The year ahead should be dominated in the UK by the debate over what kind of society we want to live in, with politicians setting out the vision for the UK post Brexit. It should be the time we discuss the rise of technology and growing social inequality as the owners prosper whilst workers are losing their jobs. It should be a time we determine how we re-energise our economy so that the tax system is seen as effective and fair, allowing the government to meet expenditure from income rather than borrowing. It should be an opportunity for a leadership that sets out the vision for the majority middle ground rather than allowing narratives from both extreme to dominate.
However, much more likely is that 2018 is dominated by arguments over the terms of the Brexit divorce as if this was a solution in itself, maintaining a strategic vacuum that erodes the confidence needed to drive investment and UK economic growth.
For this reason, we suspect 2018 will see investors and occupiers holding back from decision making where possible, further regulatory scrutiny, more tax for investors and greater risk aversion. The positive from this inertia will be sustained low nominal interest rates and a continued focus on prime assets, as evidenced already by some very large transactions in 2017. There is also a positive for investors who can look at asset not on a pure rent and yield perspective but in terms of the alternatives uses the asset provides in a changing world.
We suspect the worst performing sector will remain retail. Whilst there is still a place for physical touching points for almost all retailers, the footprint will need to shrink to reflect margin pressure from discounters, on-line migrating to bespoke distribution facilities and muted consumer spending. Lease extensions on the best trading stores may be used to generate cash flow but generally rents will decline in all apart from the best locations. Larger bulky goods units, high street properties and secondary shopping centres will be looked at for alternative uses, but capital values need to fall further for this to make sense. Many covenants will be re-rated as investors worry about the long term lease obligations they have, meaning fewer true investment grade opportunities. In short, only best in class assets and the strongest corporate tenants will allow investors to achieve growth in real terms.
In the office market we think that a combination of inertia from occupiers, increased office use density, automation of jobs and the end of the government hub programme will reduce occupational demand and the potential for rental growth. At the same time the investment market will need to adjust to more shorter term leases from increasingly choosy corporates who demand more of a service offering from their landlords. The result will be a focus on best in class Grade A office buildings and, whilst new development will happen, overall the Grade B office stock will need to convert to residential as the gulf grows between the best and the worst offices by build quality, tenant and location.
The picture for industrial/warehousing and last mile logistics remains good occupationally, particularly in areas where retailers would prefer to pay industrial rents to store and distribute stock from accessible logistics units rather than from historic store locations. We think that this market will continue to grow and may get a boost from manufacturing moving to the UK in order to take advantage of cheaper currency, post EU trade barriers for imports, and automation making differential in international labour costs less relevant.
We also feel confident about the prospects for the residential market, albeit domestic day to day residential rather than the prime market, given continued population growth and lack of new supply creates a shortfall of accommodation whether for old or young, rich or poor, for rent or for sale.
So, Palmer Capital remain positive about creating population driven assets, about creating high quality real estate that meet tomorrow’s technological demands, and repositioning assets to meet the new retail distribution channels. However, we remain nervous of growing obsolescence, political instability and an economic lack of direction. Investors should remain cautious and measured when taking risk and only acquire assets that are either core or have core potential that can be supported by strong asset management.
Author: Alex price, CEO at Palmer Capital