Mayfair Capital: Impact of coronavirus outbreak on UK real estate

James Thornton is chief executive of Mayfair Capital

Real estate impact – short term

It is still too early to fully assess the impact of coronavirus on the UK real estate market as this will depend on the duration and severity of the current outbreak. However, we can identify some short-term implications related to pricing and rental growth:

1. Pricing: Real estate investment volumes are expected to reduce as investors adopt a wait and-see approach against a backdrop of heightened uncertainty. Volatility in other asset classes will also have impacted portfolio weightings and these may need to be rebalanced. Any slowdown in activity is likely to be compounded in markets that are reliant on overseas capital, due to travel restrictions. Consequently, the competitive pressure seen at the start of the year may reduce and yield compression that we anticipated in some segments at the start of the year looks less likely. In contrast, there is potential for yields to increase over the short term. That said, any outward yield movement is expected to be constrained by the lower interest rate environment. Against a 10-year gilt rate of around 0.7%, the income characteristics of real estate mean the case for investment based on relative pricing remains compelling. We anticipate that investor demand for long-let, index linked income streams will remain particularly strong and pricing may harden in this segment.

2. Rental growth: Short-term rental growth expectations may need to be revised downwards. Weaker economic growth will have a negative impact on occupier business activity, increasing the risk of greater tenant failures and therefore, loss of income. Faced with the current levels of uncertainty, occupiers are likely to delay real estate decisions, reducing activity in the leasing market. However, the underlying real estate fundamentals remain robust. Good quality supply remains in short supply, particularly in the office and industrial sectors, and should be supportive of a return to rental growth once the virus is contained.

With regards to individual sectors, hotels and retail assets look most vulnerable. Holidays and business trips are being cancelled or postponed, retailer supply chains have been disrupted and people are less likely to visit physical retail due to fear of infection. In our view, this compounds the challenges facing the retail sector and it is expected that value loss in this sector this year will be sharper than previously anticipated.

The industrial sector may be vulnerable in the short term given the disruption to global supply chains. For many occupiers, this will have a negative financial impact resulting in rent arrears and an increased default rate. However, the latest crisis has highlighted the vulnerability of global supply chains and just in-time delivery models. Many industrial occupiers may look to reassess their supply chain arrangements in the medium-term. There is potential that this results in more demand for UK storage space or a shift towards the reshoring of some manufacturing. This driver is likely to be exacerbated by Brexit, depending on the final deal agreed.

Potential long-term structural impacts

In our view, the current coronavirus outbreak is likely to accelerate many of the structural changes which inform our thematic investment approach. This includes a shift towards re-shoring or near shoring manufacturing – as outlined above. While Brexit, will support this shift, it is also aligned with the growing focus on climate change and reducing the carbon footprint of manufacturing and supply chains.

In the office sector, there is likely to be more demand for more flexible arrangements, which would see more people working remotely. This is expected to expose vulnerabilities in some IT infrastructures and may bring forward greater investment into digital connectivity. This will hasten the shift towards flexible working and the related transformation of office floorspace, even once the virus has been contained.

In the retail sector, current events are likely to drive further increases in online retail as people seek to avoid public spaces. Already Ocado has reported a surge in orders and delayed fulfilment times due to demand. This will increase obsolescence in the retail sector and drive increased demand for logistics stock.