Core investors remain hesitant to invest in commercial real estate due to market volatility and returns offered by competing asset classes, and many remain under pressure to service redemption requests. When they might return on any meaningful scale is the most important question facing our sector.
Of all the difficult questions facing the UK commercial real estate sector, few are more important than when – and indeed if – core investors will return.
Core investors are generally those targeting 6% – 8% returns from well-located buildings filled with strong tenants. They are often institutional investors who typically account for nearly a quarter of annual commercial real estate (CRE) investment volumes. That makes them vital sources of confidence and liquidity – developers in particular seek to exit projects by selling to core investors. But UK institutions’ share of CRE investment volumes fell to just 15% last year amid uncertainty regarding future occupier demand, the attractive risk-adjusted returns offered by competing asset classes, and the pressure to prioritise redemptions over acquisitions. Indeed, these investors have been net sellers of CRE for 12 of the last 15 years.
Until the latter months of 2024, consensus suggested we’d see a resolution as borrowing costs eased, but that’s now by no means guaranteed. Indeed, with bond yields reaching historic highs in January and inflation rising again, the question as to when core investors will return looks more uncertain than ever, and the search for answers touches on difficult issues, such as the role commercial real estate now plays in relatively conservative portfolios.
Seeking Exposure
High fixed income yields lie at the core of the problem. Is purchasing a prime City of London office building viable when a lower-risk, A-rated corporate bond offers a comparable or even better income return?
CRE investors must work harder for these returns, too. These are no longer assets that passively accrue income; they require active management to meet higher expectations from tenants and -in most cases high levels of capital expenditure to meet tightening environmental regulations. This is why sovereign wealth funds and their peers are increasingly choosing to back real estate platforms rather than investing directly; a trend that will only grow as investors seek greater exposure to specialist sectors like build-to-rent and senior living.
Fixed income yields are unlikely to ease materially over the next 12 months, and the recent spike in the 30-year gilt yield to a level not seen since 1998 is likely to be a precursor to further volatility. The 10y gilt is likely to sit at around 4% a year from now, according to the latest BNP Paribas Markets 360 forecasts, which means real estate investors must rely on rental growth to achieve the appropriate returns. That will in many cases require them to take on development risk, which doesn’t match up with traditional core strategies that need low-risk, long-term stabilised income.
Banding Together
The key question for 2025, then, is whether we see any signs that core investors plan to make a more meaningful return at all. That would mostly come in the form of fundraising, and there are unquestionably bright spots already.
In October, three local authority pension funds banded together to begin a £1.2 billion strategy targeting 4% returns over CPI over rolling 10-year periods. The same month, Australian superannuation fund Aware Super and Delancey announced a partnership to invest £1bn in UK property, primarily targeting central London offices. A month earlier, state-backed pension fund Nest said it planned to invest £1 billion in build-to-rent properties alongside L&G and the Dutch pension fund manager PGGM. That looks to be the beginning of a large ramp up for Nest, which will more than double in size over the next decade. These are not the only examples, either.
What makes them believe that core strategies will work by the time they are ready to deploy that capital? Well, these investors are aware of the outlook for prime rental growth, which should continue to rise in small increments across a variety of cities and asset classes (see box for our forecasts). Prime office rents surged 13% in Bristol last year. The City of London saw growth of 10%. We think prime office rents in the key regional cities will climb 16% by 2028. The capital will see growth of 22% over the same period, our forecasts suggest.
For global investors seeking CRE exposure, the UK market offers greater depth than European peers, some of whom are in a state of political turmoil. In Euro terms, total transaction volumes in the UK office, industrial and retail sectors during 2024 were higher than comparable measures in France and Germany combined, while the UK’s living sectors accounted for 25% of the total European volumes, well above the 5y average of 19%.
Remaining Wary
While rental growth and improved liquidity is a start; more uncertainties must be resolved before core money returns on a scale required to fuel a proper recovery.
For example, investors would like more economic growth, rather than simply political stability. Structural challenges in the offices and retail sectors need to be worked through, though the narrative is increasingly favourable when it comes to key questions about hybrid working and consumer spending. Important regulatory questions also need to be resolved, including the deadlines for Minimum Energy Efficiency Standards (MEES).
Institutions will also remain wary while pricing is still so opaque: many would-be sellers continue to hold on for valuations they can comfortably sell at.
At the macro-level, then, the landscape will remain challenging for core investors, so why the brighter outlook when it comes to fundraising? Granted in some cases this comes down to technicalities: many institutions are now ‘under-weight’ in real estate thanks to the improved performance in equity and bond portfolios. However, investors are also recognising that purchasing real estate now comes with more variables. A challenging macro-outlook can mask the potential of opportunities at the asset level, and we’re already seeing fantastic opportunities, though they often require scale and specialist expertise to unlock. Royal London Asset Management’s purchases of stakes in 1 Triton Square and the centre:mk, and its £180 million acquisition of Atlantic House are good examples.
After all, this isn’t a standard, cyclical recovery, but the beginning of a resolution of many competing, structural shifts, exacerbated by the pandemic and the rapid advancement of technology. A reminder that, unlike paper investments, CRE is much more deeply connected to changes in the way we all live and work.
Some investors already understand this – they will have the pick of the early opportunities. Those yet to engage would do well to give CRE another look.
Discover more from our Capitalise on the Future series.
