UK economic outlook

Activity

Economic growth remained robust over the second quarter at 0.5%, as the consumer and output sectors absorbed respective headwinds in their stride. The UK retains a position of cyclical strength, but it finds itself staring down a challenging fiscal outlook. While this is markedly better than a starting position of cyclical weakness, it doesn’t solve the new Labour government’s problems in closing a projected £30 billion shortcoming. Fiscal space is likely to be created from tweaks to the Bank of England’s (BofE) quantitative tightening regime, but additional revenue raising through amendments to capital gains and inheritance tax will be needed to bridge the gap. That said, growth is at the centre of Labour’s manifesto, and so the balance between fiscal tightening and economic expansion will be under scrutiny this autumn.

Inflation

Domestic inflationary pressures in the UK seem to have faded over the summer months. While higher energy prices and fading base effects will soon contribute to the headline figure drifting higher, this is not expected to materially affect the progress made to this point. Indeed, largely positive economic signals afford the BofE a healthy margin of error in its policy path. However, it’s likely to err on the side of caution, as endogenous pressures and uncertainty around official data could complicate the path ahead.

Policy

Policy remains in restrictive territory and is quickly diverging from the more aggressive paths coming from the Federal Reserve and the European Central Bank. By holding borrowing costs at 5% in September in an 8-1 vote, the BofE emphatically reinforced its message to maintain caution. We therefore expect a series of quarter-rate cuts to follow from November. Given current levels of caution and the headroom available, we see the possibility of more rapid rate cuts if growth slows or the BofE believes that inflation persistence has dissipated, especially from the second half of next year.

Source: abrdn, October 2024
Forecasts are a guide only and actual outcomes could be significantly different.

UK real estate market overview

Following months of stabilisation, the UK real estate market is reaching, or has reached in some cases, an equilibrium point. Not only has the level of capital value decline for out-of-favour sectors moderated, but competition among the favoured and best-in-class assets has strengthened for certain segments of the market. With income returns across the favoured sectors remaining robust, total returns for the residential, industrial, and hospitality segments are now comfortably in positive territory year to date. Out-of-favour segments are struggling, largely as a result of limited liquidity, with a reasonable bid/ask spread remaining in place.

According to the MSCI Quarterly Index, all property saw capital values stabilise at 0% over the second quarter of 2024. As expected, the favoured sectors of retail warehousing, industrial, and residential drove positive growth of 1.5%, 0.6%, and 0.6%, respectively, while offices lagged at -1.8%. As ever, the bifurcation between best-in-class assets and poorer-quality stock will continue to widen as transactions pick-up, with offices offering the greatest opportunities. 

Total returns increased over the second quarter to 1.2%, given less severe capital declines. The favoured sectors prevailed, as with capital value growth. The retail warehouse sector, in particular, posted a very robust return during the second quarter, with a total return of 3.1%, the strongest return for any segment. During the first half of 2024, all property saw a positive total return of 1.9%.

The UK real estate investment trust (REIT) index has generated a total return of 23.1% in the 12 months to the end of the third quarter, according to FTSE EPRA. The UK direct real estate market has historically lagged the UK REIT index by six-to-nine months, which provides a greater level of confidence that we are entering into a growth phase for UK direct real estate. In addition, UK REITs have been actively raising capital to deploy into growth strategies, rather than balance sheet repair, with a total of £2.27 billion raised in 2024. This sentiment is carrying over to the direct space, where the second quarter of 2024 recorded the highest investment volumes since the third quarter of 2022 at around £15 billion. Cross-border and private capital have been the most active year to date on the acquisitions side, while disposals from institutions have slowed from their recent peak in 2021

UK real estate market trends

Offices

Bifurcation remains the main storyline in the office sector, as best-in-class space receives the attention of occupiers and investors. This leaves secondary space suffering, with prolonged vacancy rates and an uncertain future. Rental value growth in the favoured and undersupplied West End submarket has increased by 7.7%, taking prime headline rents to £140 per square foot, according to JLL. Despite a stickier vacancy rate in the London City office submarket, there is also evidence to suggest that tenants are willing to commit to higher rents to secure truly best-in-class space. The city recorded prime rental growth of 10% in the 12 months to the end of the second quarter of 2024, taking prime headline rents to £82.50. We still expect the West End to outperform over our forecast horizon, given supply constraints and more positive vacancy dynamics. 

Across the UK, secondary offices have dragged capital values into steep annualised declines, running at -11.5% over the year to June. While these declines are severe, they are up from their low of –19.4% over the previous year. They have also slowed notably over the first half of 2024. With further reductions in pressure due from the BofE, we expect further declines to slow, particularly for well-located prime assets in central London.

With financing costs moving in the right direction, we are seeing an increase in acquisitions for conversion to hotel and residential use. A large amount of central London’s 20-plus million square feet of vacant stock will need to be retrofitted or converted in the near future to comply with regulations. The regions are proving less desirable for core investors, although a notable few assets across central locations in the Big-6 markets have traded recently. 

Industrials and logistics

Largely unchanged from the previous quarter, the industrial and logistics sector is benefiting from structural drivers. Rental growth and vacancy rates are softening from their respective post-pandemic strengths, although this is more of a normalisation of the sector rather than any structural weakness. Capital values have largely levelled off over the year to June, at a modest -0.2%, and contributed to a market-leading 4.2% total return over the same period. 

