GRILLO EUROPE UK PROPERTY MARKET OCTOBER Independent Property Consultants. Economic Background

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1 GRILLO EUROPE Independent Property Consultants UK PROPERTY MARKET OCTOBER 2014 Economic Background In our mid-year update we suggested that the strong performance of the UK economy would result in an early increase in the cost of borrowing, which had at the time been forecast by leading economists and even hinted at by the Bank of England. The outcome has been significantly different with most economists now seeing the first increase in Bank Base rate as far off as mid The UK economy continues to outperform other EU economies but global uncertainties and falling commodity prices have subdued those inflationary pressures which were present earlier in the year. UK Economic Statistics The UK economy grew by 0.7% in the third quarter, however the pace of expansion slowed from 0.9% in the second quarter with fears mounting that recovery could be knocked further off course by a weak Eurozone economy and rising uncertainty in global markets. This was the seventh consecutive quarterly increase, taking the year-on-year growth rate to 3% in line with market expectations. The UK government may view this sustained growth as a mixed blessing, after being given a bigger bill for the EU budget thanks to the UK s relative outperformance of its EU peers. The most surprising aspect of the report was construction, which showed a 0.8% improvement. The other area that was noteworthy was business services which saw 1% quarter-on-quarter growth after 1.5% quarter-onquarter in Q2. Employment continued to rise and unemployment continued to fall. These changes continue the general direction of movement since late 2011/early For May to July 2014, 73.0% of people aged from 16 to 64 were in work, up from 71.6% a year earlier. The unemployment rate for May to July 2014 was 6.2%, the lowest since late The Consumer Prices Index (CPI) grew by 1.2% in the year to September 2014, down from 1.5% in August. Falls in transport costs and prices for a range of recreational goods provided the largest contributions to the slowdown in the rate of inflation between August and September. Housing & household services (including utility bills) accounted for a third of the rate of inflation in the year to September. If falling food and motor fuel prices were excluded, the rate of inflation would be a third higher. The Retail Price Index (RPI) is a long-standing measure of UK inflation that has historically been used for a wide range of purposes such as the indexation of pensions, rents and index-linked gilts. This index has been found not to meet the required standard for designation as a National Statistic and has been replaced with a new index, RPIJ, which complies with international standards. In September 2014, the old RPI was running at an annual rate of 2.3%, whilst the new RPIJ showed a much lower figure of 1.6%. The RPI has been de-designated as a National Statistic. It will be interesting to see over time how this new index is used by the government to reduce its expenditure.

2 Low inflation and an expected economic slowdown and troubles in the neighbouring Eurozone saw the majority of Bank of England policymakers voting against a rate rise during their October 2014 policy meeting.. All but two policymakers voted against a rise in the bank rate from its record low of 0.5 per cent - where it has been since March with economists now shifting their predictions of a first rate rise from early next year to mid or late As mentioned in our last report, house prices are the one part of the UK economy where inflation has been a problem but the Bank's new tools to constrict banks ability to make risky loans seems to be taking effect to cool down the property market without a significant rise in interest rates. UK House Prices September data from the Land Registry, which is considered the most accurate house price index based on sale values, showed an annual price increase of 7.2%, taking the average property in England and Wales to 177,299. However the monthly fall of 0.2% echoes a number of other indices released last month. Data from Hometrack and the Royal Institution of Chartered Surveyors both showed the housing market finally cooling. This correction follows a year in which values and transactions were buoyed by pent up demand, flowing credit and the Government's Help to Buy scheme. The average house price in London increased 20% in the year to August, according to the Land Registry, with luxury property in the capital's