UK real estate market commentary: January 2025
Despite the economic and market turbulence that has followed the Autumn Budget, we continue to see a cyclical buying opportunity focused on key segments that are backed by strong operating fundamentals.
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Economic backdrop
Momentum in the UK economy has continued to slow in recent months. This has been clearly reflected in the industrial and manufacturing sector, with the November PMI falling to a nine-month low owing to stubbornly low domestic and international demand. Geopolitical uncertainties, including the US’s move towards more aggressive trade tariffs, have amplified supply-chain concerns. More generally, the PMI data points to businesses turning increasingly hawkish in response to the tax policy changes announced in the Autumn Budget. Consumers remain impacted by the heightened cost of living, albeit modest increases in household real incomes continue to support demand.
Following robust growth in the first half of 2024, GDP growth for Q3 2024 was revised down to zero. With monthly GDP contracting in October, it is likely that growth in Q4 2024 was also flat. The UK economy is still expected to expand over 2025 (consensus December forecast: 1.3%) due to anticipated rate cuts, an easing of the cost-of-living crisis, and higher government spending. However, recent datapoints indicate downside to this outlook.
Further potential headwinds are also emanating from the impact of recent gilt market movements, where investor concerns over the government's borrowing strategy and fiscal policy have precipitated a sharp sell-off, despite the government communicating that it intends to abide by its stated fiscal rules. This has resulted in the yields on 10-year gilts reaching 4.7-4.8% in early January and weakening GBP against major currencies. Sustained elevated gilt yields could materially dampen economic growth, erode tax revenues, and constrain the government's ability to pursue its investment plans.
Despite slowing economic activity, inflation has increased again in recent months from a temporary low of 1.7% in September to 2.3% in October and 2.6% in November, raising fears of a 'stagflationary' environment even if the December reading fell back to 2.5%. The Bank of England’s (BoE) Monetary Policy Committee (MPC) opted to maintain a 4.75% base rate at its December meeting following a 25bps cut in November. BoE Governor Andrew Bailey has indicated the prospect of quarterly rate cuts of 25bps during 2025, given service price inflation has stabilised and recent releases point to slowing labour demand. However, markets are discounting 50bps of cuts in 2025 owing to inflationary concerns emanating from the Autumn Budget. Considering the recent gilt market movements, the trajectory of interest rate reductions may be even slower.
UK real estate market
Turning to the UK commercial real estate market, we view capital values to be passing through trough levels following a period of adjustment, with a cyclical buying opportunity. Average values corrected by ~25% between June 2022 and June 2024, the deepest decline in a global context when looking at MSCI real estate market indices across major markets. Since the summer, capital values have started to recover and increased 1% between June and November, according to the MSCI UK Monthly Index. This has been driven by notable improvements in industrial, retail and residential sector valuations.
Office values remain under downward pressure, albeit the pace of decline has slowed. Market improvement can be attributed to a combination of yield compression and income growth. According to MSCI, average net initial yields compressed from 5.7% in July to 5.4% at the end of November, levels last seen in September 2023, alongside rental growth of 1.2% over the same period. It should be noted that a more elevated interest rate environment may act to curtail the pace of further value improvements over the coming quarters.
Occupier markets, which remain on a solid footing, should continue to support income prospects, with rental growth anticipated across most segments. This is especially the case for those supported by structural demand-led tailwinds. While occupier demand is expected to be impacted by economic headwinds, tight supply conditions are continuing to support rental levels, and the scarcity of high-quality space should fuel growth once the economic outlook stabilises and confidence improves.
According to our proprietary market valuation framework, immediate opportunities are available across multiple sectors. Several property types, notably the industrial and logistics segments, have now rebased to attractive price points, and are supported by strong structural fundamentals. Upcoming refinancings will drive asset disposals, as will anticipated sales from corporate defined benefit pension schemes as they continue to de-risk. As we have noted previously, history points to the periods following economic downturns delivering above average performance. Our latest forecasts show average commercial real estate total returns at 9-10% p.a. and 8-9% p.a. in 2025-2026 and 2027-2028 respectively, representing above average rates.
Against this backdrop, there are the first signs of investment activity improving, with preliminary data from MSCI RCA showing UK real estate investment volumes across all sectors increasing by c.20% in Q4 2024. While the total volume of £11.3bn invested in the final quarter of 2024 remains below the average quarterly volumes before the start of the recent correction, our UK investment teams and advisors are observing more sources of capital showing firm interest in repriced UK opportunities. This is supported by surveys of investor intentions, which show interest in UK real estate increasing further.
Investment outlook
Regarding our current asset views, our preferred sectors and portfolio positioning have remained largely unchanged over the past three months. This reflects both that our expectations for income growth already accounted for a challenging environment, and that market repricing is progressing as anticipated, especially in terms of sector ordering.
To that end we continue to favour industrial estates (including outdoor storage facilities), cross-dock warehouses, and urban logistics assets benefitting from e-commerce and urbanisation trends. Opportunities are appearing to capitalise on significant repricing through acquisitions, refurbishments and/or development on rebased land values. The retail sector seems to have found a floor, and although we are more positive about the outlook, the risk to consumer confidence and margin pressure for retailers means we continue to favour retail parks with a low exposure to fashion that attract discount/mid-market retailers, as well as convenience formats including supermarkets.
In the more structurally challenged office market, we remain selective and focussed on well-located high-quality offices with sustainability certifications1 in London and other major regional and knowledge-based cities. There also continues to be a strong occupier preference for high-quality space in all major central business districts (CBDs), which is already scarce and the imbalance between expected limited future supply and growing demand is expected to further exacerbate this dynamic. We see potentially mis-priced opportunities to execute upgrades and refurbishments of well-located workspaces.
As UK real estate portfolio allocations evolve away from the “traditional sectors,” we remain focused on more operationally intensive real estate segments able to provide, at a minimum, inflation-linked cashflows. These can be delivered both directly and indirectly, with outsized income growth potential aligned to the success of the business activities taking place within the properties. This includes self-storage, which is benefitting from the growth in household formation and e-commerce, as well as representing an attractive consolidation opportunity. We see notable opportunities to create these formats by converting and repurposing existing assets into higher-value alternative use. Living and ‘social infrastructure’2 segments such as doctors’ surgeries are also providing long-term resilient cashflows.
We are observing an ever-increasing opportunity for private capital to fund the development of affordable and social housing3 formats, which can subsequently provide contractual inflation-linked income and positive impact attributes. This strategy is set to benefit from strong policy support, with the new government having announced ambitious plans for investment. Indeed, the recent Budget set out what was termed the largest increase to social and affordable housebuilding in a generation. This included a £500 million boost to the Affordable Homes Programme to construct up to 5,000 new units.
In summary, given the cyclical opportunity we see in the current market, our view is that investors should now actively seek to capitalise on opportunities as they emerge throughout the course of 2025. We anticipate this year being a strong investment vintage for deployment, with the potential to deliver attractive returns over the medium-term.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. The forecasts should be regarded as illustrative of trends. Actual figures will differ from forecasts.
1 Sustainability certifications are accreditations which assess sustainability credentials of buildings for example BREEAM.
2 In this context only, we are defining social infrastructure as healthcare, employment opportunities, education and training
3 As defined in Annex 2 of the National Planning Policy Framework or any subsequent regulatory definitions, as well as specialist housing, sheltered housing and other forms of housing for residents facing homelessness or other crisis situations, whether regulated or otherwise.
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