Is UK real estate heading back to the 1970s?
Is UK real estate heading back to the 1970s?
In the last few months, the UK has echoed the 1970s in a surprising number of ways. Some fun, many less so.
On the cultural front, ABBA has reformed (at least virtually). Flared jeans are back in fashion.
Unfortunately, inflation has also surged, driven in part by war in Ukraine and a jump in oil and gas prices. Workers are striking for higher wages. The Bank of England is raising interest rates and there are fears that the economy could tip into recession.
Real estate investors may recall the 1970s as a dramatic period of boom and bust, and some are asking if we about to see a repeat performance. We don’t think so.
Overall, UK real estate carries less debt, is more transparent and its investor base broader than the 1970s, while construction activity in recent years has been less intense. As such, while we do expect real estate to face some headwinds, we do not expect the storm faced 50 years ago.
What happened in the 70s?
Taken as a whole, the 1970s was not a bad decade for UK real estate.
Inflation as measured by the retail prices index (RPI)1 averaged 13.8% per annum (p.a.) between 1970 and1980. UK real estate total returns averaged 16.3% p.a.2. While commodities proved to be a better hedge against inflation, real estate returns were above inflation and stronger than both UK equities and bonds with total returns of 14.2% p.a. and 10.2% p.a., respectively3
However, strong performance at the start and end of the decade sandwiched a major downturn in the middle.
Real estate returns averaged 24.4% p.a. over the three years to end-1973. This amounted to 14.1% p.a. in real terms (adjusted for inflation). The real estate market returned 23.0% p.a. over the four years to end-1980 (8.7% p.a. in real terms).
By contrast, real estate total returns dropped to 0.8% p.a. over the three year to end-1976. This is equivalent to -15.7% p.a. in real terms.
Why was performance so erratic?
The strong performance at the start of the 1970s was driven primarily by rapid economic growth, the so-called “Barber boom”. The Barber boom refers to a series of policies introduced by then chancellor of the exchequer Anthony Barber that sought a “dash for growth”. The policies centred on aggressive fiscal policy, primarily various tax cuts, aiming to deliver a rapid period of economic growth.
At first it worked. Initially, the Barber boom lifted occupier demand and rents. However, the economy went into recession in 1974-1975. Oil prices rose fourfold. A miners strike interrupted coal and electricity supplies. The Bank of England (BoE) doubled the minimum lending rate (a forerunner of base rate) from 7.5% in June 1973 to 15% in October 1976. 10-year government bond yields jumped from 11% in 1973 to 17% in 1974, before settling at 15% in 1975-76.
The hike in interest rates impacted real estate capital values and returns in two ways.
- First, the hit to the economy and occupier demand meant that rental growth slowed, even as inflation accelerated to 20%. Rents were also put under pressure by the completion of a number of speculative building projects. Many projects started before the recession, were completed during it, destined to sit empty, unable to attract tenants.
- Second, the rise in interest rates depressed investor appetite for real estate. The increase in bond yields reduced the relative attractiveness of real estate to institutions. The doubling in short-term interest rates meant that many property companies which had floating rate debt could no longer service their loans. As a result, the all-property equivalent yield (i.e. cap rate) rose from approximately 6% to 9% between 1973 and 19754
The second period of strong returns was initially fuelled by a fall in real estate yields through 1977-78, as interest rates fell and the economic outlook improved. Rental growth then took over the running in 1979, although it began to slow in 1980 when the economy went back into recession.
Can investors expect the same to happen today?
Facing very high inflation, rising interest rates and a high risk of recession, should investors expect a repeat of the 1974 crash?
Capital values fell in 1974 fell in real terms by 33%. If we assume inflation over the next 12 months will average 8-10%, that would equate to a fall in capital values of 25-30%.
Is that about to happen?
Clearly, there are many more factors at play. A lot will depend upon the state of the economy and by how much the BoE believes it needs to raise interest rates to bring inflation under control.
We expect that the BoE will raise base rate to 3% by early 2023 and then keep it on hold. We expect 10-year bond yields will also rise to 3%. This in turn assumes that the UK avoids a repeat of the wage-price spiral seen in the 1970s when average earnings grew by 16% p.a., so that high inflation became self perpetuating.
There are also number of key differences between today’s real estate market and that of the 1970s. Here’s a quick breakdown.
Source: Schroders Capital
The factors above were broadly supportive for the stability of 1970s property.
The technology factor is relevant because in the analogue 1970s, demand for space moved in line with the economy. Online sales were not around to reduce retail space needs. Remote working did not exist to undermine office requirements. Both of these features were positive for real estate values and returns in the 1970s. But other differences added to volatility and made the real estate market more prone to large swings in capital values.
1970s – Higher debt
Real estate investors in the first half of 1970s were more reliant upon debt, so there was a greater risk of a downward spiral of falling prices and forced sales. In 1975 commercial real estate accounted for 13% of total bank lending, compared with 9% today5. The jump in interest rates and rise in vacancy between 1973-76 bankrupted many property companies. The BoE put pressure on UK insurance and pension funds to buy real estate in order to protect the big retail banks from the collapse of secondary banks. The more disciplined approach of banks and other lenders over the last decade reflects the tightening of financial regulations since the Global Financial Crisis (GFC).
