Outlook: recovery starts here

While the easing of the lockdown should mark the beginning of the recovery, the fallout from COVID-19 will fast forward structural changes that were already in train and drive opportunities to add value.

RECOVERY UNDERWAY

The COVID-19 pandemic prompted the UK’s sharpest-ever economic downturn, with GDP contracting by an eye-watering 20.3% during April. The subsequent easing of the lockdown has seen growth return; GDP rose by a modest 1.8% in May while the leading PMI survey indicators reveal that business activity accelerated in June as further restrictions were eased.

However, there is increasing evidence that the lockdown will create lingering damage, stymieing initial hopes for a sharp ‘V shaped’ rebound in the economy. Pantheon Macroeconomics forecast that GDP will still be circa 5% below its pre-COVID level at the end of the year, while the threat of a second wave of COVID-19 in the winter poses a clear downside risk to this view.

LABOUR MARKET WOES AHEAD

The UK economy may be in recovery mode but COVID-19’s impact on the labour market is yet to play out. Clearly, some sectors are more directly exposed to the fallout, with announcements of job losses frequently being made across the retail, aviation and energy industries. To date, the clearest statistical evidence can be seen in the UK claimant count, which more than doubled between March and June to 927,000.

However, with more than a quarter of the UK workforce remaining on furlough, a wave of further job losses are expected as the Coronavirus Job Retention Scheme is wound down. While the scheme has effectively frozen the UK unemployment rate at only 3.6%, the OBR expects it to surge to over 10% after the government-backed scheme is withdrawn in October. 

VOLUMES TO REBOUND IN Q4

While Q2 is likely to prove the nadir for the investment market, Q3 is expected to be another subdued quarter by historic standards. The immediate focus for many landlords is rent collection at their existing assets, while uncertainty over valuations is inhibiting prospective purchases. Against this backdrop, investors will remain risk averse, gravitating towards long-let assets and uses that remained operational throughout the lockdown, namely distribution warehouses  and supermarkets.

However, pent-up demand and the emergence of distress-related opportunity could fuel an upswing in volumes during Q4. The current downturn is unusual, as many investors have plenty of ready funds available and interest rates are at record lows. That said, Brexit may be a potential hindrance, particularly if there is little indication of an agreed trade deal before the transition period ends on 31 December.

VALUES YET TO TROUGH

While investment volumes have likely passed their low point, values may remain on a downward trend over the coming months. Since lockdown began, the pattern shown by MSCI data has been a sharp decline in capital values in March, followed by further monthly falls, albeit with the rate of decline slowing each month.

In total, all-property capital values fell by 5.9% in the four months to June. However, there has been a wide divergence between the sectors where businesses were hardest hit by lockdown restrictions such as retail (-11.1%) and hotels (-8.8%) and the more moderately impacted office (-3.9%) and industrial (-2.7%) sectors.

A lack of comparable evidence has, however, hampered property valuations. Further downward adjustments to capital values can be expected as more evidence is gathered from transactions and quarterly rent collections. As a result, movements in property values may lag behind the wider economic recovery.

CASH BUYERS HOLD THE ACES

In terms of the risks in the property market, there are fundamental differences between this induced downturn and the Global Financial Crisis of 2008. Firstly, the current cycle has not seen anything like the same level of development, which should mitigate against severe falls in rental levels within the business space markets. Secondly, lenders are far less exposed in the current cycle as LTVs and margins have been more risk averse.

The pandemic has also seen LTVs fall across the market. For cash-rich investors that have come through lockdown relatively unscathed, the current period of accelerated change may create significant buying opportunities and reduced competition, especially for those able to correctly judge the direction of travel in occupier markets. 

RETAIL ON THE ROPES

The ultimate legacy of COVID-19 for the property market may be an acceleration of structural changes that were already underway in the occupier markets. 

Riven by news of additional casualties and missed rent payments, high street retail now appears in a state of almost terminal decline in the wake of the lockdown. However, this will fast forward the transformation of UK town centres. Quality retail assets in proven locations will continue to have a future, once rents are rebased to a suitable level or linked to turnover, while non-performing assets will present opportunistic buyers with a raft of change of use angles.

RETHINKING OFFICES

The recent enforced working from home experience is also likely to accelerate moves towards more flexible working practices. 

Many landlords and prospective investors of offices will  now understandably be wary of shrinking per capita occupier demand, although its precise impact will take time to play  out as occupiers gradually adjust their office needs upon lease events. 

Increased caution towards the office sector could be reflected in an increasingly two-tier market. In the short term, investment demand will be overwhelmingly focused on prime assets with strong covenants. Meanwhile, investment demand for secondary stock is likely to soften until COVID-19’s impact on occupier demand and supply levels of grey space is better understood.