When a market is losing value, we believe there are only two questions to ask: when will the recovery come, and what will it look like? For investors in the UK commercial real estate market, we believe that 2023 will bring some welcome answers to both.
Over the second half of 2022, the UK market has devalued more dramatically than in previous recessions. In the five months from the peak of the market in June 2022, the UK Monthly All Property Index fell by 16.5 per cent. It took 10 months for a correction of a similar size to unfold during the Global Financial Crisis in 2008, and 21 months for the same move in the 1990s downturn.
In previous downturns, corrections in valuations have been slow because the general illiquidity of real estate markets makes price discovery difficult, particularly in the early months. Neither buyers nor sellers are able confidently to set prices so they sit on the sidelines until the price correction is evident and mostly complete. This has usually taken between 18 and 24 months from the point that values begin to fall.
This cycle has been different because it has been driven mainly by the sharp increase in interest rates triggered by last year’s surge in inflation. The rise in interest rates pushed the cost of debt higher and once those prices exceeded the yield available on prime real estate, debt-backed buyers were quickly priced out of the UK real estate market. By the middle of 2022, it became clear that the valuations on offer in the UK property market were not sustainable relative to yields in other, more liquid asset classes, and so prices tumbled dramatically.
However, because the devaluation was driven by the movement in interest rates, there has been far more clarity about the required scale of repricing, as well as the likely bottom of the market.
Overseas appetite
Another fundamental difference between the current downturn and previous cycles – and another reason to believe that the recovery will come soon – is that the market is still remarkably liquid because it has become so globalised over the past 15 years.
The devaluation of assets in the UK in 2022 only made the market more attractive to overseas buyers. Although American and US dollar-denominated investors had participated less in the UK market since Brexit, in 2022 the weakness of sterling encouraged them to take advantage of the currency play on offer. Cultural and systemic similarities between the two markets made the UK an obvious candidate for American opportunistic strategies, especially from the second half of the year.
Similarly, there’s been strong interest from Asian investors (notably Korean and Singaporean funds seeking to increase their allocations to international real estate). Allocating to the UK has been a profitable endeavour; over a 10-year time horizon, Japanese, Australian, Canadian, and Eurozone investors have experienced higher returns here than in their domestic markets. Meanwhile, Dollar-denominated investors allocating today can expect greater returns due to the weakness of sterling.
This interest from overseas investors means that this time around, activity in the UK commercial market has not seized up completely, as the extra liquidity they provided has supported investment volumes and price discovery.
One indicator of the confidence investors have that there are enough transactions to allow efficient price discovery is the absence of uncertainty clauses in valuations. These clauses emphasise to buyers that any valuation report has been created in extraordinary circumstances, and had become prevalent during other cycles, most recently during the first months of the pandemic. Their absence this time around suggests buyers are confident they’ll find the bottom of the market quickly.
Importantly, this sustained availability of global liquidity is giving confidence to participants that once the market bottoms out, it should recover strongly. From the second quarter of 2023, we expect more stock to the UK come to market, greater transaction volumes, and finally a recovery in valuations as interest rates stabilise.
Overall, we expect values to fall by around 25 per cent, peak to trough, from the levels seen at the end of European summer 2022, with the bulk of the correction having happened by Q4 2022 and easing off in Q1 and Q2 2023. Our own bottom-up analysis of a model covering the movement in yields and rents, utilising economic assumptions from Oxford Economics, suggests that from around the middle of 2023 the market will then begin to bounce back and should deliver returns of 10 to 12 per cent per annum over the following three years.
This recovery may not be immediately recognisable. Because of the illiquidity of the UK real estate market, it can take time to deploy capital, particularly in a market where the volume of assets available to buy is still relatively thin. Even when buyers have found the right asset, the purchasing process can hold up completion of transactions for weeks or months. The lag in the availability of data means it can then take several months for a clear picture of the full market to emerge, by which time investors may have missed out on some of the recovery’s strongest performance.
Value at the end of the rainbow
When the recovery comes, it is unlikely to be uniform across the UK real estate market. Values are likely to recover first in the industrial logistics sector (including buildings designed for storage, order picking, and distribution). It was one of the lowest yielding areas of the market, so prices tumbled quickly as interest rates ticked up. Despite the recent weakness, fundamentals in this space are still strong, with very low vacancy rates and high occupier demand. Although this year we expect rents to be broadly stable given the recessionary environment, in the recovery we forecast rent growth to return to 3 to 4 per cent per annum. This averages at 2.5 per cent per annum over the next four years.
There will be more caution around the office sector given the trend towards greater home working, although best-in-class assets with the strongest environmental qualities are likely to hold up reasonably well.
Caution still hangs like a cloud over retail property. The coming recession is likely to hit retailers hard in 2023 as real disposable incomes fall, however yields in this sector were already high and given many chains have already rationalised their portfolios since 2017, some pockets of this market may prove surprisingly resilient.
Although the residential sector will not be immune to valuation falls experienced in other sectors, strong rental growth, underpinned by constrained supply and low vacancies, are likely to cushion the fall. Specialist areas such as student housing are experiencing acute shortages, although affordability for tenants remains front-of-mind given broader worries around the cost of living.
A global bounce
UK commercial space is likely to be one of the first markets to hit the bottom of the current cycle in 2023, but there is also brighter news expected for many other parts of the real estate market this year.
Europe is on a similar path to the UK. Though valuations on the continent have not fallen as quickly as in the UK, making the subsequent recovery unlikely to be quite as aggressive, it could follow a similar pattern (albeit at a lag). One key difference in Europe may be in the retail market which has not yet undergone the same shakeout of weaker assets as the UK, suggesting there could be some longer-standing vulnerability.
In the US, the story is slightly different again: although the economy has been far stronger than the UK and the rest of Europe, there are structural problems in the country’s office sector. In Europe and the UK, our analysis suggests that occupiers have intensified the way they use offices, with around 60 to 70 desks offered per 100 employees, and vacancy rates running at 5 to 7 per cent. By contrast, vacancy rates in the US run over 16 per cent1, and there is almost a one-to-one ratio of employees to available desks. At least 58 per cent of employees work from home at least one day a week since the pandemic2, suggesting that there is the strong potential for rationalisation in the market as office occupiers begin to downsize over the next 12 months, with a widespread revaluation of the sector’s pricing to follow.
By the end of the first half of 2023, we expect the UK commercial real estate market to have made it through the bulk of this painful repricing process, with the rest of Europe close behind. The UK is now way ahead of the global curve, and with sterling looking historically cheap, we believe that the market will become especially attractive to buyers looking for investment opportunities - a situation which we don’t expect to last very long. After a difficult few years, 2023 could prove to be the year that the UK real estate sector begins to rebuild.
Sources:
1: CommercialEdge, National Office Report, December 2022
2: McKinsey & Company, Americans are embracing flexible work – and they want more of it, June 2022