core now considered the most expensive in the world on a square foot basis. However, the annual pace of growth in the mainstream market then dropped back to 18.4% in the 12 months to September, with the monthly rate showing a 0.7% fall to 460,521. The biggest drop was seen in Yorkshire & Humberside, where monthly prices were down 2.2%. Declines were also seen in the West Midlands (-1.3%), followed by a 0.8% fall in the East Midlands. The only regions to escape house price falls were the East, the South West and Wales. Cost of Finance Since our last update in June 2014, 3 month LIBOR has remained relatively stable currently running at 0.55%. Despite the improved economic outlook, potential rises in Base Rate are now likely to be deferred until mid-2105, SWAP rates have fallen since our June report with the 3 year SWAP now down another 28bps at 1.44% and 5 year SWAP down by 36bps at 1.84%. There is currently a good level competition amongst the banks for commercial property lending. According to Kingfisher Property Finance, most banks now have an active allocation to the sector and some have even had trouble meeting their quotas. The debt market is still multi-tiered with regional variations depending on the quality of the property and the strength of the borrower s track record. Banks now compete strongly for the most attractive loans with borrowing levels for smaller prime loans below 15 million at a maximum of 65% LTV (Loan to Value), in comparison for 60% available earlier in the year for similar quality properties, all-in interest costs for a 5 year fix would be in the range 3.75% to 4.5% based on margins of 2.0% to 2.75%, plus an origination fee of 1.0%. For secondary properties in the sub- 15 million range, the challenger banks have a greater appetite for risk with increased gearing levels available. Margins for such assets will be commensurately higher in the range 2.75% to 5.00%. Above the range 15 million to 20 million, margins of 1.65% to 1.85% can be achieved and at the very top end of the market for loans in excess of 75 million, margins are even tighter. For these larger loans up front origination fees are more open to negotiation. The market for development financing is more limited but funding at 65% LTC (Loan to Cost) is available at floating rates ranging from 3.0% to 7.0% above LIBOR depending on the location and track record of the developer. UK Commercial Property Market Trends The IPD Quarterly Index for Q showed a total return for all UK commercial property of 4.4% and annualised overall returns of 18.2 % for the 12 months ending September Annualised all property rental growth for Q was 2.7% lead by Central London office rentals growing at 5.6%. The top performing sector nationally was offices with 4.5% for Q3, ahead of industrials with 3.2% for the quarter. 2

3 UK commercial property has recorded strong total returns of 14.3% so far this year. CBRE suggest that if capital value growth continues at the same rate in Q4, the annual total return for UK commercial property will be 19.6%, which is well above the 2013 result of 11.5%. Central London Office Market In contrast to the first two quarters of 2014, Central London office take-up was 4.6 million sq ft in Q3 2014, as reported by Knight Frank. Q was the highest level of take-up since 2007 and 45% above the long term average quarterly take-up. The two largest transactions of the quarter, which accounted for 760,000 sq ft, involved the technology and financial sectors, reflecting the demand profile across the whole market. There was strong demand across all size brackets with the middle market continuing to show strong performance; one-third of transactions involving leases of between 20,000 sq ft and 100,000 sq ft. For the sixth consecutive quarter availability in Central London fell and now totals 14.4 million sq ft, reflecting a vacancy rate of 6.2%. Since the low-point of the cycle back in 2009, availability has dropped by 10 million sq ft, with the majority of the fall attributable to the reduction of the supply of second-hand space. Supply is very constrained in the West End, with a vacancy rate of 4.5%. Across Central London there is 6.7 million sq ft of space currently under construction, 46% of which has already been pre-let. As demand strengthens, Knight Frank expects tenants to acquire more space from the pipeline, exacerbating the relative lack of new and refurbished options across the market. City of London Q saw a strong take up of City offices with 1.8 million sq ft leased in 116 deals, according to a recent Estates Gazette survey. This