Supply remains elevated in response to the strength in demand seen over the pandemic. Over 55 million square feet is currently under construction across the UK, according to CoStar, although construction starts have slowed materially and currently account for 1.5% of stock. Outward shifts in yields, prohibitive development financing costs and rising construction costs should maintain this supply balance. And with tenant appetite for ‘green’ buildings remaining strong, we see robust fundamentals in the future.

While overall demand has slowed from its peak, large releases of warehousing space from troubled retailers have helped drive net absorption into negative territory over 2024. This would be more concerning if the sector had structural troubles. Instead, tenant preferences for environmental, social and governance-compliant buildings, and expectations of a strengthening economy, should feed into growing demand. As such, we expect rental growth to remain robust, driven by ‘green’ premiums and refurbishment activity capitalising on these premia.

Investors remain upbeat about the sector. This is reflected in 2024’s year-to-date investment volumes comprising 19% of the market’s total, equalling the 10-yr average for the sector. REITs have been particularly active over 2024, as they recycle and raise additional capital in the expectation of improving economic conditions. Looking ahead, we see industrial yields sharpening as investor confidence returns to real estate. But outperformance will be generated by investors capturing reversion, by stock picking, and by creating polarisation in performance through quality.

Retail

The retail sector is enjoying high relative income returns. As capital value growth has shifted into positive territory, returns over the second quarter were a healthy 2%. Over the first half of the year, capital growth was slightly positive at 0.1%, much improved from 2023’s value of -5.7%. Importantly, this performance is not exactly broad based. Total returns over the second quarter varied, from outperforming retail warehouses (3.1%) and supermarkets (1.8%), to less favourable standard shops (0.8%) and shopping centres (1.0%).

Consumer confidence has improved since the throes of the pandemic. Despite some monthly wobbles, retail sales have improved over 2024 to post 2.5% year-on-year growth in September. The outperformer here was food retailers, which have been robust in their trading figures over 2024; except for Asda, which continues to struggle. As real wages improve, the retail sector should see more optimism.

The retail sector’s landscape is working to absorb shifting consumer preferences inclusive of ecommerce and experiential shopping trends. Retail parks and select prime high-street retail are seeing strong leasing demand, while dwindling construction and conversions to alternative uses reduce existing stock. As such, London’s Bond Street and Oxford Street have renewed interest from investors, particularly family offices and cross-border capital, who are keen to pay competitive yields. Meanwhile, retail parks have a strong pull with institutional investors who are attracted by re-based yields on parks with a bias towards value retailers.  

Living

The private rented sector (PRS) has been in the news of late, given the Labour government’s commitment to revitalising the UK’s housing market and the launch of the Renter’s Rights Bill. According to Realyse data, rents across the UK increased by 6.3% over the year to August 2024, down from 11.3% in August 2023. The abrdn real estate research team was already forecasting a moderation in rents for the PRS, largely because of affordability constraints. Importantly, rents are expected to grow from here as inflationary pressures ease and real wages remain in positive territory. Demand continues to comfortably outstrip supply, which remains constrained. 

It's unlikely that we will soon see any material rebound in supply, given prohibitive construction and financing costs. This is shown by the amount of build-to-rent (BtR) stock under construction, which has slowed by 19% over the past year. Given the more positive economic sentiment of late and the anticipation of further rate cuts from the BofE, we would expect these pressures to ease, resulting in more construction starts. Overall, we view the BtR asset class favourably. It’s maturing in the UK and serves an incredibly important role in addressing the shortfall in housing provision.

Purpose-built student accommodation has also made headlines, as supply constrained markets have seen meteoric rental growth. When digesting this segment, the impact of higher- versus lower-tariff universities  on accommodation performance must be considered. The latest data from the Universities and Colleges Admissions Service (UCAS) demonstrates that while applications for higher-tariff universities have grown by 7.8% for the 2024/25 academic year, lower-tariff university applications declined by 4%. To minimise risk, appropriate stock tied to strong universities has quickly become a target model for institutional investors.

Outlook for risk and performance

UK real estate seems to have taken the initial tailwinds of economic momentum in its stride as sentiment towards the sector improves. Investors have largely sat on the sidelines, awaiting further evidence of rate cuts from the BofE. With the bulk of the correction behind us and economic conditions improving, we see capital more actively seeking to allocate to UK real estate. Competitive tension is returning for prime assets in favoured sectors. With financing costs remaining prohibitive at present, current market conditions favour equity-backed buyers for UK real estate. 

Sector bifurcation is still very relevant to expected performance, even as we expect the market to shift into gear. Notably, offices face structural problems outside of the relatively small proportion of best-in-class assets. The industrial and logistics, residential, and retail warehouse sectors will shine, given their thematic and structural drivers. We also see the ‘other’ segment performing well, driven by robust hotel fundamentals. 

Given the UK’s headroom in economic policy compared with its peers, we see the BofE remaining cautious. There is an upside risk of swifter cuts from the second half of next year. Taking this possibility into account, we are forecasting a front-loaded return profile on the basis of large inward yield shifts.