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Outlook for 2021: Small prizes and big penalties

04/11/2020

Who knows what will happen next year? The pandemic has limited our predictive horizons to weeks and months at best – or perhaps that’s always been the case! At least, now, we can look to 2021 with humility and an open mind.  

In a collective moment of introspection, occupiers are reviewing their existing portfolios to understand what space they need, and, in turn, investors will decide what assets they want to own. As a result, the difference in investment performance between sectors, and assets within each sector, will be highly polarised. Some buildings will be in high demand, while others will struggle. 

Although the economy will continue its recovery next year, it will still feel like a downturn. And, as always with downturns, the prizes for those that make the right decisions will be small, while those that make a mistake could suffer big losses. 

How will the economy perform in 2021? 

Fast growth doesn’t mean the economy is strong. The economy should grow by 4.4% in 2021, according to our base case. There are two things to keep in mind. First, annual growth could briefly hit double-digits by next summer, but this overshoot is just volatility in growth rates created by the sharp drop in output in April 2020. As a result, the impact of Brexit on the economy will be almost impossible to determine. Second, economic output will not be back to pre-covid levels by the end of 2021. The economy still would be eating into slack capacity.  

Hours worked will slowly increase, despite job losses. Two million people were still on furlough when the Government extended the scheme into November 2020. The successor, the revised Job Support Scheme, gives workers less protection but does give employers the “option of keeping their employees in a job on shorter hours rather than making them redundant.” Total hours worked should increase throughout 2021 keeping the economic recovery on track, as furloughed staff return to work. However, mass job losses are inevitable, and unemployment should peak at close to 3 million people in the second half of 2021. 

The Treasury will try to inspire more private spending. Fiscal policies introduced since March 2020 have cushioned the drop in private demand. New schemes, in the same mould as Eat Out to Help Out, will struggle to stimulate a meaningful and sustained increase in private spending while consumer sentiment is weak. Nonetheless, we expect another year of heavy fiscal stimulus. Tax hikes and other measures to consolidate the government debt pile – already over £2tn – is likely to come in later years. 

Central banks plug the gap in demand with more cash. The Bank of England can still buy another £80bn of gilts before hitting its £745bn limit. It has recently slowed the pace of its buying to keep some powder dry but will undoubtedly expand its asset purchasing programme again if needed. Interest rates will stay low and negative interest rates on short-term debt are likely. UK 10-year gilt yields will be close to zero next year, perhaps rising above 0.5% if the economic recovery stays on track. 

Inflation will be volatile, but deflationary pressures will be strongest. Inflation will stay below the 2% target throughout 2021. Volatility will come as energy prices fluctuate and fiscal policies change – for example, the end of the Eat Out to Help Out scheme boosted inflation by over 20bps in September. But given weak demand from businesses and households, disinflation and short periods of deflation are more likely next year than high inflation. Major central banks have put over £5tn into their economies since March, but inflationary pressure is unlikely considering the economic slack.

What factors will drive pricing in 2021? 

Income quality will be a stronger driver of pricing than asset quality. In the 2007-09 downturn, the most resilient properties were those with the longest leases. Whether an asset was “prime,” or its location “core,” was temporarily irrelevant – if the asset’s lease was so short that re-letting in the ongoing recession was inevitable, its value fell. Long-term property investors should focus on location and asset quality, as those factors drive performance over a cycle. But, right or wrong, risk aversion to income risk tends to trump other factors in downturns and will dictate pricing trends in 2021. 

Will people want to be in this building in future? The accelerated pace of shopping online and working from home has proven milestones once slated for the distant future can pass in a matter of weeks. The pandemic and the ongoing recession have occupiers of all property types reconsidering where they want to be and how much space they need. Real estate investors must review each asset and honestly answer: will people want to be in this building in future? Buyers’ attitudes to obsolescence will have a greater effect on asset pricing in 2021 than in previous cycles. 

What are the biggest risks in 2021? 

A lack of real estate debt could limit buyers’ options. Lenders need to refinance loans worth over £43bn in 2020/21 according to the CASS UK Commercial Real Estate Lending Report. To put that into context, new loan origination in 2019 was £44bn. There is a wider range of bank and non-bank lenders today than in 2007-2009, but those lenders will struggle to keep their pace of lending. A financing gap is likely, given the weaker economy, material uncertainty on valuations and large drawdowns on existing facilities. These factors curb the appeal of new lending and, ultimately, will limit investment activity in 2021. 

Insolvencies will rise, but by how much? Reported company and individual insolvencies have been far below normal since lockdown. New government measures, reduced HMRC activity and reduced operational running of the courts combined to keep insolvencies artificially low. Government support will reduce and measures, such as the Corporate Insolvency and Governance Act 2020 (CIGA), will wind down. Only then will the fallout from the pandemic be clear. With millions of people on furlough and many tenants failing to pay rent on time, default rates in 2021 could be higher than in the Global Financial Crisis. 

Our outlook 

Logistics are the top performing sector…again 
We forecast 28 sector and geography combinations. Total returns for these markets will spread across 14 percentage points in 2021 – half should deliver positive returns and half will likely register losses. Seven of our top 10 markets are in the logistics sector, with prime logistics in the Midlands topping the list with returns over 10%. 

Prime retail returns bottom out in 2021 
Prime retail recorded heavy losses in 2019 and the same is true this year, with most markets down around 20%. Next year will see losses stabilise and limited to single figures. Some markets will see low, positive returns in 2022. Long-run returns will trend around 7% a year thanks to high income returns and moderate growth from rebased rents. 

The office recovery won’t hit full speed until 2022 
While logistics returns will still be strong in 2022, most office markets will have started their recovery. Prime offices in Bristol should be the top performer in 2022, thanks to the extremely low availability of prime space. 

Data and Pharma sectors pique long-term investors’ interest
Beyond the forecasted markets and looking longer term, data centres and life sciences will emerge as the top picks within the specialist sectors. Both benefit from heavy institutional and private equity investment, and strong technological and demographic trends, respectively. 

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