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Outside London, UK property remains strong

It’s an interesting time to observe the UK property market. Uncertainty over the country’s economic and political future comes at the same time as an uptick in global growth, driven by Europe and Asia. With these factors pushing in opposite directions, it shouldn’t be surprising that the current outlook for the property market looks mixed.

UK commercial property

The UK investment volume for H1 2017 was £27.2 billion, which is 1% higher than the same period in 2016. London accounted for 50%. Low levels of investment stock are pushing prices higher. After a spike after the EU referendum, prime rental yields across sectors have fallen back to pre-Brexit levels. The differential between prime and average yields is close to their 180 basis-point 10-year average.

According to the latest RICS survey for Q3, demand for industrial and office use was up over the quarter, but for secondary retail demand was down significantly. Surveyors believe that UK-wide industrials look most likely to secure growth in capital value and rental income over the next 12 months. Non-prime retail looks weak across the UK. Prime office and retail are strong with the exception of London, which 67% of respondents say is overvalued. Despite concerns over London, 3-in-4 surveyors believe the UK market as a whole is fairly-valued, and up to half think the market is still in its upturn phase.

The UK student housing market has also been robust since the Brexit vote. 2016 saw the second highest ever investment volume into purpose built student housing with £4.5bn ploughed into the sector. The combined effect of the weaker pound, the UK’s strong reputation in higher education, and the government’s clarification on the fees and living status of EU applicants has eased concerns.  Investors still see student housing as a source of stable and reliable income.

However, there are concerns over data from the construction industry, which fell into recession in Q3 2017. IHS Markit says that the combination of continued uncertainty over Brexit negotiations and fears of higher interest rates has delayed or discouraged new commercial and residential projects.

While sterling has recovered as the economic effects of Brexit have proven to be weaker than expected so far, there are downside risks. Fundamentally, Brexit put a discount on the UK economy of around 10-25% in terms of currency depending on the deal that is eventually struck. This centres new sterling’s long-run value to 1.30$/£ and 1.1 €/£. In the short-term, a weakening of the British economy will push the currency down, but the main worry is the non-trivial risk that Britain leaves the EU without a deal. However, if the government succeeds in maintaining many of the economic benefits of EU membership, the post-vote effects on the currency and the wider economy can be largely reversed.

The Bank of England is likely to raise interest rates in November, with effects already priced into sterling. But if the Bank moves onto a path of further interest rate rises, downward pressure on property prices can be expected if the spread of property yields over government bonds is maintained. This pound will strengthen if interest rates rise without significantly weakening growth.

UK residential property

In the residential market, a clear division can be seen between the performance in London and the rest of the UK. Since 2014, prices for homes valued over £1m in Central London have fallen by 15.2%. The rise in stamp duty land tax by 300 basis points in 2016 to 15% for homes valued above £1.5m is cited as a major reason for the downturn. However, according to Savills, there has been little change in the number of transactions of £1m+ properties in London since the 2014 market peak. Brexit uncertainty is more likely to be a factor as is the growing attraction of other world cities such as Sydney, Toronto and Stockholm. But rental yields point to the key driver. In West London, yields are below 3%, indicating an overvalued market for ownership that cannot be supported by local incomes. Further price falls in 2018 are probable.

The rest of the UK residential property market is in better shape, with year-on-year price growth in October at 2.5% according to Nationwide. Some areas still offer attractive returns to buy-to-let investors. Towns and cities in the South East such as Luton, Colchester and Peterborough offer yields between 4-5%, double-digit capital gains, and strong rental price growth. The North-West region and Wales report strong price and yield growth, with Manchester and Salford doing particularly well. Manchester remains the UK government’s centre for its Northern Powerhouse project, while high living costs in London are pushing people to search for value in the wider commuter belt.

In summary, the UK property market looks healthy but economic and political uncertainty is keeping investors and builders cautious. Downside risks are concentrated in London, where the impacts of Brexit on commercial activity are likely to be greatest and there are concerns over affordability. The fortunes there and across the rest of the UK depend on whether the country stays open for business.

Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.

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