UK real estate market commentary: November 2024
UK commercial real estate values are now showing signs of a recovery after steep price falls experienced since 2022, set against a muted economic backdrop.
Autheurs
Economic backdrop
The UK economy remains on its path of recovery, even if recent data releases point to signs of softening. GDP expanded by 0.7% in Q1 and 0.5% in Q2, while inflation (CPI) has been close to the Bank of England’s (BoE) target rate since May, with the latest reading (September) of 1.7% reflecting energy and airfare price declines. Whilst the heightened cost of living continues to impact consumers, the housing market has shown renewed momentum and price indicators have shown improvements each month since April this year.
Signs of softening in recent months include consumer sentiment dipping significantly in September, according to market researcher GfK. Meanwhile business surveys such as Purchasing Managers’ Indices remain in expansionary territory, but companies are broadly now less optimistic. This softening is likely attributable to geopolitical uncertainties and concerns over the (at the time) upcoming Budget, which the new government had communicated would be “painful”, warning of potential spending cuts, tax rises and increased borrowing.
In the event this was not an “austerity” budget, with roughly £40bn of tax rises, focused predominantly on businesses, more than offset by spending announcements that will ultimately result in significantly higher borrowing. Ahead of the Budget, 10-year gilt yields increased to around 4.3% from approximately 3.8% in July, and yields have pushed higher since. Overall, although downside risks remain, not least from geopolitical events, the UK economy is expected to continue to expand year-on-year, with the Office for Budget Responsibility (OBR) forecasting growth will almost double to 2% in 2025, before falling back slightly.
Growth is being supported in part by looser monetary policy, with the Bank of England delivering its first interest rate cut since 2020 in August, reducing the base rate by 25 bps to 5.00%. However, a five-to-four vote split of the Monetary Policy Committee (“MPC”) indicated that it was a “finely balanced” decision, with several members who voted for the cut judging that “there remained some upside risks to the [inflation] outlook”. Indeed, in its forecasts published alongside the Budget, the OBR predicted price rises will increase slightly from an average of 2.5% in 2024 to 2.6% in 2025, before falling back. Still, given the recent falls in quarterly headline inflation indicators, markets and economists are still expecting a rate cut at this week’s MPC meeting.
UK real estate market
Turning to the UK commercial real estate market, values are now broadly showing signs of a recovery. The MSCI UK Monthly Index showed average capital values increasing by 0.1% in August and 0.3% in September, driven by notable improvements in both industrial and residential sector valuations. Offices remained under downward pressure.
This increase in capital values was driven by yield movements, with income levels remaining supportive. According to MSCI, average net initial yields have now compressed from 5.65% in July to 5.45% in September, levels last seen in October 2023. Further compression is expected through year-end, which will drive positive performance.
Given these recent movements, average UK commercial real estate values have now fallen by approximately 24% since June 2022, showing the deepest declines in a global context. To illustrate, global commercial real estate values have fallen by approximately 18% over the equivalent period, according to the underlying asset valuations in the MSCI Global Core Property Fund Index. With positive value momentum, we believe that the cyclical buying opportunity we flagged earlier this year for UK real estate is now very much “live”, with many parts of the market now offering compelling cyclical attractive value.
This is set against a backdrop of continued subdued investment activity over the past three months. Preliminary data from MSCI RCA, a provider of real estate transactions data, shows volumes across all asset classes of just below £9bn during the third quarter. While this preliminary figure is likely to be corrected slightly upwards, these volumes were still in line with the low levels of activity we have seen since the end of 2022.
Given the low levels of investment activity, UK commercial real estate lending volumes were commensurately down, with the Bayes Business School lending survey showing an annual fall of 9.8% in new lending activity through the end of June. However, with positive signs for values going forward, we expect investment activity to improve in the coming months. Anecdotally our UK investment teams are observing more sources of capital, such as private equity real estate groups, showing firm interest in repriced UK opportunities.
The positive outlook for real estate investment is also being supported by occupier markets, which remain on a solid footing. Positive rental growth is expected across most segments, especially those supported by structural, demand-led tailwinds. Whilst occupier demand has recently moderated, tight supply conditions due to higher construction and debt finance costs continue to support rental levels, and the scarcity of high-quality space will fuel rental growth once the economy returns to expansionary mode.
Investment outlook
According to our proprietary market valuation framework, immediate opportunities can already be found across multiple sectors. Several property types, notably the industrial and logistics segments, have now rebased to attractive price points, and they continue to be supported by strong structural fundamentals. Upcoming refinancings will likely drive asset disposals, as will anticipated sales from corporate defined-benefit pension schemes as they continue to de-risk.
Investors should be cognisant that history points to the periods following economic downturns and associated price corrections delivering above average performance. Our updated projections show all property total returns in 2024 at c.5%, improving to above average performance of 9-10% p.a. in 2025 and 2026, and 8-9% p.a. thereafter in 2027 and 2028.
We continue to favour industrial estates (including outdoor storage facilities), cross-dock warehouses, and urban logistics assets that are 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.
Elsewhere, self-storage is benefitting from the growth in household formation and e-commerce, as well as an attractive consolidation opportunity. We are becoming increasingly less cautious over prospects for the retail sector, but continue to favour retail parks with a low exposure to fashion that attract discount/mid-market retailers, and resilient convenience-oriented formats including supermarkets, to outperform.
In the more structurally challenged office market, we remain selective and focussed on well-located high-quality offices with sustainability certifications (such as BREEAM) in London, as well as other major regional and knowledge-based cities. There is also a strong occupier preference for high-quality space in all major central business districts (CBDs), which is scarce – and the imbalance between expected limited future supply and growing demand will further exacerbate this shortage. We see potentially mispriced opportunities to execute upgrades and refurbishments of well-located workspaces.
As UK real estate portfolio allocations evolve away from the “traditional sectors”, we continue to favour more operationally intensive real estate segments able to provide, at a minimum, inflation-linked cash flows, both directly and indirectly, with outsized income growth potential aligned with the success of the tenant. We see notable opportunities to create these formats by converting and repurposing existing assets into higher-value alternatives.
Living and other more operational segments can provide long-term resilient cash flows, with outsized income growth potential. We are observing an increasing opportunity set developing in affordable and social housing formats, providing both stable inflation-linked income and positive impact attributes. Within the student accommodation sector there are supply shortages in select cities and towns, and universities with strong academic credentials seeing strong growth in both domestic and foreign student enrolments.
Given the extent of the revaluations experienced in the UK, our view is that investors should position themselves on the front foot, looking to capitalise on opportunities as they emerge through the remainder of this year and into 2025, which we anticipate being a particularly strong investment vintage for deployment.
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.
Subscribe to our Insights
Visit our preference center, where you can choose which Schroders Insights you would like to receive.
Autheurs
Topics