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DTZ Foresight
UK Fair Value Q2 2011
Widening yield gap raises scores
23 August 2011
Contents
Overview 1
Fair Value Index 2
UK market classifications 4 UK versus global forecasts 5 Office market forecasts 6 Retail market forecasts 7 Industrial market forecasts 8
Economic drivers 9
Authors
Ben Burston
Forecasting & Strategy Research +44 (0)20 3296 2296
[email protected] Zubaer Mahboob
Forecasting & Strategy Research +44 (0)20 3296 2312 [email protected]
Contacts
Martin Davis Head of UK Research +44 (0)20 3296 2304 [email protected] Tony McGoughGlobal Head of Forecasting & Strategy Research
+44 (0)20 3296 2314 [email protected] Hans Vrensen
Global Head of Research +44 (0)20 3296 2159 [email protected]
The DTZ Fair Value Index
TMscore for the UK stands at 50,
indicating that investment market attractiveness has improved
significantly since Q1, when the score was a low 28 (Figure 1).
Market pricing is now well balanced, with an equal number of
HOT and COLD markets.
The improvement in the index score has arisen because of a
sharp fall in the UK five year government bond yield, which is
lowering our estimated required return for commercial property
and making UK markets relatively more attractive.
In Q1 we had rated ten markets in the UK as COLD, but the
sudden drop in bond yields means that there are now only two.
We now consider 18 of the 20 UK markets in our coverage to be
appropriately priced for investment.
London will continue to lead the office occupier market, with the
West End and the City providing the best rental growth. High
income returns in Nottingham are forecast to contribute to annual
total returns of more than 8%, similar to total returns in London.
Rental growth and total returns in the retail sector will be modest
in most markets, with Manchester outperforming London and
Glasgow. Manchester is also expected to generate the best total
returns in the industrial sector, with double-digit returns
throughout the forecast period.
Growth forecasts for the UK economy have been revised down in
light of renewed external threats. The Bank of England is thus
holding interest rates at 0.5% for now, in spite of rising inflation.
Figure 1Improving UK Fair Value Index Scores
10 2 6 1 9 16 6 11 1 2 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% All-p roperty Q1 2011 All-p roperty Q2 2011 Office Q1 2011 Office Q2 2011 Co ld Warm Ho t 28 50 25 46 Source: DTZ Research
Fair Value Index
UK Fair Value Index score jumps to 50 in Q2 2011 The DTZ Fair Value IndexTM score for the UK stands
at 50, indicating that the investment market has become significantly more attractive to investors since Q1, when the score was a low 28 (Table 1). Market pricing is now well balanced, with an equal number of HOT and COLD markets.
Table 1
UK Fair Value Index scores Q2 2011
Q2 2011 Q1 2011 UK all-property 50 28 UK office 46 25 Global all-property 55 50 Global office 49 45 Global retail 64 56 Global industrial 57 53 Source: DTZ Research
The improvement in the index score has arisen because of a sharp fall in the UK five year government bond yield, which is lowering our estimated required return for commercial property and making UK markets relatively more attractive. This reverses the trend of Q4 2010 and Q1 2011 when the bond yield was rising and leading to lower UK index scores.
Our outlook for property returns in UK markets remains largely unchanged, and is characterised by solid income returns but weak rental growth in most markets. However, these income returns look
increasingly attractive in the current climate of increased equity market volatility and very low fixed income returns. Table 2 UK market classifications Q2 2011 HOT markets Change since Q3 COLD markets Change since Q3 UK all-property 2 ▲ 2 ▼ UK office 0 - 1 ▼ Rest of UK all-property 2 ▲ 1 ▼ Source: DTZ Research
The sharp drop in required returns led to several upgrades for UK markets this quarter. In Q1 we had rated ten markets in the UK as COLD, but the sudden drop in bond yields means that only two are now rated COLD (Table 2). We now consider 18 of the 20 UK markets in our coverage to be
appropriately priced for investment.
This marked shift underscores the appeal of the solid income returns offered by prime property amidst a clouded economic outlook. While capital growth is expected to be subdued in coming years, and there are downside risks, most retail and office markets are trading at yields of around 5-6%, which offers a substantial premium over five-year bond yields, which sat at just over 2% at end Q2, and have since fallen further.
Box 1: Guide to the DTZ Fair Value Index™
The DTZ Fair Value Index™ is intended to provide investors with insight into the relative attractiveness of current pricing in global commercial property markets. Fair Value Index™ scores reflect the proportion of HOT and COLD markets, with higher scores implying more HOT markets.
