Partner Insight: Early signs of a pricing recovery in UK real estate

It's been a volatile 12 months in UK real estate. The speed and extent of the capital market repricing, -25% from June 2022's peak through to February 2023's trough, was more severe than we saw during from 2007-09 during the global financial crisis¹.

Figure 1: capital market context - monthly valuations indicate nascent pricing recovery

While we have reached the end of the "free money" era, we are not yet seeing signs of capital market distress. With the UK economy still adjusting to the effects of Brexit, Covid-19 and the Ukraine conflict, and policy response continuing to prioritise tackling inflation, this may seem surprising.

Within the institutional marketplace, a knock-on impact of higher rates was to reduce the present value of UK defined benefit pension scheme liabilities, accelerating the de-risking process and removing capital from growth markets, including property. Open-ended unleveraged funds managed their flows through a combination of selling at prevailing prices, and/or deferring redemptions. But there was no evidence of forced selling at steep discounts, which was the accusation levelled at "retail funds" following the Brexit vote in 2016, nor a return of Material Uncertainty Clauses, which were introduced during the Covid-19 pandemic.

Leverage is a more likely candidate for distress, as while average real estate leverage is vastly lower than historic levels - according to CBRE the average loan-to-value at market level as at the end of June 2022 was 48%, comparatively low against 72% at the end of 2007 - impending loan maturities will doubtless bring pain. With the base rate rising from 0.25% at the end of 2021 to 5.0% in June 2023⁵, and with markets pricing further rises in, many refinances will not be viable. Both borrowers and lenders will have to decide on the relative merits of either extending loan terms and topping up equity, or selling at book losses. Anecdotal evidence suggests at least some lenders are already heading for the exit door, and more are likely to follow.  

Where will performance come from?

Headline annualised rental growth of 3.7% to end-May indicates a trailing occupational resilience at market leve⁶. The inflation picture and ongoing interest rate rises undoubtedly place additional strain on corporate occupiers, but the lead indicators for real estate are vacancy rates and insolvencies - both of which remain low by historic standards. Remember that rental cash flows are asset backed so in the extreme scenario of elevated insolvencies, real assets fare better than fixed income.

We retain a high conviction towards industrials, where rental growth is moderating from a high of 13% annualised seen in August 2022, back towards its pre-Covid-19 average of around 3.3% annually⁷. Retail warehouses, which feel occupationally resilient, have benefitted from the recent rates revaluation, and with national vacancy levels at around 5% could be at a tipping point of more sustained rental growth - which is currently 1.6% annualised to May⁸.

Residential subsectors, in particular student accommodation, continue to provide opportunities to increase rents, however this sector did not experience any meaningful price correction and so values based on forward-looking net operating incomes need careful interrogation on a case-by-case basis. Also under the umbrella of residential, there is a place for single-family housing, albeit at scale, offering granular and relatively sticky income with strong growth potential. Finally, we think other alternative sectors, including life science, still have a valid place within forward-looking portfolios.

Where are the risks?

Offices continue to go through a transformational structural change towards flexible/hybrid working patterns, which has reduced overall demand levels. However, occupational densities post-Covid have also trended down, which has acted as a mitigator against more severe downsizing. On the supply side, in spite of new development, net office supply has actually reduced by 6% from its 2014 peak, as secondary stock has been demolished or converted to alternative uses faster than new stock is being built⁹. While "best-in-class" offices will continue to thrive in an increasingly discerning occupational marketplace, market vacancy levels of around 20% are unsustainable in the medium term. There will be a growing divide between the best and the rest and further price falls will reflect these risks. Leisure also looks challenged, as Covid-19 piggy banks are whittled away and discretionary consumer spending decreases (here again, Cineworld is a case in point).  

What about decarbonisation?

Decarbonisation continues to represent one of the biggest structural drivers of returns, as investors, occupiers and valuers come to terms with legislative requirements and the risks and opportunities they present - something we covered in depth earlier in the year¹⁰.

In June 2019 the UK became the first major economy to pass emissions laws requiring all greenhouse gas emissions to be net zero by 2050. As it stands, only 22% of commercial property energy performance certificates logged in the past three years are rated B or better, which is the requirement under the Minimum Energy Efficiency Standards (MEES) by 2030¹¹.

The cost of implementing environmental improvements creates both opportunities and risks for those in real estate. We believe a pro-active approach to environmental and social risk management provides the best opportunity to deliver sustainable outcomes aligned with financial performance. This is via direct asset interventions - asset refurbishment and the introduction of renewable energy sources - and via engagement with occupiers who increasingly recognise the value of shared initiatives.

Conclusion

UK real estate continues to offer a favourable investment environment: a generally benign political landscape, a clear operating environment, an established legal framework and a favourable ownership and leasing structure. It has a diverse investor base, with overseas investors increasing their market share to around 60% in London¹². And it's a market that offers consistently attractive returns: grossing an average 8.2% per annum since 1987 (unleveraged) with approximately 80% of total return derived from rental income¹³.