Australian economic and property outlook
Research | 5 minute read
Activity, from both occupiers and investors, in the UK’s office sector recorded a relatively positive Q2 amidst the continued Brexit haze. While political uncertainty has tempered market activity, deals are being done, prime yields are at, or close to, historic lows, supply-strapped markets are seeing an uptick in headline rents and the resilience of the UK office market is evident.
Addressing the uncertainty of Brexit head on, there were inevitably some companies who decided to move some of their operations away from the UK when the outcome of the 2016 Brexit Referendum was announced. Further, there are some that have decided they cannot live with the continued delay to the outcome of Brexit and have relocated some staff. Finally, there are some companies that are looking at their structures and where their personnel are based and restructuring, unrelated to Brexit.
However, there are some, possibly overlooked headlines of positive job creation and investment banks buying their headquarter buildings. This further demonstrates the resilience of not only London, but the UK market as a whole. Unemployment is at its lowest level in a generation, which is finally seeing some real wage growth. Immigration levels might be lower than in the recent past, but the working-age population will still expand through natural increases and further rises in the state pension age.
The UK is in a leading position in several service sectors such as financial and business services. Additionally, according to JLL’s ‘Innovation Geographies’ report, London has the highest concentration of talent in the world due to its leading universities and a highly-educated workforce.
GDP growth is expected to reach 1.3% in 2019, stronger than the Eurozone average, suggesting a subdued but nonetheless encouraging level of confidence in the economy given the political situation and lack of a definitive outcome of Brexit. The latter will continue to deter some business investment until the UK’s future trading relationship with the EU becomes clearer, but businesses must continue to operate and cannot, therefore, take no action.
The UK real estate market offers size, diversity of product, depth of investors and breadth of occupiers all of which contribute to its appeal. Additionally, liquidity, transparency and high-quality stock in large lot sizes makes it one of the most significant markets in Europe.
In 2018, over £60 billion transacted, approximately 20% above the ten-year annual average. Both 2017 and 2018 trading volumes were above those of Brexit-year 2016, unlike the dramatic falls in activity following the GFC in 2008, after which volumes took at least five years to recover to pre-crisis levels.
In 2018, the office sector accounted for a 40% share of activity. £8.2 billion was invested into UK offices in H1 2019 – mirroring the expected slowdown following the decision to extend the Brexit deadline to October, and partly due to the flurry of deals that closed in the final quarter of 2018.
First-half activity was boosted by a couple of megadeals in excess of £1 billion, including Citigroup’s acquisition of their head office building in Canary Wharf. Stripping out mega deals, the strength of demand, supported by robust occupier market fundamentals continues to see a significant amount of capital allocated to UK real estate. Overseas investors are expected to continue to take advantage of the favourable exchange rate, looking for long-income deals as they prepare to hold through the current late-cycle environment.
2020 is expected to see somewhat of a rebound in GDP growth (1.6%) when greater certainty should return, stabilising market dynamics and possibly pushing prices up further, especially if the lack of quality supply remains a feature in key office centres. The low interest rate environment is likely to be around for longer as the Monetary Policy Committee (MPC) will not want to raise interest rates until the Brexit route ahead is clearer, so no hikes are expected until May 2020, and gradual thereafter.
This has highlighted the desire for prime product, and with limited amounts coming to market, investors are being forced up the risk curve which, in turn, is seeing key regional cities in the UK provide some solution as they hold a premium over London. In addition, there is rising interest in the value-add/opportunistic space with investors aware that the restrained pipeline, particularly evident in London, will result in a supply gap in 2021 – 2022 and are therefore targeting development opportunities.
With limited distress evident and vendor expectations on pricing remaining high, some deals are being held back. There is, however, a noted rise in risk-aversion among some investors given the political landscape. Due diligence is tending to take longer as the market has reached a mature stage of the cycle, which is also impacting on lower investment volumes.
Simply, investors are taking a more considered approach. There is some, albeit limited, evidence that yields are beginning to soften in some secondary markets, which will present opportunities for investors willing and able to take a possible capex, long-term position.