was the highest total quarterly take-up in the City core since the fourth quarter of 2004, when 2.1 million sq ft was leased. The profile of the lettings highlights the diverse range of business sectors now active in the City core. TMT, which more usually locates in the West End or City fringe, accounted for 13% of take-up. The largest deal in the City core in Q was M&G s 323,000 sq ft prelet of Generali s 10 Fenchurch Avenue, EC3, where demolition works are now under way. The second largest deal was Amazon s 96,000 sq ft letting of Brookfield s Leadenhall Court, EC3. Availability in Q was 8.65%, down from 9.41% in Q2. While the drop is sizable, the rate is not as low as at the end of 2013, when it dipped to 7.93%. The declining availability of space is pushing rents upwards, with the average rent on new-build space in the City core now standing at per sq ft. The largest new instruction to this market in Q3 was 62,071 sq ft at St Martin s-le-grand, EC1. Construction starts in Q3 totalled just 520,000 sq ft but still more new starts than the first two quarters combined. 310,000 sq ft of this new space has been pre-leased, so these starts will have little impact an increasing shortage of grade-a space in the City core. The largest construction start of the quarter was at One London Wall Place, EC2, where Schroders pre-leased 309,397 sq ft in Q Future development supply dropped by 1.15 million sq ft quarter-on-quarter. Looking ahead to 2015, the situation is better, with 2.1m sq ft to be delivered and 61% of it still available. However, of the 460,000 sq ft scheduled for 2016, only 33% is still available. Both CBRE and Knight Frank report Q prime headline rents in the City at per sq ft, although since the end of the quarter British Land and Oxford Properties are believed to have agreed a deal to lease the 7,700 sq ft, 41st floor of the Leadenhall Building (locally known as the Cheesegrater due to its shape) to US-based insurance company, FM Global at almost 85 per sq ft, which would be a record for the City of London. West End West End take-up in Q totalled 942,000 sq ft as reported by Strutt & Parker. This total was in excess of the three year average (789,980 sq ft) and the five year average (838,930 sq ft). It was however down from the Q total of 1.13 million sq ft. The largest amount of take up was in the Victoria / Knightsbridge village, totalling 328,545 sq ft, up from 174,584 sq ft last quarter. A large proportion of this (70%) was due to Parliamentary Estates Directorate s acquisition of 39 Victoria Street (90,596 sq ft), Dong Energy s acquisition of 5 Howick Place (82,000 sq ft) and Jupiter Asset 3

4 Management s acquisition of the Zig Zag Building (56,357 sq ft). 600,000 sq ft was also placed under offer in the West End in Q3, which bodes well for a strong finish to the year. Strutt & Parker report Q West End availability (excluding under construction) at 2.85 million sq ft reflecting a vacancy rate of 3.89%, down from 4.46% in Q2. Availability including buildings under construction stands at 4.53 million sq ft, a vacancy rate of 6.20%, down from 7.00% in Q2. Within this current availability (excluding under construction) total Grade A (new and second hand) availability totals 1.50 million sq ft or 53.00% of available stock. The highest headline rent achieved in the West End in Q was per sq ft at Lancer s 50 Berkeley Street, W1, where Salamanca signed a 10 year lease of 10,800 sq ft, with a 19 months initial rent free period. Other rents in excess of 100 per sq ft were achieved at Devonshire House, W1 where Advent Capital Management took some 3,000 sq ft on a 10 year lease, with 5 year break option, at per sq ft and London Executive Offices committed to a 15 years lease of 23,700 sq ft at rents averaging 105 per sq ft. Midtown Take-up in Midtown continued to perform strongly in Q3 2014, rising by 11% over the quarter to 600,000 sq ft. CBRE report that take-up has been consistently above the 10-year average of 300,000 sq ft since Q4 2013, supporting a rolling annual total of 2.1 million sq ft. In Q3, pre-letting accounted for 50% of the total, with advertising firm Havas acquisition of 158,000 sq ft at Three Pancras Square, King s Cross, N1, the largest pre-let and largest deal of the quarter. There were six deals over 20,000 sq ft in Q3, of which four were over 50,000 sq ft. In the second largest deal of the quarter, law firm Mishcon de Reya committed to taking 116,400 sq ft at Africa House, Kingsway, WC2. Q availability in Midtown was 1.2 million sq ft, up by 3%, reflecting an availability rate of 5.0%. Supply remains