns driven by sector and location

Michael Morris

There is a marked range of returns across sectors and locations; the devil is in the detail.

The strongest performing funds will have a high weighting to the industrial sector, a low exposure to high street retail and be focused on safeguarding and enhancing income, and capitalising on opportunities to add value.

Flexibility and agility will be key to adapting to changing market conditions.

This article was written for Expert Investor by Michael Morris, chief executive of Picton Property Income, a UK Reit.

Part of the Bonhill Group.