- Following a difficult 12 months for UK real estate in which values declined 25%, deal evidence from March 2023 indicated a nascent pricing recovery
- Inflationary and interest rate headwinds persist, especially pertinent for debt refinancing, but occupier markets have been more resilient than expected
- On balance, we see growth opportunities in industrials, retail warehouses, some residential subsectors, and (very selectively) urban offices.
Figure 1: capital market context – monthly valuations indicate nascent pricing recovery
Source: MSCI, May 2023
Capital market distress?
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.
Where will performance come from?
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?
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.
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.
Real estate has been particularly affected by societal changes accelerated during Covid-19, and the dust continues to settle. There will be winners and losers over the coming years as this plays out. But this recalibration is creating a value premium for assets that retain functional relevance to occupational business operations: we favour industrials, retail warehouses, residential, and (very selectively) urban offices, and we believe dynamic, thematic allocation and experience in stock selection will prove key to delivering positive returns in this environment.