below the 10-year average of 1.4 million sq ft and the majority of the space available in Q3 was second hand (600,000 sq ft) with newly completed space accounting for 300,000 sq ft. 900,000 sq ft expected to complete during 2014 compared with a 20-year average of 400,000 sq ft. 4.2 million sq ft is scheduled for delivery from 2015 to 2018, of which 2.0 million sq ft is speculative. High demand and limited availability resulted in strong rental growth during 2013, and CBRE forecast that prime Midtown rents will reach per sq ft by the end of the year, reflecting year-on-year growth of 13.0%. Docklands Knight Frank report Docklands office take-up was 205,000 sq ft in Q3 2014, down by 38% from 328,000 sq ft in Q2. However, take-up levels for the year so far are already 58% higher than the total take-up figure recorded for The largest deal of the quarter was at 25 Canada Square, where Truphone Limited took just under 61,000 sq ft on a 10-year lease. There was a further 62,000 sq ft leased in the building to occupiers including GFK Limited and NetNames. Availability in Docklands increased marginally from 1.4 million sq ft to 1.6 million sq ft, although this level is 18% below the level recorded during the same quarter last year. Supply in Canary Wharf is currently at 1.0 million sq ft, which is 9% below the long-term average. The largest unit of space currently on the market is the entire 319,000 sq ft building at 5 Churchill Place, E14, which has yet to attract any tenants. There are currently no office buildings under construction in Docklands, which is hardly surprising as prime Docklands office rents are currently stable at per sq ft. There is however reportedly upwards pressure on rents in Canary Wharf. South Bank Office take-up in Southbank fell by 46% in Q to 137,900 sq ft, although CBRE comment that take-up had been above the 10-year average of 221,500 sq ft for every quarter since Q Despite this quarterly fall, the rolling annual total remained strong at 1.0 million sq ft, some 9% above the 10-year annual average of 900,000 sq ft. There was only one lease of more than 20,000 sq ft in 4

5 Q3, the 24,100 sq ft letting to IT solutions firm Alternative Networks at 240 Blackfriars Road. The second largest deal of the quarter was at 1 London Bridge where software company E2X acquired 9,900 sq ft. There was a significant number of deals totalling 552,700 sq ft under offer in Q3, against a 10-year average of 217,700 sq ft. CBRE anticipate a strong final quarter of take-up, with the total for the year well above trend. Availability increased for the first time in 15 months, rising by 11% in Q to 1.0 million sq ft, above the 10-year average of 900,000 sq ft and reflecting an availability rate of 5.3%.. The majority of availability was made up of newly completed space totalling 500,000 sq ft, the bulk of which of which is 374,500 sq ft at The Shard accounted. Southbank prime rents, increased by 3% over the quarter to per sq ft, the prevailing rate in More London, SE1 M25 & Thames Valley Office Markets M25 take-up rose strongly driven by consistent demand as for all Grades of space across all locations, according to Colliers International. 1.3 million sq ft was transacted across all size bands with the Thames Valley accounting for 56% of activity. Even allowing for the exclusion of the Dixon Warehouse deal in West London, overall take-up still rose by 15% quarter-on-quarter with Thames Valley quarterly take-up rising by 47%. In their M25 Offices report for Q3 2014, Knight Frank report M25 vacancy rate unchanged during Q3 at a 12-year low of 6.4%, the M4 vacancy rate fell for an eighth successive quarter, reaching a record low of 7.5%, and the M3 vacancy rate fell to a 12-year low of 6.8%. Whilst Colliers report much higher vacancy rates they agree that acute shortages are now evident in key locations such as; Hammersmith (2.2%), Chiswick (4.6%), Windsor (4.4%), Woking (6.6%) and Wimbledon (4.1%). Across the 39 M25 Centres monitored by over 70% are now experiencing vacancy below the 10 year average. Knight Frank comment that falling availability is partly explained by increasing rates of take-up, postrecession, but is also linked to the extension of Permitted Development Rights. During the past 12 months, almost one million sq ft has left the market for residential conversion, with a particular focus in Croydon, Slough, Bracknell and Crawley. Six speculative office developments totalling circa 300,000 sq ft were completed in Q3 2014, the highest quarterly level of completions since Q Two of the completions were in Staines, Boultbee