Economics, Politics and what they all mean for Property: A quarterly update
In this quarter’s update we look at:
?The Economy: "Gangbusters", apparently, but inflation (and rates) look stickier than we thought
On the economic front, the news has been a real mixture of the positive and the negative. Starting with the good news first, an economic recovery looks genuinely to be on the cards, with a 0.6% increase in GDP recorded in the first quarter – which more than reverses the small declines seen in the second half of 2022. Much of this was driven by a particularly strong March (0.4%). Consumer-facing services were notably strong, perhaps reflecting the early Easter, alongside health, where a comparative lack of strike action pushed up growth.
?Nevertheless, the expansion was broad-based, with services and manufacturing seeing 0.7% and 0.8% growth respectively. Construction, on the other hand, was the most significant drag, with output shrinking by 0.9% over the three-month period. This is mostly explained by the extremely wet weather, although wider issues around development viability and demand may also have played a role. The most recent PMIs, though, suggest very strong expansion in the sector – the strongest for about 14 months – alongside similar strength in manufacturing, which will make up for some of the upside seasonal factors in the last set of figures. The services PMI fell back, as did April’s retail sales figure, implying that the rate of growth will be somewhat weaker in May and perhaps in Q2 more generally.
?Overall, this suggests the recovery will continue, albeit steadily given wider monetary and fiscal tightness, with Oxford Economics raising its 2024 GDP forecast from 0.6% to 0.9%. It is still expecting the economy to grow by 2.0% in 2025, mainly driven by lower inflation boosting spending power; consumer confidence measures, while still negative, are improving rapidly.
?Moving to the less promising news, inflation was some 0.2 percentage points higher than the Monetary Policy Committee (MPC) predicted. Most commentators argue that this means that the first rate cut will be pushed out to August rather than June. The higher figure was driven by very strong service inflation – at 5.9% it was 10bp lower than in March but 40bps higher than expected. Low or negative figures for food and energy, with the price cap cut, were the main contributors to the lower figure. However, survey evidence does suggest that inflation will fall again in May, although base effects around energy will need to be borne in mind (inflation is measured year-on-year; the very high energy costs will soon be more than a year ago).
?The general view is still that there will be one or two more 25bps rate cuts by the end of the year, bringing base rates to 4.5-4.75% as we enter 2025. It is worth noting that most forecasters expect cuts to stop at around 3.5%, given higher equilibrium inflation driven primarily by a changed labour market. This implies that gilt yields will also fall back only so far – to around 4.0%, with higher government borrowing also a factor.
The Residential Market: Two steps forward, two steps back
The most obvious effect so far of the changed inflation picture on the property market has been a tick up in mortgage rates. The average rate for a 75% LTV 2-year fix loan rose to 5.00%, with the market expectation that this falls only slightly to 4.8% by year end – higher than at the start of 2024. This will doubtlessly have a dampening effect on the housing market. Transactions will continue to increase (March was a 19-month high in mortgage approvals) but at a slow rate. Prices rises are likely to be positive but modest, partly because the supply of second-hand properties is increasing while demand remains flat.
There are also signs of the rental market slowing somewhat. According to Hometrack, average rents increased by 7.8% in the year to March, the lowest for two years, driven mainly by London where the figure was 5.1% - a third of the rate a year ago. This is probably driven by a combination of the unwinding of post-pandemic effects, a slightly cooling labour market and perhaps most importantly of all, affordability issues for tenants. Similar effects are apparent in all the major cities, although perhaps not to the same degree, while rents in the South East outside London are seeing higher inflation levels than a year ago, perhaps demonstrating more resilient demand for certain types of housing and locations. It is worth noting, of course, that these levels of rental growth are still very high compared to most other sectors, meaning build-to-rent will remain very attractive, especially if the viability pressures around construction and debt costs unwind.