Markets are categorised by comparing expected and required returns. Markets estimated to be more than 5% under-priced are classified HOT; markets more than 5% over-priced are classified as COLD; and, markets between this range are classified as WARM.
The DTZ Fair Value Index™ is a forward looking index based on econometric forecasts incorporating local econometric drivers and local market
knowledge.
For further information on the methodology used for classifying different markets and calculating Fair Value Index scores, see the DTZ Research report: DTZ Fair Value IndexTM Methodology, Solid Foundations for Future Returns.
Index Fair Value Classifications Economic Forecasts Page 2-3 Page 4 Page 5-8 Page 9 Property Forecasts
Fair Value Index
Figure 2
Global Fair Value Index scores Q2 2011
42 29 8 5 2 86 58 19 9 16 63 11 31 21 2 0% 20% 40% 60% 80% 100%
Global Europe Asia Pacific
US UK
Cold Warm Hot
55 41 70 73 50
Source: DTZ Research
Figure 3
Five year government bond yields – selected markets
1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5%
Jan-10 Apr-10 Jul-10 Oct-10 Jan -11 Apr-11 Jul-11
UK Germany France Sweden
Belgium Italy Spain
Source: Bloomberg
Figure 4
UK Index scores: change from Q1 to Q2 2011
10 2 6 1 9 16 6 11 1 2 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% All-property Q1 2011 All-property Q2 2011 Office Q1 2011 Office Q2 2011 Cold Warm Hot
28 50 25 46
Source: DTZ Research
Modest upgrades to global outlook in Q2
An increase in the index scores for Europe and Asia Pacific has contributed to the rise in the global score in Q2, from 50 to 55 (Figure 2). As in the UK, the European score has risen on the back of lower bond yields in core markets, lowering the required return for property. In the US, the score fell slightly this quarter, as the negative impact of the gradual lowering of cap rates from their elevated levels more than offset the positive impact of lower Treasury yields at end Q2.
According to our index scores, prime property investment in the UK is now more attractive than in most of Europe, the latter still having a heavier weighting toward COLD markets, in keeping with a weak economic outlook.
Box 1: Turmoil in European debt markets impacting on the UK
Recent weeks have seen continued ructions in European debt markets, which have impacted on the economic outlook and correspondingly lowered bond yields in the UK (Figure 3).
The sovereign debt crisis has spread to Spain and Italy, as markets seek reassurance that European authorities will take the necessary steps to restore liquidity and solvency. This uncertainty is damaging the wider
economy, as are the associated falls in equity prices and tightening of credit conditions, and there are clearly significant downside risks to the European outlook in the current environment.
With the US economy also having deteriorated, the global outlook is casting a shadow over the UK recovery, and markets now expect interest rates to be on hold well into 2012. This revised outlook, and an associated flight to safety from other asset classes has caused the UK bond yield to be bid down below 1.5% in recent weeks. Market participants are hoping for a firmer signal from European authorities that they are prepared to take whatever steps are necessary to contain the risks of the crisis deepening. Should contagion escalate, banks in larger countries such as the UK will be impacted by uncertainty over their exposure to overseas events, increasing the risk of a renewed downturn.
UK market classifications
Markets getting warmer in Q2
Eight UK markets were upgraded from COLD to WARM this quarter, reflecting a rebalancing of expected and required returns (Figure 5). The Manchester retail market shifted back into the
HOT category. Manchester industrial is also in the HOT category, with both markets expected to see stronger rental growth than other regional centres over the next five years.
Regional office markets upgraded
Following the uplift in Glasgow office yields last quarter, the Newcastle office yield has also shifted out by 25 basis points to 6.5%. We have held the view for some time that yields in regional markets were too firm in late 2009 and early 2010, and see this as an encouraging move toward more attractive pricing for investors in regional office markets. Rents are expected to remain steady in the
Newcastle office market and as such capital growth will remain muted, but supported by higher income returns, the market has been upgraded to WARM (Figure 6), along with Manchester, Leeds,
Birmingham and Bristol.
Stronger rental growth but lower yields in London The London office markets continue to lead the way,
in terms of rental growth, over the next five years. Rents have come back strongly since the downturn, but are still well below their peak levels, and we see scope for continued growth.
While this will support capital value growth over the period, lower yields in these markets will limit income returns and as such, they are rated as WARM rather than HOT.
