For a warning against making predictions, look back twelve months.
January 2022 began two weeks after the Bank of England made a surprise interest rate hike to 0.25%, its first in three years. The Omicron variant of COVID-19 was spreading rapidly, but with inflation running at an annual rate of a little over 5.1% and expected to peak at 6% in the spring, BoE officials decided they couldn’t wait. Pricing in financial markets suggested the base rate would hit 1.1% by December.
A year of shocks followed. From the war in Ukraine to China’s unwavering commitment to its zero-COVID strategy, events converged to trigger a coordinated tightening of monetary policy that left the global economy teetering on the brink of recession.
Investors today unquestionably face more difficult conditions than they did twelve months ago, but we arguably know more about the future now than we did then. Of course, there will be surprises – few people could have predicted the outbreak of war in Europe twelve months ago – but from the path of inflation, to working habits and demographic shifts, the data is sending some clear signals about what likely lies ahead for UK real estate markets in 2023. Here are my three picks:
1. Deal volumes will recover as the reset completes
Investment in central London offices fell about a fifth during Q3 compared to the same period a year earlier, largely down to a mismatch in views on pricing between buyers and sellers. We expect interest rates to stabilise during spring, and for pricing to better reflect the new interest rate environment during the second half of the year.
We know that investors are waiting to deploy a significant pool of capital once values reach a level that is more in line with target returns. Globally, investors increased average target allocations to real estate to nearly 11% in 2022, up 10bps compared to the same period a year earlier, according to a survey of 173 institutional investors across 34 countries conducted by Cornell University on behalf of Hodes Weill & Associates. Respondents also noted that, while today’s investing environment is particularly challenging, they expect attractive buying opportunities to emerge over the next 12 to 24 months.
Much of that capital will come from overseas, particularly Asia Pacific (APAC) and economies tied to the US dollar. APAC investors spent £4.8 billion on London offices during the year to Q3 2022 – almost four times the amount they spent during the entirety of 2021 – and we expect the weakened pound, lower vacancy rates and attractive yields to act as a powerful draw as the year progresses.
2. Equity rich, income-seeking buyers will drive activity
Lenders will continue to be risk averse, providing advantages to cash rich institutions prioritising income over capital growth. Activity from pension funds will increase, particularly targeting opportunities for rental returns over capital returns in industrial, healthcare, build to rent, infrastructure and well located, sustainable offices, particularly in prime central London.
Tenants are coalescing around a limited supply of the highest quality, energy-efficient office buildings to assist in delivering their environmental commitments, which will continue to drive rental growth as delivery of new supply slows. Though the development market has been active – we along with our colleagues at BNP Paribas Commercial Institutional Bank were able to arrange close to £1 billion in development funding for clients last year – the pipeline of buildings is small relative to projected demand. Of the circa 5 million square feet of new office space due to complete this year, 80% had already been pre-let at a the close of Q3 2022.
Lease events will further drive rental growth as supply dwindles. In the West End, for example, our agency team is expecting a wave of lease events across 2023 and 2024. This freedom of tenant movement coupled with restricted supply and growing demand for green offices, could drive prime rents in this market by 30% over the coming two years.
3. Investors will compete for a shrinking pool of the best assets
The range of assets favoured by investors is narrowing. That will accelerate the diverging fortunes of buildings that are in demand and those that aren’t, for example. Prime, sustainable offices enjoy a strong income story and are future-proofed against incoming regulations like minimum energy efficiency standards that will make letting EPC F-G offices prohibited this year. The minimum standard is set to rise to C by 2027 and to B by 2030.
Investors with the knowledge, funding and relatively long-time horizons will turn around underperforming assets, but many will opt out of taking on the risk in difficult conditions, compressing yields for the best properties.
This bifurcation story extends beyond the office market. Swelling allocations to real estate will be funnelled into a narrower range of sectors. Increasing numbers of investors will compete to enter the UK’s booming life sciences market, or will choose sectors underpinned by strong demographic stories, like student housing, build to rent and seniors’ housing.
The story tying the three themes together is one of greater economic and inflationary headwinds but with easing volatility, allowing longer running macro trends to return to the fore to an even greater degree that we had initially anticipated.
Of course, the events of twelve months ago prove that making predictions is a risky business, and this would be the moment for caveats, but you can hold me to these.
This first appeared in React News on Friday 13th January.