Land s TWENTY scheme (45,413 sq ft) and LIM / Bell Hammer s Strata (89,893 sq ft). At the end of Q Knight Frank state that there are 20 speculative schemes under construction across the main markets totalling just under 2 million sq ft, a rise of 23% from Q2. This is likely to expand further, with circa 700,000 sq ft expected to commence in Q4, mostly comprising redevelopment of existing buildings. Prime M25 and Thames Valley office rents at the end of Q reflect this renewed demand with Chiswick at per sq ft, Hammersmith per sq ft, Richmond per sq ft, Wimbledon per sq ft, Staines and Maidenhead 33.00, and Uxbridge at 32 per sq ft. Reading prime rents are per sq ft while Slough at per sq ft, St Albans per sq ft, Watford per sq ft and Bracknell at per sq ft provide some of the lower rents in the region. Regional Offices 2014 is set to be the most active year for the regional office markets since 2008 according to a recent report by Knight Frank. For the majority of markets, 2014 take-up to date is already above or close to the annual average for each of the previous five years. Aberdeen has already achieved a record year, with 647,874 sq ft of take-up, which included two substantial pre-lets, while Manchester is likely to break the 1 million sq ft mark for Active demand remains robust, rising by 5% in Q3 overall. Birmingham lagged other regional markets in 2014 to date but saw a substantial 80% rise in demand in Q3. HS2 s imminent 110,000 sq ft deal at Two Snowhill should boost Q4 take-up. Leeds is also expected to end 2014 strongly, with two prominent pre-let deals in the pipeline. 5

6 The growing shortage of Grade A supply in the majority of the UK s key regional markets has been met with a measured response from developers. Regional speculative development activity climbed to a six year high of 2.2 million sq ft by the end of Q3, despite several notable completions, such as One St Peters Square, Manchester. Glasgow accounts for 20% of total speculative development activity in the regional markets surveyed, although healthy interest is already being seen for pre-let opportunities. Prime headline rents remain under upward pressure. Two markets saw headline rents increase during Q3, with Glasgow rising to psf and Leeds to psf. Rental growth is expected to take place across the majority of markets over the next 18 months, with new development completions securing higher prime rental levels in Bristol, Birmingham and Manchester. Investment Market Activity Investment in UK commercial property totalled billion in the first three quarters of 2014 compared to billion during the same period in 2013 as reported by IPD (Investment Property Databank). Central London investment volume was one of the main drivers with transaction volumes totalling 10.2 billion, with overseas purchasers accounting for some 60% of all Central London deals. Outside London, offices were the most actively traded investment with total volume for the year to end of Q standing at 4.68 billion; shopping centres and industrial were not too far behind at 3.91 billion and 3.87 billion respectively. For the first three quarters of 2014, the breakdown of total acquisitions and disposals by purchaser group based on figures prepared by Cushman & Wakefield, revealed that UK institutions acquired 11.0 billion of property assets but disposed of 6.2 billion (a net investment of 4.8 billion) whereas UK property companies were net dis-investors with 7.68 of acquisitions verses billion of sales. Despite the high level of overseas acquisitions totalling billion, offshore investors also sold billion of UK properties for a net inflow of just 3.13 billion. Central London investment volumes increased by 4% over the quarter to reach 4.3 billion in Q3 2014, bringing the total for the first three quarters of the year up to 11.3 billion, as reported by CBRE. This was broadly in line with the total during the corresponding period in The West End saw the highest volume of transactions over the quarter, contributing 2.2 billion compared with 1.3 billion in the City, 605 million in Midtown, 163 million in Docklands and only 40 million in Southbank. Overseas purchasers accounted for the majority of Central London investment in Q3, with 60% of the total. US and Canadian investors were most active, accounting for 25% of turnover. The proportion of domestic investors increased to 36% from 28% in the previous quarter with UK property companies accounting for 14% of investment volumes. In the largest deal in Central London in Q3, the Norwegian Sovereign Wealth Fund, through Norges Bank Investment