Figure 5
Selected changes in Fair Value rating – Q1 to Q2
Q2 2011
COLD WARM HOT
COLD Glasgow offices
Birmingham retail Heathrow industrial Newcastle offices Manchester offices Glasgow retail WARM
London City offices West End retail Edinburgh offices Birmingham industrial
Manchester retail
HOT Manchester industrial
Q1 2011
Source: DTZ Research
Figure 6
Regional offices upgraded: Newcastle offices WARM
0% 2% 4% 6% 8% 10% 12%
Required return Expected return
WARM
COLD
Source: DTZ Research
Table 4
UK Fair Value Index: major market classifications
Market Category Degree of over- valuation (negative indicates under-priced) Office Markets
London City WARM -2%
Edinburgh WARM 1% Glasgow COLD 5% Retail Markets Manchester HOT 6% London WE WARM -1% Birmingham COLD 2% Industrial Markets Manchester HOT 8% Birmingham WARM -2% London Heathrow COLD 4% Source: DTZ Research
UK versus global forecasts
Figure 7
UK vs global all-property rental growth
-10% -5% 0% 5% 10% 15% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 UK Global Source: DTZ Research Figure 8
UK vs global all-property capital growth
-25% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 UK Global Source: DTZ Research Figure 9
UK vs global all-property total returns
-20% -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 UK Global Source: DTZ Research
UK rents set to underperform in 2011
Prime property rents in the UK rose by 7.7% in 2010, boosted by a sharp rebound in the London office market. However, although UK rents performed better than global rents last year, this year the positions are likely to be reversed (Figure 7). Overall, UK rents are expected to grow by just 2.7%
in 2011, compared to 2.9% rental growth globally. In the five-year forecast period, UK rental growth and global rental growth will be quite similar, at 2.5% pa. Average rental growth in the UK will also be stronger than in the US or in Europe, with Asia Pacific the only region recording faster rental growth over the
forecast period.
UK capital value growth to be flat from 2012 onwards Capital values also bounced back quite sharply last
year, driven by an uplift in rents – concentrated in London – and some yield compression. Capital growth of 17% easily outpaced the global growth figure of 7.5%. But in 2011, UK capital growth at 4.3% will undershoot global growth of 7.4% (Figure 8).
In the medium term, capital growth will underperform in the UK. Over the five-year forecast period, UK capital values are forecast to rise by just 1.5% pa, compared to the 2.8% rise per annum forecast at the global level. It should be noted however that from 2012 onwards, yields will come under upward pressure, and capital growth figures will be quite modest. Any difference between UK and global capital growth figures are thus expected to be marginal.
2011 total returns forecasts downgraded
Total returns on UK property were 22.8% in 2010, well ahead of returns of 14.1% at the global level. In 2011 we expect total returns in the UK to be around 9.6%. This is a downgrade from the Q1 forecast of 10.1%, and it will also trail the 13.8% returns forecast at the global level. The higher global figure reflects the rise in capital values, particularly in Asia Pacific (Figure 9).
From 2012 onwards we expect total returns in the UK to be slightly lower than at the global level. This is due to marginally weaker capital value appreciation and a lower income return. Thus for the five year period 2011-15 we expect UK total returns to be 6.9%, compared to 9.0% at the global level.
Office market forecasts
Strongest office rental growth forecast in London London West End has shown the sharpest uplift in
office rents in the UK in 2011. In the first six months, rents jumped by 6%, taking year-on-year rental growth to 12.5%. London Midtown which grew by 30% in 2010 has yet to show any rental growth this year. However, London City has managed to record growth of 2.8% year-to-date. Apart from the West End and the City, rents in the other UK office markets have held at 2010 levels.
We expect London to continue to lead the way over the next five years, with the strongest office rental growth forecast there. We expect West End office rents to rise at 6.2% pa over the 2011-15 period and City rents to rise by 4.9% pa. Strong rental forecasts reflect relatively tight supply combined with steady demand (Figure 10).
By contrast, we expect much more modest rises in rents in office markets outside London, which tend to be less volatile to begin with. Over the period, we expect Edinburgh rents to grow the most, albeit by just 1.8% pa. Glasgow and Bristol will be the worst performers, with forecast growth of just 0.7% pa. Yields to move higher from 2012
London West End and City are the only locations that have experienced any yield compression in the past year. Even that compression has been marginal - only 25 basis points (bps). Another seven markets, all in the regions, have seen prime yields soften by 25 bps in the same period. In Q2 2011, Glasgow and Newcastle yields moved out by 25 bps.
