This article was sponsored by Savills Asset Management.
An emphatic general election result for the Conservative Party in December 2019 finally saw some stability return to UK politics. And one noticeable side effect is that investor sentiment in the UK market has spiked in the weeks since. But in this transition year, much work has yet to be done to fine-tune a formal trading relationship between the EU and an independent UK. All eyes will be on how the negotiations between the two sides develop over the next few months and, critically, whether this renewed investor positivity can be maintained.
PERE’s Noella Pio Kivlehan talks to Harry de Ferry Foster, co-head of UK at Savills Investment Management, and fund director for The Charities Property Fund, to get his expert take on how the UK real estate market will stand up immediately post-Brexit and throughout 2020.
What does Brexit certainty mean for the UK private real estate market?
Since the 2016 referendum, the market has been subdued – there is no doubt Brexit has restricted new development and decision-making in recent years. In 2019, for example, we had tenants wanting to lease buildings, but in the eleventh hour they just could not get sign-off or they did not have the money to expand or invest. But we have more certainty now.
More positive sentiments started to come through in the middle of January. A CBI industrial survey recently recorded the biggest quarterly swing on record in business confidence since the CBI started conducting the survey in 1958. House building shares are also up 20 percent since December’s general election.
It will be interesting to monitor how this translates through to the wider business community and, of course, to property investment, and how long it lasts. We might have a very good first six months in 2020, and then everyone will realize a trade deal still needs to be done with the EU, which might dampen the initial optimism we have seen at the start of this year. I hope that the UK government will reach a sensible deal with the EU, one that is not too far a departure from the trading relationship we have now, because business generally is afraid of a no-deal Brexit. Businesses like to be able to plan, but a no-deal scenario would make it more difficult to do that.
But at this point, sentiment has improved significantly, and I am optimistic for 2020.
How does the UK commercial property market fare against other core markets in Europe? Will UK property be a favored destination for institutional money?
In 2019, there was £23 billion ($30 billion; €35 billion) of foreign investment into the UK property market, and about £40 billion was traded in the UK, which was down from around £50 billion in previous years. We certainly expect these figures to increase this year. The US is by far the largest market for real estate investors. Germany is second, but not by much more than the UK, while the French market, for example, is still mainly dominated by domestic investors.
So, the UK commercial property market is still a favored destination for institutional money with Singaporean, Korean and now German investors particularly eager to get exposure. Since the election, enquiries have increased from Hong Kong, Germany, the Middle East and Israel. London and the UK are finally back on the agenda.
A lot of this interest is driven by income. In the UK, we have gilt rates of 0.5 percent, while government borrowing rates in the likes of Germany and Switzerland are negative – a third of all government rates around the world are showing negative yields. So, we are still seeing a real demand for income-producing assets. Interest rates are also going to continue to be very low for some time yet – in January it was announced they will remain at 0.75 percent – and with inflation and GDP growth also low, having property assets yielding at plus 5 percent is going to be exciting for investors. Further, pension funds still have only got 5 percent exposure to UK real estate, so we may well see them looking to increase that.
Is the perception that the UK commercial property market is too London-centric a fair one, or can investors find good opportunities across the regions?
There is little point trying to deny London’s strength and appeal to investors. The capital generates 25 percent of the UK’s GDP and it is the largest city in Europe, so it has a disproportional effect on the UK economy, and this filters through to the commercial property sector too.
For London, it has been a virtuous circle because it is the political, financial, cultural and technological center, and its where there is occupational demand. However, if prices become too expensive, people move elsewhere. Manchester, Bristol, Leeds and Birmingham are all doing very well, partly because house prices are lower and the cost of setting up businesses is lower. Investors are all about the opportunities, but one of the problems is that while institutions like investing in these cities, the investable stock is limited. Investors end up competing for the few large, super prime offices that exist in these regional centers and as they get hotly contested, investors simply will not get a discount. Occupiers will locate to the regions if it is cost effective – rents and rates are cheap – and the labor pool is good, and that will be supported by housing affordability.
As we all know, the retail sector has been struggling globally. What is your assessment of the state of play of this segment of the UK real estate market? Has the bottom been reached?
Retail makes up 25 percent of all property assets in the UK, but it is not currently on many investors’ shopping lists. But there are funds being set up to target retail – private equity firms like Delin Capital Asset Management and Orchard Street have established small retail warehouse funds with around £250 million ($324 million; €297 million) each of capital to deploy.
Essentially, there are two different retail markets – the high street and out of town. The high street remains unattractive because of falling rents, which need to fall further. Of course, the sector has been hit by many problems, such as the internet and the might of Amazon. And a lot of shopping centers have been built in the UK, so oversupply is a big problem now, too.
The high street is not yet ripe for the picking. But it will improve once rents have fallen. It will take time, however, for rents and rates to rebase. Plus no one will be building any retail units because there is simply too much supply.
One area of this market we do like at Savills Investment Management is out-of-town retail warehousing with its relatively affordable rents. Units are let to convenience and discount retailers like Home Bargains, B&M, Iceland Food Warehouse, Aldi and Lidl’s – these tenants are paying rents of around £13 per square foot. They also benefit from free parking and will increasingly benefit from electric car charging points. These discounters tend to sell products you would not buy online and because the rents and rates they are paying are much lower per square feet than those paid in the high street, they are sustainable. This compares to the fashion parks, where the rents are in excess of £50 per square foot in some areas.
From an investor perspective, what other property sectors in the UK are looking attractive?
The office sector is still a good opportunity to invest in currently. Savills Investment Management has just bought an office building in Cheltenham – GCHQ (Government Communications Headquarters) has expanded massively in the town and numerous cybersecurity companies have also based themselves there, and this is generating a lot of demand for office space. On top of which, much secondary office space has been lost through Permitted Development causing a shortage.
Logistics take-up remains good. Internet penetration from retailers continues to grow, albeit at a slower level than in the past, so logistics still has a place. We continue to see demand for just-in-time and next-day delivery.
In the residential space, interest centers around build-to-rent and the private rental sector. But BTR is still an embryonic market and difficult to invest in. Some private real estate managers have said they would build lots of BTR, but have found themselves having to compete with house builders for sites. Unfortunately, developers are overpaying for sites on the basis they are going to get great rental growth, but I struggle to see how they are going to get that if they have paid too much in the beginning, so returns may be disappointing. Nevertheless, investors are expressing interest in these assets, but returns are likely only going to be around 3 percent per annum.
Savills Investment Management favors assets in the office and logistics sectors, particularly in the main urban centers and greater south east of England. Plus more established ‘alternative sectors’ including hotels, serviced apartments and data centers.
A view on ESG
PERE’s Investor Perspectives 2020 Survey findings indicate investors could be doing more to prioritize this issue in their due diligence. But Harry de Ferry Foster sees real progress being made
ESG is massively important and it is almost overtaking traditional investment returns as the top priority in some areas. The Charity Commission, for example, recently suggested that charities should look at putting their spare cash to work regardless of returns and should expect to receive lower returns by doing good rather than trying to maximize investment returns. We are getting the big money managers saying to us, ‘If you do not have an ethical, sustainability policy then you are not even going to be on the list to invest in.’ And I believe this sentiment is only going to strengthen in the years to come. Everyone – private real estate managers and institutional investors included – is going to want to appear that they are doing something and, further, to work to be actually doing something.