The investor base remains broad, and looking back over the past 12 months, domestic buyers remained active (36%) with Asian buyers the next largest group, specifically capital from Singapore and South Korea. Different capital sources are seeing opportunities in different areas.
London, Europe’s leading gateway city, retains its crown in the UK office market, consistently attracting around 75% year-on-year of total capital inflows into the office sector. Manchester and Birmingham round out the top three spots. Private equity is more attracted to value-add opportunities with a focus on London, while longer-term capital such as Korean, is buying into the growth story of the stronger performing regional cities.
Fundamentals are robust by and large, with performance primarily driven by the lack of supply across key centres and supporting rental growth, especially at the quality end of the market. Development activity is increasingly constrained, with pipelines limited in a number of key locations. This does, however, present opportunities for the redevelopment and repositioning of secondary stock as companies continue their ‘flight-to-quality’ strategies.
Vacancy in London is 4.25%, having declined since the beginning of the year despite a slower Q1 2019 in terms of take-up, with Q2 seeing a more robust performance. More stock is coming through, with an estimated 13.2 million square feet (1.2 million sqm) under construction, but this is unlikely to dramatically impact the level of availability as around 55% has already been let or is under offer.
Active demand is also holding up well against the political headwinds, and at approximately 3.7 million square feet (344,000 sqm) is above the ten-year average of around 3.0 million square feet (279,000 sqm), suggesting the slower start to the market is not here to stay and a pick-up in activity will follow in the coming months.
With that said, there are further reasons for optimism. Both the professional services and technology sectors are forecast to account for the majority of London’s GDP growth in the next five years, which should translate to a need to increase headcount. Oxford Economics highlights other positives for London, including the continued high performance of London’s universities and colleges, an unusually young population, flexible labour market, and relatively easy access to finance. These strengths should help counteract the negative impact from Brexit as well as the threats to the global economy.
Regionally, 2.34 million square feet (217,000 sqm) of space was let in Q2 across the ‘Big Nine’*, bringing the half-year total to 4.3 million square feet (399,000 sqm), 10% above the long-term average. Activity was heavily focused on larger deals, quality space in city centres and flexible space. The technology sector was very active while there was a retraction from traditional sectors such as financial, professional and business services.
The UK may not be for all investors at the moment, but there are opportunities to be had. The UK continues to attract capital despite the backdrop of political uncertainty and a slower economic environment. For those that are taking a longer-term view and can see through the noise, supply constraints and a lack of speculative development remain key drivers of performance.
While transaction volumes are down, loan-to-value ratios and debt levels are lower than before the GFC, meaning any disruption due to Brexit is likely to be relatively limited, particularly for long-term investors.
Landlords need to be creative and flexible. The way that office space is being used is changing, and owners and investors need to be open and responsive to these changes while looking to preserve income streams. The war on talent continues and the need for companies to tap into talent pools and having them accessible to transport infrastructure is increasingly important, as is the need to provide services and amenities in the office that were unheard of ten years ago.
Technological advancements, supporting the changing needs and lifestyles of employees and facilitating the rise of small businesses, as corporates strive to facilitate a productive workforce, are boosting the need for flexible space. In addition, the desire from larger corporates to have space they can expand into and divest from at short notice is more prevalent in today’s world than ever before.
Co-working space is gaining prominence amongst flexible operators. Conventional landlords are making a move to enter the market as well, rather than simply rent their buildings to flexible operators, they are looking to take a share of the profits.
Flexible workspace providers remain an important driver of leasing activity, accounting for 15% - 20% of office take-up in the UK capital over the past three years. The UK is also an important and growing market for flexible workspace solutions, with the concept being increasingly adopted with new entrants to the market alongside the established providers. Currently an estimated 5.1% of Central London’s office stock is occupied by flexible workspace operators, up from just 0.8% in 2008.
Given their success in meeting the needs of their customers, this trend is here to stay.