In the remaining quarters of 2011, we expect office yields to show no change in every market but one. Only in London West End do we think that yields will drop, by 25bps, supported by sustained investor demand. From 2012 onwards we expect office yields to edge higher as they come under pressure from rising interest rates and bond yields. However, we think that rises will be relatively modest (Figure 11). Highest returns forecast in Nottingham and London Total returns for 2011-15 are forecast to be above
8% pa in Nottingham, London West End and London City. In these markets, rent rises should boost capital value growth and push up total returns (Figure 12). Outside London, lacklustre rental growth and
softening yields will hold back capital growth. As such, total returns outside London are forecast as below 8% pa over the next five years. In Glasgow, capital values are forecast to decline marginally, generating returns of 5.4% pa.
Figure 10
UK office rental growth forecasts 2011-15 (% pa)
0% 1% 2% 3% 4% 5% 6% 7% Source: DTZ Research Figure 11
UK office yield forecasts
3% 4% 5% 6% 7% 8%
Birmingham Edinburgh Leeds
London (City) London (WE) Manchester
Source: DTZ Research
Figure 12
UK office total return forecasts 2011-15 (% pa)
-2% 0% 2% 4% 6% 8% 10%
Income Return Capital Value Growth Total Return
Retail market forecasts
Figure 13
UK retail rental growth forecasts 2011-15 (% pa)
0% 1% 2% 3% 4% Source: DTZ Research Figure 14
UK retail yield forecasts
3.5% 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% Birmingham Glasgow
London (West End) Manchester
Source: DTZ Research
Figure 15
UK retail total return forecasts 2011-15 (% pa)
-2% 0% 2% 4% 6% 8% 10%
Income Return Capital Value Growth Total Return
Source: DTZ Research
Manchester retail rents to show strongest rise
In 2010 there was a sharp contrast between trends in retail rents in London and in the regional centres. London West End rents rose by 27%, while in Birmingham, Glasgow and Manchester, rents fell by more than 5%. London retailers have been supported by tourist trade on the back of a weak pound.
Over the next five years we expect retail rents to show modest growth of 1-2% pa in Birmingham, Glasgow and London West End. Retail will perform strongly in Manchester, where rental growth is expected to average about 3.2% pa (Figure 13). Following sharp increases in 2010, we think that there is less scope for similar spikes in London rents in the near term. We forecast that retail rents in the West End will rise by 1.7% pa over the forecast period.
Yields to edge up over next five years
Prime retail yields fell over the course of 2010 in Birmingham, Glasgow and London West End. London remains the most expensive retail market in the UK, with a yield of 4.25% at the end of 2010, followed by Birmingham and Glasgow at 4.75%. In 2011 we expect yields in London to edge down
even lower to 4.0% on the back of continued investor demand for high-quality properties. Outside London though, prime retail yields will show no change this year, except in Glasgow where a softening of 25 bps is forecast (Figure 14). From 2012 onwards we expect retail yields to come under upward pressure as interest rates and bond yields start to increase. However, we expect the rises in yields to be fairly modest, with the West End yield forecast to rise to only 4.35% by 2015.
Total returns forecast to be highest in Manchester Total returns over the forecast period are expected to
be highest in Manchester, at 8% pa, supported by a solid yield and relatively robust capital growth of 3% pa (Figure 15). London West End is forecast to deliver the next best returns over the period, at 5.3% pa. West End returns are expected to be boosted by a modest uplift in capital values on the back of moderate rental growth.
In contrast, negligible capital growth is expected in Glasgow and marginally negative capital growth in Birmingham. Total returns in Glasgow are forecast to be 5.1% pa over the next five years, and 4.5% pa in Birmingham.
Industrial market forecasts
Industrial rental growth weak in most markets Prime rents in most industrial markets showed no
change in 2010, although London Heathrow rents declined 4%. During the forecast period of 2011-15, we expect rental growth to be below 3% pa in all the UK industrial markets covered in this report. In Manchester, where we forecast rental growth to be strongest, we expect rises of just 2.6% pa. Edinburgh is the market with the weakest forecast, as
annualised rental growth of only 0.5% is expected over the five-year period (Figure 16).
Modest rise in industrial yields in the medium term Prime industrial yields edged lower in most markets
in 2010, with sharp declines of 75bps in Glasgow, Newcastle and Park Royal. Going forward, we expect limited further compression.