Management, agreed a 90:10 joint-venture with The Crown Estate to purchase a 64.2% interest in the mixed use Pollen Estate in Mayfair from the Church of England for 381 million. Greenwich Hospital and the Pollen family continue to own the remaining 35.8% of the estate. Investment in the South East office market remains strong, with Q3 turnover reaching 620 million, which is 37% above the 5-year quarterly average as reported by Knight Frank. Q3 activity totalled 32 deals, taking the total for the first nine months of 2014 to 89, the highest number of investment sales seen in the first three quarters since The market continues to be dominated by domestic investors and institutions, which together accounted for all but 6 of Q3 s deals. These UK buyers prefer well-located, multi-let assets, whilst overseas investors favour single-tenant buildings. Regional office investment activity was exceptional in Q with 1.30 billion of assets traded, the highest volume in a single quarter since Q Knight Frank reports that total regional investment volume to the end of Q was 3.1 billion, which is already above the annual total for each of the last six years. Manchester was key to activity in the quarter, with Schroders purchasing City Tower, Piccadilly for 132 million and Legal & General s acquisition of 1 Piccadilly Gardens for 75million. There was also significant investment activity in Birmingham with Q3 volume of 185 million, dominated by M&G s 140 million purchase of Two Snowhill, which was the largest deal across all regional markets in the quarter. 6

7 IPD report that yields strengthened by 200bps in Q3 2014, having peaked at 9.1% in Q2 2009, the all property equivalent yield now stands at 6.2% but still above its all time low in Q of 5.4%. Prime City of London yields remain at 4.5% in Q but there is continued downward pressure on West End offices with prime yields now at 3.50%, equivalent to the low point in Q Outside London investment yields are approaching the lows of 2007 with Thames Valley offices at 5.25% compared to 4.75% in 2007, Manchester, Birmingham and Leeds also at 5.25% (2007: 4.5%) and other cities such as Newcastle, Sheffield and Liverpool with further to go at 6.00% (2007, 4.75%) Outlook UK economy continues to perform more strongly than mainland Europe but pressure for an early increase in UK interest rates has receded. Prospects for real rental growth are no longer confined to Central London with rises being seen across a number of South East and regional markets. Offshore capital continues to flow into the Central London markets, although some offshore investors have taken the opportunity presented by the high prices achievable to cash in profits from purchases made earlier in the property cycle. Outside London, South-East and prime regional city offices continue to attract capital predominantly from UK based fund managers and those overseas investors who have found the low Central London yields unattractive. Yield compression in Central London and the South-East has largely run its course but we can expect further reduction in yields in many regional centres as investors become more confident in rental growth prospects. On the political front, the No vote in Scottish Independence Referendum has allayed some fears for the time being but the run up to the UK General Election in May 2015 could result in uncertainty in the first half of The rise in support for UKIP (the UK Independence Party) with its recent by-election victories is pushing the Conservative party, which is the senior partner in the Coalition government, to take a more confrontational approach to EU membership with a promised referendum on UK membership by Although we doubt if such a referendum would result in the UK leaving the EU, there is no doubt that current sentiment is questioning the benefits of being tied into the wider European economy with all the problems being faced by the faltering economies of the Eurozone. UK property markets are currently performing well with a reasonable balance between occupational demand and availability in the commercial markets. Shortages in supply in some submarkets will encourage more new development and, with pressure from the lending banks to deploy capital to the sector, there is likely to be an increase in development activity over the next 12 to 18 months with new deliveries not arriving to the market until 2017 or later by which time interest rates are expected to be higher and the marginal risk adjusted returns from property over fixed rate investments could be substantially lower. Grillo Europe October