Aviva Investors outlines key risks for UK real estate in 2016

The impending vote on EU membership is one of several risks that could affect UK real estate returns this year, according to Richard Levis, global real estate analyst at Aviva Investors.

“We expect healthy occupier demand and a broader recovery in the rental market to drive capital appreciation in coming months. Good quality, higher-yielding assets are likely to do especially well this year, but there are multiple risk factors that could have both negative and positive implications for the market,” he says.
 
Other potential downside risks include Brexit, Euro-zone debt and UK rate rises.
 
“We doubt the UK electorate will vote to leave the EU this year,” says Levis. “However, short of a decisive mandate to remain in the EU, the aftermath of the vote could see unusually high currency volatility, higher gilt yields, capital flight, weaker economic growth and another Scottish referendum. All of this could drain liquidity and damage investment performance of UK real estate in the short-term.
 
“Even in the event of Brexit, the UK will probably retain extremely close economic and political ties with the EU. Hence, longer-term impact would depend on the outcome of trade negotiations between the two parties. A UK exit would put the central London office market most at risk within the commercial occupier sector. London’s financial district is especially vulnerable due to a potential drop in demand for buildings from the financial services industry.
 
“The fragile political situation in Greece could provoke a re-run of the 2011/12 debt crisis and renewed fears that the Euro project could be derailed. The impact on UK real estate would vary according to how a subsequent crisis was to unfold, but the economic outlook would weaken, and confidence in the market would fall.
 
“Our central view is for UK interest rates to remain extremely low in 2016, rising at a gentle pace in coming years and peaking below their pre-2008 historical norms. But unexpectedly rapid policy tightening would savage real estate returns if property yields also rose rapidly. Although, crucially, the causes of the acceleration would dictate the effect on real estate markets.
 
Potential upside risks include stronger rental growth and more overseas investment.
 
“Rental growth in UK real estate is currently at levels not seen since the last cyclical peak,” says Levis. “Our central case is that we expect it to cool this year as the central London office market slows. Yet, there is a possibility rents will surge on restrained supply, low vacancy rates, a lack of new development and steady economic expansion. The biggest upside potential is in the industrial sector, which has not had much real term rental growth since the late 1990s.
 
“This year we expect overseas net investment to ease amid slowing emerging economies, heightened geopolitical tensions and low oil prices. But we can also envisage an upside scenario where overseas net-investment continues to rise and, as a result, yields for the best quality assets would fall further. In addition, demand for lower quality secondary assets and strategies would rise fuelling a further “re-rating” of secondary yields. This scenario would also put further pressure on investors to increase exposure to non-core real estate assets such as infrastructure, residential, healthcare, care homes and leisure.

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