When the tide goes out

Read this article to understand:

• Why the real-estate market may have entered a K-shaped recovery
• How valuations could be impacted by the macro cycle and structural dynamics
• Our sector-by-sector outlook

“A rising tide lifts all boats” was an analogy commonly used to describe the recoveries in real estate in the early 1990s and 2010s, when most sectors experienced sharply rising capital values. However, the current thawing of the market is far more nuanced. A more appropriate description for what we are witnessing now –  with higher interest rates, inflation and structural dynamics causing greater dispersion between sectors and individual assets – might be Warren Buffett’s oft-quoted line: “Only when the tide goes out do you discover who's been swimming naked.”

Last autumn’s “mini-Budget” turned a likely three-year slide in values into a three-month collapse. Whilst confidence appears to be returning following the sharp repricing at the end of 2022 – and more quickly than perhaps was expected – all signs point to increased polarisation in the market.

According to CBRE, UK capital values fell by 13.2 per cent and annual total returns by 9.1 per cent in 2022. Values have continued to fall this year even before banking collapses in the United States and the hastily arranged acquisition of Credit Suisse by UBS in Europe threatened to suck more liquidity from the sector.

We believe the market has now entered a “K-shaped” recovery where polarisation will become more pronounced. Some assets will see an improvement in value more quickly; others will see an accelerated decline.

At a country level, the UK is further ahead on its repricing journey than many European markets, so it stands to reason its recovery is likely to happen relatively quicker. As a result, the UK is starting to offer better relative value, particularly on a short-term basis. European markets are continuing a downward adjustment for now, which means this is probably a shorter-term feature of the market rather than a lasting trend.

We are used to seeing sectors fall and rise in lockstep. Last year, retail values fell by 8.1 per cent, offices by 12.1 per cent and industrial by 21 per cent. Yet even this variation between sectors disguises diverse performance within sectors.

From here, the next phase of the cycle will require investors to be more discerning, with valuations more closely aligned to the macro cycle and structural dynamics.

Offices

The office sector is likely to go through most change and has remained remarkably resilient; we think that has fooled many. Our expectation is for a prolonged repricing, with two critical considerations not yet adequately priced in: namely net-zero compliancy and structural demand changes. Assets with the best environmental credentials will likely be spared but others, stranded by demanding regulations and a change in the pattern of demand, will fall behind.

If owners don’t have the ability to refurbish assets or adequately price climate risk, they will face chronic underperforming assets over the longer term. The same applies for assets where capital expenditure cannot be justified. Their decline – in demand and therefore value – will accelerate further still.

Residential

We like single-family residential from an investment and ESG perspective. There is a huge economic and social need for homes, particularly those that can make the residential sector more environmentally conscious. With increased mortgage rates forcing some families to put home-buying plans on hold, it is important these schemes also tick the “affordable” box for those on average incomes.

The bottom half of our residential “K-curve” comprises build-to-rent product that lacks amenities and fails to create a community location. Invariably these developments will be over-priced and likely to struggle to attract renters. There may be demand for housing – but only at rents people can afford.

Retail

Retail parks that thrived during the pandemic due to their ease of access and appeal as “click & collect” points are places we expect will continue to perform, alongside outlet malls that provide the value and experience today’s shoppers crave.

The lower half of the retail “K-curve” will include shopping centres that do not cater to shoppers’ “experiential demands” and high-street shops that have already plummeted in value. These places are likely to find retailers unwilling to pay the rent required to justify the capital expenditure needed to ensure the survival of the property.

Industrial

It is perhaps surprising the value of warehouses has fallen more sharply than other sectors, but this is more a function of its stellar run over recent years than the underlying credentials of the sector. There are strong structural currents supporting these assets, trends accelerated by the pandemic.

We remain keen on well-located, flexible and high-quality logistics and distribution warehouses, remaining an active and opportunistic buyer for assets likely to fall into the upper-part of the “K-curve”.

The lower portion of the “K-curve” is secondary industrial units in poor locations, badged as “urban logistics” but now looking unaffordable to tenants struggling in a flatlining economy.

What next

There will undoubtedly be a recovery in UK real estate. The critical issue will be in asset selection, with the shape of the recovery creating greater returns dispersion across the market. As we look to take advantage of our position as a strategic buyer – we have earmarked £750 million for the right opportunities – it is assets in the top half of the “K” that we will be investing in.

These will be assets that already incorporate longer-term thematic trends into their design and philosophy, putting them in the strongest position to deliver best long-term value and performance.

This article was originally published in Property Week.