The Truss government leaves a mixed legacy.  On the plus side, the energy price guarantee means that inflation is likely to peak at 10% rather than 13%, and slow to 4% by the end of next year.  That will support consumer spending and reduces the risk of a wage-price spiral.  On the downside, the short-lived plan for large, unfunded tax cuts damaged the UK’s credibility and has put more pressure on the Bank of England to raise interest rates.  We expect base rate to rise to 4.5% by March 2023 and the increase in finance costs is likely to trigger a fall in house prices and increase in corporate insolvencies.  Schroders forecasts that GDP (total output) will fall over the next nine months, before recovering in the second half of 2023 as inflation moderates.

Commercial real estate returns are highly correlated with GDP and all property total returns switched from +4.1% in the second quarter of 2022 to -4.0% in the third quarter (source: CBRE UK Monthly Index), as the economy weakened.  The reversal was due to a widespread increase in real estate yields, which depressed capital values.  The all property initial yield rose by 0.25% to 4.3% between June and September and capital values fell by 5.1%. 

The initial phase of the correction in capital values was caused by a sharp change in sentiment and  associated decline in liquidity.  The total value of transactions in the third quarter of 2022 was 30-40% lower than in the first quarter.  In part, this reflects the jump in finance costs which meant that many debt backed investors were priced out of the market.  The total cost of hedged bank debt on good quality assets has doubled from 3.5% at the start of the year to 7%.  At the same time, the sharp fall in equity and bond prices means that some institutions have became over-allocated to real estate (i.e. the denominator effect).  In addition, although occupier demand remained positive in the third quarter, investors have become more pessimistic about prospects for future rental growth.

At this stage it is It is difficult to know how far capital values will fall, although we expect a smaller decline than during the GFC.  On the one hand, the high rate of inflation and limited amount of new building should prevent a big fall in rental values, at least in nominal terms.  We forecast that rental values will fall by 1-2% in 2023, and then stabilise in 2024.  On the other hand, the parity between the all property initial yield and the 10 year government bond yield is unlikely to satisfy investors.  Assuming the 10 year bond yield settles at around 4.25%, we expect the all property initial yield to increase to 5.5% by mid-2023.  While the fall in sterling versus the dollar has made UK real estate more attractive to US and Asian investors, history suggests that they will wait until there is greater certainty on the economy before deploying capital.   Our working assumption is therefore that capital values will decline on average by 15-20% between end-2021 and end-2023.

Which assets will be most defensive?  While it is possible that yields rise by the same amount across the market, hitting prime assets harder, we expect that investors will become more risk averse and that spreads between prime and secondary yields will widen.  Furthermore, prime assets are less likely to suffer an increase in vacancy and a resultant decline in operating income.  That was the main reason why prime out-performed secondary in both the early 1990s and during the GFC.

We think the assets which are likely to be most defensive over the next 18 months are those with decent demand and supply fundamentals, and good prospects for rental and income growth over the long-term.  These include bulky goods retail parks and high quality offices in Bristol, Leeds, London, Manchester and the Oxford-Cambridge Arc.  Although the industrial sector is currently seeing the sharpest fall in values, as debt back buyers withdraw, we believe that good quality multi-let estates in urban areas will be relatively resilient in 2023, given good demand from parcel firms and trade counters.  We think that certain niche sectors benefitting from long-term structural changes will be relatively defensive including life sciences, self storage, social supported housing and student halls.

Conversely, we think that the sectors and assets which are most exposed to rising interest rates are those with relatively fixed, or insecure income streams.  These include secondary shops and shopping centres, dedicated conference hotels, offices in secondary locations and, more generally, any building with poor energy efficiency.  Increasing construction costs and the tightening in bank loan terms is also likely to depress prices for land and re-development projects. 

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