BTR Shines Even as CRE Sales Plummet; Here’s What to Focus on Next

In the first quarter of 2023, quarter-over-quarter investment sales volume in the UK rose slightly (6.5%) but year-over-year volume plummeted by -71.5%. These figures represent three commercial real estate categories combined (office, retail and industrial) based on sales volumes of £17.2 billion in the first quarter of 2022, £4.6 billion in the fourth quarter of 2022 and £4.9 billion in the first quarter of 2023, as reported by CoStar, the publisher of LoopNet.

For perspective, Oliver Kolodseike, London-based director of research and forecasting at Colliers, noted that the fourth quarter of 2022 was one of the weakest sales quarters on record. “December was the weakest December ever. Nothing really transacted.”

The end of the year is usually robust in terms of sales, as investors face deadlines to place capital, with Kolodseike saying that “December is normally the strongest month of the year by far, with an average of around £10 billion transacted [that month] and we didn't even manage to transact £4 billion, so it was really weak.”

The slowdown started in October. “We had the mini budget and then Liz Truss was Prime Minister for two weeks, and financial markets went into complete turmoil.” That led to a lot of investor uncertainty, Kolodseike said.

No one wanted to do anything in the UK because interest rates were expected to rise to about 6%. So, investors, especially those who had to buy with debt, stayed away, as did UK institutions. “Then January and February were pretty weak with a bit of a pickup in March,” Kolodseike said.

“However, we're now seeing some form of stabilisation in yields, especially for industrial,” Kolodseike added. This fosters a market dynamic that enables investors to set targets in proformas, thereby opening the door to more sales transactions.

Inside the “living” asset class, the build-to-rent (BTR) category posted a robust first quarter of the year, reaching £1.3 billion in sales volume, which represented a record 16% share of total first quarter volume, according to data from property consultant Lambert Smith Hampton. This share is significantly above the 6% share of sales volume that BTR has represented, on average, over the past five years.

Kolodseike noted that the BTR sector in general is becoming more sophisticated in the UK, and investors are starting to understand how it works. It's more of an operational asset class so it needs to be serviced and managed. “I think investors are getting more and more comfortable with the idea of this just because the yield is considerably higher than it is for an office building in London, for example,” Kolodseike said.

For those looking for a return above 3% or 4% in the current environment, Kolodseike noted that looking outside the typical asset classes of office, logistics and retail may become more common.

Mark Stansfield, CoStar’s senior director of market analytics in the UK, said some panelists at a recent EPRA conference were also bullish about build-to-rent, as well as industrial properties. “These are seen as good defensive assets with strong supply/demand balances and positive structural tailwinds,” Stansfield said.

“Currently people are waiting to see where interest rates settle,” Stansfield said. “There had been talk at the start of the year that this year would be a year of two halves, with a quiet first half and a busier second half. But given the banking issues that emerged a month ago and the tightening of credit conditions, [investors] think that that recovery and investment has probably been delayed by three to six months. So, that hoped-for rebound in the second half of this year might be shifted out a little bit.”

But Stansfield added that access to financing at reasonable rates is difficult for some, which opens the door in some ways to “equity rich investors, because there is less competition on the buy side for them.” And if there are opportunities out there for distressed sales, or bargain sales because investors need to refinance other parts of their portfolio, then that's something equity rich investors are considering.

“If you're not a forced seller, then you'd probably wait, because if your capital values have come down by 20% or 30% over the last year, now is not really the time to sell,” Kolodseike added. On the other hand, “if you are an opportunistic buyer with a lot of equity and you don't rely on debt, then I think now is actually the time to buy because yields are stabilising, and they might recompress by the end of the year.”

Stansfield noted that among some investors there is a bit of a disagreement about the future of the office market, and the gap between “the best and the rest” has never been so wide. And that's reflected in occupier demand, rents and investor appetite.

“It's pretty much a two-tier [office] market where demand for Grade-A, ESG-compliant space is still pretty strong and there's very limited availability of that kind of space,” Kolodseike said. “But anything that's secondary or tertiary space … it's anyone's guess really.”

In the next few years, Kolodseike said the focus will be on finding some cost-effective way to refurbish or convert those office spaces. However, “refurbishing at the moment is expensive because construction inflation is so high, so you would need a lot of capital expesne to do that. Are you going to knock down the building? People don't want to because it’s against the ESG agenda”, another factor that complicates decision making for owners.

As an economist, the Purchasing Managers’ Index (PMI) is among the datasets Kolodseike follows closely. “We look at it because it’s a monthly indicator”, so you need not wait until the end of the quarter for a read on economic activity. “It’s quite a good lead indicator for GDP [with a] pretty high correlation historically.”

He added that PMI data is something the Bank of England looks at as well to see what economic activity is doing, and it helps inform them on monetary policy decisions.

“We look at the composite PMI, which includes everything”, but different versions exist for the services sector, manufacturing and construction, Kolodseike said. Detailed data is provided under each index for metrics such as new orders, backlogs of work, costs, employment and other categories.

“All of these indices are leading indicators [that feed into] the official data,” Kolodseike said. These are indices, based on longstanding data, that can provide some perspective about future economic conditions, which can be coupled with what real estate professionals are seeing on the ground.

According to data provider S&P Global the UK PMI Composite Output Index rose in April to 53.9, a 12-month high. The UK Services PMI Business Activity Index also rose reaching 54.9, another 12-month high. But indices for Manufacturing Output and Manufacturing PMI both fell to 48.5 and 46.6, posting 3- and 4-month lows, respectively. Readings above 50 indicate expansion in a sector, while those below 50 signal contraction.

Stansfield said these indices express how confident businesses are feeling relative to previous months, as well as how they're feeling about the future, so they can help inform demand for real estate, albeit generally. He added that overall, PMI indices have been on an upward trajectory in recent months, underscoring that the first half of the year could be economically stronger than expected.

However, Oxford Economics believes that momentum will be potentially offset by slower growth over the next 18 months due to various tailwinds like stickier inflation and interest rates that may not come down as some are anticipating, Stansfield explained. In the near term, the current strength of the underlying economy raises the likelihood that interest rates will rise again based on confidence that the economy is doing okay.

“It's a bit of a mixed picture,” Stansfield said. The Bank of England might raise rates to tackle inflation in the long run, rather than be too concerned about the short-term health of the economy.

At the moment, “the big uncertainty is where rates will go and then settle”, Stansfield said. And that's one of the major factors that's keeping investors from transacting, because it plays such a big role in determining price as well as return expectations and strategy.

“We're essentially in a freeze and we're probably going to stay in a freeze until there's more certainty about interest rates,” Stansfield said.

“But I think at the next Bank of England meeting or the next Fed meeting there might be a bit more of a steer as to where the end is going to be and what the outlook might be beyond the next few months, which might hopefully give people a bit more confidence and bring them back into the market.”