The recent falls in retail sales and house prices suggest that the UK is in recession.  The main area of weakness is consumer spending, as inflation runs ahead of wage increases.  Real incomes fell by 4% in 2022 and are forecast to fall by 3% in 2023, the biggest consecutive drop on record.  In addition, higher interest rates are hitting investment, given that most business loans have floating rates.  Unfortunately, neither the government, nor the Bank of England is able to provide much relief.  The new Chancellor has had to rein in the Energy Price Guarantee and announce a series of tax increases in order to placate financial markets, following the turmoil created by the Truss government.  The Bank is concerned that the tight labour market will stoke a wage-price spiral and we expect it will raise base rate to 4% in February and then leave it on hold.  Schroders forecasts that GDP will fall by 0.8% in 2023 and then grow by 0.3% in 2024, as inflation slows and real incomes start to recover.

Commercial real estate capital values and returns are highly correlated with GDP and after a 7% increase in the first half of 2022, capital values fell by 20% in the second half of the year. This is the fastest correction since the six months after Lehman Brothers failure in September 2008.  The immediate cause has been an increase in the all property initial yield from 4.2% in June to 5.0% in November, but the real driver has been a drop in investor appetite, reflecting the rise in interest rates and concerns that the recession will depress occupier demand and rents.  10 year bond yields now stand at 3.6%, having briefly hit 4.5% after the mini-budget in September and the total cost of hedged bank debt on good quality assets has jumped from 3.5% a year ago to 6%. 

While it is difficult to know how much further capital values will fall, we believe that we are now more than half way through the downturn and that values will probably bottom out in the first half of this year.  On the downside, some debt backed buyers who need to re-finance are likely to have to sell.  Around £50 billion of assets will need to be refinanced in 2023.  However, on the upside, if 10 year bonds stay at 3.5-4.0%, then real estate will start to look attractive again to UK institutions.  Furthermore, we are starting to see renewed interest from international investors, given that the UK has re-priced more quickly than other real estate markets and that sterling has strengthened since the change in government.  As a result, we think that the all property initial yield will probably level out at 5.25-5.5% in the next few months.  Although capital values will also come under pressure from falling rents as the recession hits occupier demand, the high rate of inflation and low level of new building should limit the fall in rental values to between 0 and -2%. 

Where should investors focus once capital values stabilise? In retail, we favour convenience retail and retail parks with a low exposure to fashion.  Both types offer relatively high yields and although the fall in consumer spending will hit bulky goods retailers, the most important set of retailers on retail parks are now grocery retailers (e.g. Aldi, Lidl, M&S Food).  In office, we continue to see good demand for high quality offices in city centres with strong knowledge based economies including Bristol, Edinburgh, Leeds, London, Manchester and the Oxford-Cambridge Arc.  While occupiers are generally down-sizing when their lease ends, they are simultaneously up-grading, in order to attract staff back into the office and meet sustainability targets.  In industrial, the relatively sharp increase in yields since June means we are starting to see value again in good quality estates outside London.  Initial yields are back to 4.5-5.0% and we expect demand to recover next year, once the recession ends.

Outside the major sectors, we favour self-storage and student halls.  Self-storage is benefitting from the growth in households, e-commerce and de-cluttering as people work more from home and we expect net operating income to grow by 3-4% p.a.   The student hall market is more mature, but the relaxation of work visas has increased demand from international students and there is a shortage of student accommodation in Bristol, Cambridge, Durham, London, Oxford and Manchester.  We are cautious on private rented housing, given that falling house prices mean that more young professionals will be able to buy rather than rent.

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