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REAL ESTATE: An Introduction

Contributors:
Bryan Cave Leighton Paisner LLP Logo
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The real estate market staged a recovery in 2017 as it emerged from the aftermath of the EU referendum in June 2016. Factors such as the weak pound and the safe haven status of certain elements of the UK market drove overseas investment, including in prime London assets – the obvious ones being 20 Fenchurch Street (the Walkie Talkie) and the Leadenhall Building (the Cheesegrater). 2017 also saw record rental and capital growth across much of the logistics and industrial sector, whilst the office occupier sector remained resilient and other sectors such as Build to Rent, hotels and healthcare performed well.

The outlook for 2018/19? The ongoing Brexit negotiations continue to undermine economic growth. At the time of writing it is unclear what kind of Brexit the UK will experience. It is also uncertain if a further referendum or general election is on the horizon. Other factors of equal or greater importance are also at play – the end of the current market cycle is upon us and the market faces structural shifts resulting from technological advances and changes in the way people work. Although the UK real estate market continues to face a number of challenges, there are opportunities in the year ahead.

The UK real estate market remains attractive to domestic and overseas investors. In the investment market, the move to prime stock continues, with 2018 witnessing the sale of 5 Broadgate for £1 billion and the acquisition of 14 Cabot Square in Canary Wharf for £460 million. Although the pound may have recovered, overseas investors from Asia (especially Korea and to a continuing degree China) are still attracted to the UK market. However, the consensus appears to be that investment activity will remain steady but unspectacular in 2018/19. One of the issues that faced investors (especially domestic ones) in 2017 remains – although debt and equity are available, demand outstrips supply and pricing expectations flow from that. It is possible that 2019 may see a softening in pricing expectations, especially if economic growth stalls further, if there are increases in inflation or interest rates, or if overseas interest cools. Investors may also need to become more inventive in pricing and/or how they structure transactions. Although the Hammerson/Intu merger collapsed in early 2018, will 2018/19 witness a major merger or takeover in the market (given that NAVs are trading at a discount)? As for overseas investors, the scope and full impact of the Finance Bill 2019 and the requirement for overseas investors to pay capital gains tax on disposals of UK property and property rich entities remains to be seen.

The office occupier sector has remained relatively resilient to the challenges facing the UK market. Generally, the outlook for the office market appears stable over the next six to twelve months. Demand outweighs supply in London and in most of the 'big six' cities (in Manchester, for example, rental levels have reached record levels as a result) and vacancy rates are relatively low. The bigger picture across the sector is that rental growth and especially capital growth will continue to slow in 2018/19. Secondary stock is likely to struggle and landlords face other challenges, such as compliance with the Minimum Energy Efficiency Standards (MEES).

However, 2018/19 is expected to see a continuation of the emerging trends in this sector. The impact of technology (where greater control is devolved to the end user) and the rise of flexible working and co-working are forcing the sector to adapt. Occupiers are increasingly looking for space that enables it to attract the best employees and provide a positive experience (such as Media City in Manchester). The continued economic uncertainty, changes in working habits and the introduction of IFRS16 mean that occupiers of varying sizes are also looking for greater flexibility or alternative approaches in respect of overheads, fit-out costs, lease terms and expansion/contraction options. The result is that real estate is likely to become less of an asset and more of a service in many ways. WeWork has continued to expand in 2017/18, and is now the largest corporate occupier in central London. Others are also responding to the trends, such as the developers of 22 Bishopsgate, and more will need to do so in 2018/19. Although it remains to be seen how the serviced office model will fare in a downturn, it is clear that structural changes are well under way in this sector and will continue in 2018/19.

Retail, the sector that has been impacted most by technology, is expected to face a tough twelve months due to economic uncertainty, e-commerce and increases in business rates. CVAs and, to a lesser degree, profit warnings, in relation to anchor tenants such as House of Fraser, John Lewis and Marks & Spencer are disconcerting. Retailers will continue to struggle over the next year as they look to realign their businesses. There is a clear dichotomy in the market between prime (especially those in good locations that proactively focus on consumer experience/place-making) and secondary assets. The market view is that rental growth is only forecast in prime Central London retail assets. Broadly, the investment market is likely to remain flat, with the possible exception of investors seeking long-term income and local authorities seeking to acquire strategic assets as part of a wider regeneration plan (such as Canterbury City Council buying a 50% stake in the Whitefriars shopping centre for £75 million, having already acquired 50% in 2016 for £80 million). Could 2018/2019 be the year in which landlords successfully challenge a CVA? Or should the focus be on the cause and not the symptom?

A clear beneficiary of the advent of e-commerce and impact of technology is the logistics (including last mile logistics) and industrial sector. Rental and capital growth in this sector is expected to continue in 2018/19, with an undersupply in London and other key areas. In the past year, domestic and overseas investors seeking income growth have acquired prime assets such as the £20.8 million acquisition of Orchard Business Park by Royal London. However, the market could cool in 2019 if yield compression continues. It also remains to be seen how the shortage of stock can be addressed, especially if Brexit necessitates greater supply. Will investors begin to focus on mixed-use industrial schemes in 2018/19?

Investors are also expected to continue their focus on “alternative” sectors and asset classes in order to seek value and returns, with the focus being on longer-term income-producing assets. Despite the anticipated fall in student numbers, student accommodation remains popular but location and affordability are key. Investment in the healthcare sector (especially elderly care and retirement living) is expected to grow in 2018, whilst performance in the hotels sector is likely to remain steady. Other alternatives such as data centres, education, science parks, storage and power/energy are also likely to remain popular in 2018/19.

The consensus is that the residential market will continue to struggle across the board. However, the Build to Rent sector is likely to remain popular in 2018/19, including investment across the UK. The most recent example of this is Oxford Properties’ acquisition of a £600 million stake in Get Living. As we continue into 2019 and beyond, we will see Build to Rent developers and operators move away from the idea that renting is just for millennials, and increasingly focus on delivering homes for a diverse range of consumers, such as the over 35s, families and those reaching retirement age. As such they will need to look to deliver innovative, flexible schemes that can be shaped to the needs of a wide variety of end users.

With the market expecting annual total property returns to decline through 2018/19, it is clear that the real estate market is facing a challenging time. However, those that are flexible and prepared to adapt will approach 2019 with cautious optimism.