Monthly UK GDP grew by 1.8% in May 2020 but is 24.5% lower than the levels achieved in February before the full impact of COVID-19. In May, some businesses saw staff return to work, but this was on a very limited basis. ONS estimates that 8% of the workforce returned from furlough in the first two weeks of July, while 4% returned from remote working to their normal workplace. Some of the sectors hit hardest by the lockdown e.g. food and drink, retail and construction together with manufacturing showed some signs of recovery.

This month the OBR published further guidance warning that the UK was on track to record its largest annual fall in GDP in 300 years and warned that the pace of any recovery remained highly uncertain. In its central scenario, economic output recovers slowly and regains its pre-virus level by the end of 2022. City forecasters estimate of the average economic decline in 2020 has improved from -14% in April to -9% in July. But the range varies between -7% and -12%.

In the UK and across Europe the daily number of confirmed COVID-19 cases has continued to decline from April’s peak. Pandemic cases, however, are still increasing throughout much of the rest of the world. Consequently, as economies gradually open up again, the risk of a second outbreak remains which would be disastrous for public confidence. The OBR’s downside scenario envisages “a significant loss of business investment, more firm failures and persistently high unemployment”. Output only recovers its pre- virus level in Q3 2024.

The Bank of England’s guidance to financial institutions warning against the payment of any distributions to shareholders remains in place until the end of the year. Almost half of the companies listed on the FTSE 100 index have now cancelled or suspended their dividend.

The FTSE 100 index fell 32% between 23rd March and 21st February but has since staged a recovery of 23%. In the USA the Dow Jones Industrial Average fell a similar 36% between the start of the year and 23rd March but has since jumped by 44% although remaining 7% below its 2019 year- end level. However, the NASDAQ Composite index of tech stocks is now 15% higher than it was at year-end, having increased 53% since 23rd March.

UK REITS fell -28% in Q1 but have recovered only 3.8% in Q2. Industrial and logistics specialists Segro, Big Box, London Metric and Big Yellow have all fared better than Intu and Hammerson with shopping centre portfolios and Shaftesbury with its central London village shops.

Risk free assets are now yielding close to zero and UK short term rates are negative. Gilt yields have hardened by a further 20 bps in Q2 and by 66 bps since the start of the year as investors have sought to limit volatility and risk in portfolios. In March the spread on investment grade corporate bonds over 10-year Treasuries increased to 4.3% from 2.0% in February but has now fallen back to the long term average of 2.75%.

With UK commercial real estate values continuing to fall, the current property initial / gilt yield gap has therefore increased to 5.1% more than | standard deviation above the 10- year average. It has never been higher. In June 2009 as UK real estate prices reached the trough of the slump caused by the GFC, the yield gap stood at 3.7%.

The current level of property yields relative to the risk free rate should provide some level of protection to UK real estate asset prices. But it is also a comment on the liquidity premium required as a result of the collapse in the number of real estate transactions.

Ten open-ended property funds aimed at retail investors remain closed to redemptions. However, for the first time, funds targeted at institutional investors have also closed. Twenty of the 29 institutional-focused funds in the MSCI/AREF UK All Balanced Property Fund Index have suspended or deferred redemption payments saying that “material uncertainty” means that they are unable to provide accurate valuations. There is speculation that it is unlikely that funds would unfreeze before September. Thereafter a rush to exit the funds could cause further closures whilst a series of forced sales are completed.

All Property capital values decreased by -3.6% in Q2 as Retail capital values fell by -6.7%. Office capital values fell by -2.6% and Industrial values decreased by -1.7%. A degree of transparency has returned to the market and the “Material Uncertainty” qualification applied to all valuations at the end of QI has been lifted for all types of assets except Shops, Shopping Centres, Retail Warehouses, Offices outside London, Leisure and Hospitality uses.

As the quarter progressed the impact of softening yields has diminished and the main driver of falling values has been declining market rental values. All Property rental values decreased -1.0% in Q2. Office rental values fell just -0.3% while industrial rental value growth remained positive. However, rental values for Shopping Centres, Retail Warehouses and Shops continue to fall.

Our central forecast remains much as it was at the end of last quarter. Capital values could fall by -12% this year. However, data from Re-Leased, providers of cloud based commercial property management software, shows that 60 days after the March quarter day only 67% of commercial rents had been collected. And, seven days after the June quarter day 46% of rents had been collected. Consequently, we have now built in an element of tenant delinquency which reduces total return to -9% and income return to 3%.

Transaction activity has plummeted (see Chart) as investors do not have the confidence to transact without valuation certainty. But lost rental income could pass through to missed mortgage payments causing forced sales by delinquent borrowers thus finally providing evidence on the level of real estate values.