UK commercial real estate has seen a sharp correction in prices over the last nine months. Capital values began to fall last summer and are now 21% below their peak in June 2022. That is the sharpest correction since the period immediately following Lehman Brothers failure in 2008. The key question now for investors is how much further will prices fall before the market finds a floor?
Cost of borrowing the main culprit
To date the main factor depressing capital values has been the rise in interest rates and an adverse switch in investor sentiment, rather than a fall in occupier demand and rents. The total cost of hedged bank debt on good quality assets has jumped from 3.5% a year ago to 6%. The 10 year bond yields now stand at 3.75% compared with 1% at the start of 2022.
In response, both debt-backed buyers and investors with equity have demanded lower prices in order to meet their return targets. The stand-off with sellers has pushed up real estate yields and depressed transactions.The average initial yield rose to 5.2% in January from 4.2% in June 2022 (source MSCI) and the total value of transactions in the fourth quarter of 2022 was 60% lower than in the final quarter of 2021. By contrast, rental values at the aggregate level continued to increase slowly through the second half of last year.
Inflation will be tricky to tame
What happens next will largely depend on inflation and interest rates. There is a risk that high inflation becomes self-perpetuating as a shortage of staff fuels a wage-price spiral. It is also possible that the EU’s need to replace Russian gas with alternative sources triggers a further spike in energy prices.
However, while there are tail risks, the consensus among economists is that inflation will halve to around 5% by the end of 2023. Past increases in food and energy prices will drop out of the annual comparison and the end of China’s zero-Covid policy should smooth out supply chains. As a result, the Bank of England is expected to increase base rate one more time to 4.25% and then stop. We think that the fall in house prices will also encourage the Bank to take a dovish stance, given its responsibility for financial stability and the large mortgage book of many banks.
Implications for real estate – a year of two halves?
If the consensus on inflation and interest rates is correct, then there is a strong possibility that capital values will find a floor over the summer, 25-30% below their peak in June 2022.
We expect that rental values will be broadly flat at the all property level through 2023-2024. This year’s recession is forecast to be relatively mild and there is little risk of an over-supply of new space hitting the market at the wrong time.For example, the total amount of office space in central London will only grow by 1-2% between 2022-2024. This compares with 5% during the global financial crisis (GFC) and 13% during the recession of the early 1990s.
On balance, we expect that a decline in shopping centre, leisure and secondary office rental values will be offset by growth in industrial, retail park, prime office and residential rental values. The increasing emphasis on sustainability means that “green” buildings will generally see faster rental growth and suffer less vacancy than buildings with poor energy efficiency in the same part of the market.
Buyers are out there
Turning to the investment market, some investors with high levels of debt will struggle to re-finance loans which fall due this year. We estimate that around £45 billion of debt is due to re-finance in 2023 and the rise in finance costs means that the interest cover ratio on assets with high loan to value ratios have probably slipped below 1.5x, which is the critical threshold for many lenders. Owners of these assets will either have to inject more equity, or sell.
However, on the plus side, the sharp increase in yields since last summer means that real estate is now approaching fair value for UK pension funds and other investors with equity. The spread between the average initial yield and 10 year bonds in now back to 1.5%, close to its average of 2% over the last 30 years. The gap is lower than in the last decade when it averaged 3%, but the spread was exaggerated by quantitative easing which artificially lowered bond yields.
We are also seeing renewed interest in UK real estate from international investors.The latest INREV (Investors in Non-Listed Real Estate Vehicles) intentions survey published in January found that the UK is the second most popular real estate market among Asian, Middle Eastern and North American investors targeting Europe. It is the third most popular among European investors.
In part this reflects the fact that that the UK real estate market is more liquid than other European markets and has re-priced more quickly. We estimate that capital values in the eurozone have only fallen by 6-8% since June 2022. In part it is because political risk has fallen following the appointment of Rishi Sunak’s government in October and sterling has stabilised.
Recovery taking shape
The factors that will support a recovery in investor demand for UK real estate are starting to fall into place. Bond yields appear to have found a new post pandemic equilibrium, the UK has re-priced more quickly than other real estate markets and sterling has steadied. Admittedly forecasting is a dangerous business and predicting turning points is particularly hazardous.
However, we take comfort from the fact that previous recessions have immediately been followed by periods of strong real estate performance. If UK inflation continues to fall and the recession is relatively mild, then we believe investors should consider deploying capital later this year.
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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.