Indeed, with interest rates and bond yields rising over the forecast period, we expect yields to move out by 2015 in a number of locations, e.g. London Heathrow, Glasgow, Milton Keynes and Park Royal. However, we expect the increases in yields to be relatively modest, between 25 bps and 50 bps (Figure 17). We expect yields in Birmingham to remain at 7.0%
over the forecast period. In Manchester, yields are expected to edge down to 7.15% by 2015 from the present level of 7.25%. London Heathrow should still remain the most expensive industrial market in the UK, with a forecast yield of just 6.0% in 2015. Total returns forecast to be highest in Manchester Total returns over the period 2011-15 are forecast to
be highest in Manchester, at 10.1% pa. Returns are supported by a high income return and uplifts in
capital values, as rents rise and yields fall (Figure 18). Total returns in Birmingham, Bristol, Cardiff, Dartford
and Leeds are forecast to be above 8% pa throughout the period 2011-15, aided by modest uplifts in capital values as rents rise.
Park Royal is the weakest market, where total returns are forecast to be just 5.5% pa over the next five years. This reflects rents showing no change and yields edging higher, which will have a slight negative impact on capital values.
Figure 16
UK industrial rental growth forecasts 2011-15 (% pa)
0% 1% 2% 3% Source: DTZ Research Figure 17
UK industrial yield forecasts
4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5% 8.0% 8.5% Birmingham Glasgow London (Heathrow) Manchester
Source: DTZ Research
Figure 18
UK industrial total return forecasts 2011-15 (% pa)
-2% 0% 2% 4% 6% 8% 10% 12%
Income Return Capital Value Growth Total Return
Economic drivers
Figure 19 UK GDP growth by quarter (% q/q) -2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% Q 1 2 0 0 5 Q 3 2 0 0 5 Q 1 2 0 0 6 Q 3 2 0 0 6 Q 1 2 0 0 7 Q 3 2 0 0 7 Q 1 2 0 0 8 Q 3 2 0 0 8 Q 1 2 0 0 9 Q 3 2 0 0 9 Q 1 2 0 1 0 Q 3 2 0 1 0 Q 1 2 0 1 1 Q 3 2 0 1 1Source: Oxford Economics
Figure 20
UK consumption growth and unemployment rate
-4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6%
Cons. spending growth Unemployment rate
Source: Oxford Economics
Figure 21
UK inflation and interest rates
0% 1% 2% 3% 4% 5% 6% 7%
CPI inflation Lending interest rate
Source: Oxford Economics
GDP growth disappoints in Q2
The preliminary estimate of quarterly GDP growth for Q2 2011 came in at 0.2% (Figure 19). This
disappointing result was largely attributed to a series of temporary factors, including the extra bank holiday in April and the supply chain disruption caused by the natural disasters in Japan. Without these exceptional factors, the ONS estimates that growth would have exceeded the first quarter's pace.
Most of the disruptive events occurred early in Q2. It may have been expected therefore that the economy would be stronger going into Q3, but survey evidence on this remains inconclusive. More recently, turmoil has returned to the financial markets with some force, spurred by rising concerns over the sovereign debt crises in Europe as well as the ongoing economic and political stalemate in the US.
Higher unemployment leads to negative consumer spending growth
Forecasts for GDP growth have therefore been revised downwards for both 2011 and 2012. As of August, Oxford Economics expects GDP to grow by 1.1% in 2011 and 2.0% in 2012. Both numbers are 0.2% lower than the corresponding figures in July. The outlook for exports and business investment has
weakened substantially due to ongoing uncertainties. Figures released in August showed an unexpectedly large rise in unemployment in Q2. The number of jobless increased by 38,000 between March and June, driving the unemployment rate higher. Correspondingly, forecasts for consumer spending have deteriorated. It is now expected that consumer spending will actually show a decline of -0.3% in 2011 before returning to positive territory in 2012 (Figure 20).
Bank of England to hold rates steady through 2012 A series of adverse developments has led the Bank
of England to revise its stance on monetary policy. In spite of persistently high inflation, the Bank has recently indicated that interest rates will stay at present levels till the end of 2012 (Figure 21). CPI inflation picked up in July to 4.4%, but for the moment, uncertainty about the strength of the recovery is trumping other concerns. Indeed if there is a substantial worsening of the outlook, further quantitative easing cannot be ruled out.
Disclaimer
This report should not be relied upon as a basis for entering into transactions without seeking specific, qualified, professional advice. Whilst facts have been rigorously checked, DTZ can take no responsibility for any damage or loss suffered as a result of any inadvertent inaccuracy within this report. Information contained herein should not, in whole or part, be published, reproduced or referred to without prior approval. Any such reproduction should be credited to DTZ.