UK economy exceeding expectations

Preliminary Q2 real GDP figures reveal the UK economy has outpaced forecasts. While growth was expected to slow sharply to 0.1% q/q, it reached 0.3%. Government spending (+1.2% q/q) and robust exports (+1.6%) led the way. Despite a slight dip in goods exports from Q1 (-0.2%), services exports surged by 3.0%. Private sector weakness showed through a 4.0% q/q decline in business investment, but this offset a previous strong quarter. Household consumption grew just 0.1%, but when adjusted for tourism, the pace improved to 0.5%. Overall, combining Q1 and Q2 data, the UK led G7 growth. Additionally, the August PMI Composite Output Index hit a 12-month high, signalling momentum into Q3.

Mortgage squeeze moderates

Higher mortgage costs have pressured households since the Bank of England started raising rates in late 2021. Millions have seen payments rise, squeezing disposable incomes. Looking ahead, 3.6 million households with longer-term fixed mortgages are set to remortgage on to higher rates, but around 2.5 million on shorter fixes have already adjusted, now benefitting from recent Bank Rate cuts. This transition is stabilising average interest rates on the stock of outstanding mortgages. Although payments are still rising overall, the pace is slowing, lessening drag on consumption growth. Notably, mortgage holders comprise around 30% of UK households, with 35% owning outright and another 35% renting. Broader financial health is shaped by wage growth and inflation, with July’s ONS public opinions survey indicating households generally feel better placed to meet payments. Support from robust savings and incomes has lifted personal finance sentiment to a 12-month high, according to the GfK survey.

Q4 rate cut could hinge on the Autumn Budget

The Bank of England has lowered interest rates by 25bps for five consecutive quarters, but market hopes for a Q4 rate cut have faded. BoE now projects headline inflation to peak at 4.0% y/y in September, mainly due to higher food prices, which may cement persistent inflation if consumer expectations rise. Stronger growth and upward revisions to payrolled employment also challenge the restrictiveness of current monetary policy. While higher rates typically encourage saving over spending, near-4% inflation erodes real returns, dampening saving incentives. Thus, our long-held forecast for a 3.75% base rate by end-2025 faces risks. However, additional fiscal consolidation in the Autumn Budget could weaken demand, keeping the door open for a Q4 rate cut.

Fundamentals provide room for optimism…

As Q4 approaches, GDP growth has exceeded expectations, business surveys look encouraging, and consumer spending remains resilient. These trends underpin a favourable commercial real estate leasing market backdrop and continued rental growth across the core sectors, while higher yields have supported above-average total returns. Improved debt availability also suggests improving market liquidity as year-end nears.

…but outweighed by inflation and fiscal policy worries

Yet, global macroeconomic headwinds challenge these fundamentals. Investor sentiment remains cautious due to ongoing public finance concerns, trade policy uncertainty, and the complex inflation environment. Investors are seeking higher returns to offset rising long-term inflation risk and uncertainty over government borrowing’s impact on growth. This has pushed up UK government bond yields: the 30-year Gilt recently topped 5.6%, its highest since 1998. The 10-year Gilt yield has climbed from 4.5% in early August to 4.75%, and, adjusted for inflation expectations, is now higher than the levels seen after the 2022 ‘mini-Budget’. These yield increases are stretching asset valuations. 

For core real estate, this presents notable challenges. 10-year investment-grade A-rated corporate debt, priced at ~5.6%, offers a higher risk premium than prime stabilised commercial real estate, which bears additional tenant and capital expenditure risks. Achieving strong, inflation-beating rental growth is thus crucial for achieving attractive risk-adjusted returns, driving investor focus toward prime core market assets where leasing and rental growth are strongest.

Construction sector headwinds—a blessing or a curse for investors?

While robust income growth remains attainable, the prevailing environment introduces distinct challenges, notably elevated capital expenditure risks. Construction sector PMI data highlight longer delivery times, softer demand, and rising costs, contributing to insolvencies, job losses, and project delays. Annual build cost inflation, tracked by BCIS, has risen above 3% since April and is forecast to near 4% by year-end. Coupled with persistent planning bottlenecks, investors are adopting a more cautious approach and accounting for higher costs in underwriting. 

Nonetheless, these constraints may serve to moderate supply, preventing rapid expansion that once led to greater leasing volatility—especially in periods of looser financial conditions. Today’s market is shaped by tighter regulation, enduring planning hurdles, higher interest rates, and sustained cost inflation, all constraining new development. Planning approvals over the past year reached historic lows, about 30% below the post-pandemic peak of 2021. This results in a marked shortage of new, ESG-compliant space that attracts talent, supporting ongoing rental value growth.

In this uncertain economic environment, with tight labour markets and elevated interest rates, investors able to navigate these challenges and pursue core-plus or value-add strategies are well placed to capture compelling returns over the medium term.