Residential Development: An (even bigger) crisis In the making
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Meanwhile, the pipeline for residential development looks worryingly thin. According to Government statistics, starts were made on just 15,860 new homes in England in the final quarter of 2023. This is the lowest figure on record. (The 10-year quarterly average is about 39,000) While most regions are in a similar place, the picture for London is particularly stark – work was started on just 480 homes; the ten-year average is almost ten times this at around 4,500.
Molior’s more timely data shows a bit of a bounceback is likely in Q1, with over 3,500 starts – but at the same time its planning data shows that the longer-term pipeline has collapsed, with applications and permissions at 30% and 35% of the 10-year average respectively. This does not bode well for housing supply over the next year, even if the mortgage market improves more rapidly than expected.? This is not just a London thing; the number of units in planning applications across England has fallen from around 350,000 in early 2021 to around 225,000 at the end of 2023, although clearly this is not as much as fallback as in the capital.
?So what is causing the slowdown? It must be a result of a mixture of planning and land supply (and infrastructure) difficulties, issues around site viability reducing appetite for developer expansion, and the higher cost of mortgages. All of these issues are most pronounced in London. Which of these is thought to be most important is, in my experience, dependent on your political outlook and your recent experiences – I’d argue that it’s really hard to separate them out.? It does, however, imply that releasing more sites for residential may help to an extent, but without the other factors changing, will not result in the increase in building that many would like to see.
The Commercial Market: Signs of life, but only in places
There is no sign – in the figures at least – of a revival in the commercial investment market (even if coalface anecdotes sometimes suggest otherwise). Some ￡10.2bn changed hands in the first quarter of 2024, down 4.8% on Q4 2023 and 12.5% below the same period a year earlier. It was the weakest first quarter since 2012. However, this slump is not affecting all sectors equally. Compared to Q1 2023, offices transactions are 52.3% down, compared to just -7.1% for industrial and -4.3% for residential. Hotels are also showing a sharp uptick from a low base. This would certainly still look like a bit of a slow period were it not for offices, but it is the weakness in that market that is turning that into a genuine slump.
?This pattern is repeated in the MSCI indices. Total returns for offices are at -9.3%, compared to 0.0% for retail, 1.7% for residential and +4.7% for industrial. These differences are mostly driven by capital growth (-13.3% for offices) but residential and industrial are also seeing rental growth of above 6%. This may explain the stability in yields in these sectors, even if offices are, unlike retail and hotels, seeing positive rental growth of 2.8%.
?The sentiment around offices, perhaps driven by the far more dire situation in the US, is weighing heavily on the sector. That is not to say there are not huge structural challenges in this market – we’ll be exploring these in an upcoming paper – but these headline figures ignore how polarised the market has become. London offices, for example, are seeing positive net absorption and rental increases, whereas some out of town and secondary markets are in a whole world of pain. The spread of rental growth between ‘grade A’ offices and the rest is very marked indeed.
?The logistics market, having seen very strong levels of demand, is cooling slightly with vacancy rates rising and leasing volumes falling back. This is more of a soft landing than anything else, as the tailwinds remain strong and the fundamentals robust, but this market is seeing bifurcation too, albeit perhaps not quite as marked. In this case, however, it is between the ‘big box’ market where planning pipelines are significant and supply responsive, and the much more constrained urban logistics/multi-let market, particularly in London and the South East.
Retail, meanwhile, does look well positioned for a recovery as consumer confidence and spending recovers and the cost-of-living crisis recedes against the backdrop of pricing that most believe has reached a trough. The retail warehousing market is still seeing strong activity so far in 2024 and given where more cash-rich consumers live this is likely to continue. The market will more generally remain polarised between convenience and destination, and it is perhaps in this latter area that we should expect a recovery as the year continues. Parts of the retail market will remain severely problematic.
But the real excitement in the commercial sector is still the ‘alternatives’ more generally, with the rise of artificial intelligence driving a new wave of interest in data centres.? Their rise in partly constrained by energy issues, which alongside water issues, represent yet another infrastructure challenge for the next government.
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