1970s – More speculative development
In part because of this more disciplined approach from lenders, the last decade has seen much lower levels of speculative development than 50 years ago. In the 1970s total office floorspace in central London grew by around 10% and the amount of shopping centre space doubled. Over the last 10 years the total amount of central London office and shopping centre space has increased by just 1% and 8%, respectively. There is therefore much less risk now that the impact on rents of a recession from falling occupier demand will be compounded by a swathe of new space arriving on the market at the wrong time.
1970s – Less diverse and liquid investment market
In the 1970s exchange controls meant that the UK market was dominated by domestic investors. International investors now own approximately 30% of UK commercial real estate6. The wide range of investors, with different time horizons and costs of capital, means that the investment market is inherently more liquid. Capital can respond more quickly if prices look detached from underlying value.
Repeat of the 1974 crash unlikely
In light of these differences in market structure and assuming that UK 10-year government bond yields peak at 3%, we believe that a repeat of the 1974 crash is unlikely. That said, we believe all property capital values could fall by around 10-20% between end-2021 and end-2023.
Most of the decline will be due to an increase in the all property equivalent yield, in response to more muted interest rate increases. While it is possible in some segments (see below) that rental growth will accelerate in response to higher inflation, we expect that rental values on average will be flat.
That would leave total returns between zero and -5% in 2022 and 2023 or between -8% and -13% in real terms. Looking further ahead, we expect that total returns would then settle at 6-8% p.a. through 2024-2026, assuming real estate yields find a new equilibrium level and rental growth resumes as the economy gains momentum.
Which sub-sectors look more vulnerable?
It is unlikely that any part of the market will completely escape the downturn.
We would expect to see a more limited rise in yields and smaller fall in capital values where there are good demand and supply dynamics and/or the landlord’s income is aligned with the success of the businesses. Where a landlord’s income is “operationally aligned”, higher inflation is more likely to feed through to rental income.
Generally the real estate market has broadened significantly since the 1970s, which means investors have more choice across sectors and exposures, each with its own dynamic.
Sectors we expect to be more resilient:
- Bulky goods retail parks – These generally enjoy steady demand from discounters like Aldi, B&M and Lidl, as well as mid-market retailers such as M&S, Next.
- High quality, energy efficient, city centre offices – Energy efficient and attractive offices can enable occupiers to attract staff and cut their carbon footprint. Strong opportunities in Bristol, Leeds, London, Manchester and the Oxford-Cambridge Arc.
- Multi-let industrial estates - Benefitting from the growth in trade counters - such as Screwfix or Toolstation - and last-touch industrial / logistics units.
Certain niche sectors are also gaining from long-term structural changes to make them more defensive. These include laboratories, self storage, social supported housing and student halls. The jump in construction costs and tightening in bank loan terms is likely to depress prices for land and re-development projects, limiting additional supply to these sectors and further supporting rental growth.
Sectors we believe look more vulnerable:
Rents in segments with weak demand and supply fundamentals are unlikely to enjoy a slipstream effect from higher inflation.
- Secondary shops and shopping centres
- Dedicated conference hotels
- Offices in secondary locations
We do not favour any building with poor energy efficiency and general lack of higher-rated tenant amenities. We are also cautious on distribution warehouses. It is the one part of the market which has seen significant new building over the last three years and non-food retailers account for around a third of space. In the short term consumers are likely to cut back online, as well as in-store.
Prime versus secondary
It is sometimes argued that prime assets are more vulnerable to an increase in yields, because prime yields start from a lower level. However, that assumes that prime and secondary yields rise in parallel. In previous downturns the gap between prime and secondary yields has widened as investors have become more risk averse. Furthermore, prime assets are less likely to suffer an increase in vacancy and fall in operating income. That was the main reason why prime out-performed secondary assets in both the early 1990s downturn and again during the GFC.
Don’t overlook real estate debt
One area which investors should consider is UK real estate debt. There has been a gap in the finance market since the GFC as banks have cut back on loans with higher LTVs (i.e. > 60%). While the slowdown in the economy could lead to more defaults, the risk can been mitigated by careful underwriting and focusing on assets with good bricks & mortar fundamentals managed by experienced operators. The forecast rise in interest rates will add further to returns.
History may rhyme, but unlikely to repeat
The current downturn is unlikely to be on the same scale as 1974.
Although inflation and interest rates are rising, they are still low by 1970s standards. Overall there is a lower level of debt and new building now compared with the 1970s, so real estate is better placed to withstand a recession. The UK investment market is also much more international, transparent and diversified.
We think the decline in capital values over the two years to end-2023 will be limited to 10-20%. Prime assets, segments with good demand and supply dynamics and assets where the landlord’s income is aligned with the success of the tenant will be more defensive. History may rhyme, but it shouldn’t exactly repeat.
1. Schroders estimate. MSCI UK equivalent yield data begin in 1976.↩
2. The more accurate consumer price index (CPI) measure of inflation does not start until 1988.↩
3. MSCI UK Annual Real Estate Index↩
4. Barclays Equity & Gilt Study↩
5. It is not possible to calculate an aggregate LTV ratio, because there are no data on the total value of commercial real estate in the 1970’s. Similarly, there are no data on ICRs in the 1970s. However, changes in the percentage of total outstanding bank debt owed by real estate investors provide a reasonable proxy for lending policies. The data quoted in the article and shown in Figure 2 include CMBS and non-bank lenders.↩
6. The Size and Structure of the UK Commercial Real Estate Market: End-2020” Investment Property Forum. January 2022↩