UK Property Market: Keep Calm and Invest On?

To describe the past two months in the United Kingdom as tumultuous would probably be – in characteristic British fashion – understating the situation.

Three prime ministers; a currency crisis; an ongoing cost-of-living challenge; these factors alone might be enough to create chaos and confusion in a country’s commercial real estate market. Couple those catalysts with a destabilising war in Ukraine and a looming global recession, and you’d forgive the denizens of UK if they were inclined towards something approaching panic.

But as the unofficial national motto goes: keep calm and (invest) on. As the governmental and currency situation began to stabilise at the end of October, LoopNet sat down with David Hutchings, head of EMEA investment strategy at Cushman & Wakefield. Hutchings leveraged his more than three decades of global commercial real estate experience to put the situation into a more long-term perspective while uncovering short-term opportunities.

Is there a sense of optimism as this new government takes the reins or are people still in state of shock?

A little bit of both. Whilst there is still some shock at the speed at which things have changed and the dramatic nature of those changes … overriding it is definitely a sense of relief that we appear to be heading into a more stable period of policy and hence, hopefully, a more stable economic environment, one that will be reflected in interest rates, etc.

How does that scenario impact the cadence of investment and transactions in commercial real estate?

It initially results in a standstill and a reconsideration. And then it depends on the result of that reconsideration, whether things grind to a halt. In some cases, the buyer and seller may reflect on the need for greater flexibility given what's happened to borrowing costs. That's an unavoidable fact that people have to reflect on in their negotiations. In some cases that has been accepted and we have a reappraisal of pricing and deals have continued. But in other cases, yes, there's been either no meeting of minds or just a decision that “we really need to sit this out now and wait and see what's going to happen”.

I think that's one of the key factors here. It's not just that borrowing costs increased so much or exchange rates fell away – it's the fact that things were very volatile. So how does an investor plan, how do you price in such an environment? But it's also important to remember that this is just one small period within a cycle – a cycle that started to shift late last year. A cycle that then accelerated because of the war in Ukraine, because of the impact that has had on inflation and hence on interest rates. There is a path that the market's been on, and then this introduced a flash point of yet greater volatility.

Up until relatively recently were the investment markets in the UK still strong?

You had the sort of bounce back, where we had a recovery of the small losses that were seen in terms of yield or cap rate [during the pandemic]. And then towards the end of last year, we had more yield compression and compression across all sectors. What we had seen before was compression in the most demanded markets – logistics, build-to-rent – but it had spread and there was office compression, while retail was also back on the agenda for people – if it was the right retail.

So, we had very strong demand. We had increasing volumes. We had good debt markets, very cheap debt and interest rates were moving down. That sort of reached its peak in the fourth quarter [of 2021] and first quarter of this year. And then things started to change quite dramatically as the interest rate environment changed, and as the inflation threat seemed to be much bigger than expected. It was driven by various changes, but obviously heightened by the war in Ukraine.

For your clients who are in the midst of a deal, how are you advising them to proceed?

Well, real estate's obviously a long-term investment. And there is still a huge weight of capital wanting to invest, and a shortage of the right opportunities for people to invest in. You may have a question about “should I rush into it now”, and “at what price should I do it?” But most investors, in general, will still want to invest. You just need conviction that this [tumultuous period] is going to be perhaps a six-month event rather than a two-year event.

We’re just trying to help clients with the questions they've got, to keep deals moving forward and to make sure that everyone is aware of the reality of the market in terms of costs. This isn't just about people trying to chip the price. This is a reflection of where deals need to be if they’re going to be economically viable today. And if they're not going to be undertaken today, we want to make sure that the conversation continues, and that the parties can come back in three months, six months, whatever the timeline might be.

Have some sectors been impacted more than others?

The sectors most impacted initially were those property types where the yields were lowest – and, hence, where the comparison with interest rates was most apparent. So, in particular, we saw logistics and then offices impacted. The build-to-rent sector, where yields can also be very low, was protected for a little while,partly because people were adjusting their strategies. Some investors seemed to figure that “if the economy's going to fall, I prefer to be in a sector that's less linked to the economy and is more about demographic factors”. So, we did see people doubling down on parts of the build-to-rent market and subsectors like self-storage. However, by the time we got to Q3 and Q4, the impact had really spread to all sectors – it's just a question of degree. But more than sector, the biggest factor is quality. Because the occupier market in most sectors, in fact, is actually very robust for good quality space.

But what would normally happen is that the best space goes up in value, and everything else follows at a lag. That's not happening now. The best space is seeing rents increase, but weaker properties are seeing rents stagnate and fall. And that polarisation is something we think will just accelerate as we go through 2023.

So, that obviously has a very chilling effect on the investment market for those B to A- properties, for instance?

Absolutely. But, at the same time, that's one of the biggest areas of opportunity going forward within the market, particularly when you consider it within the context of the ESG requirements that older buildings cannot just be knocked down and rebuilt, they need to be adjusted, they need to be repurposed, etc. The adaptive reuse strategy is one that we think is going to be rife with opportunity from all sectors in Europe and the UK over the next five to seven years.

Are there particular sectors or geographic areas where you see an interesting opportunity that's developed out of this situation, provided an investor is willing to be a little bold?

What we're seeing is a much more rapid correction in the market than is normal. Normally, when we're going into a recession, everything is driven by economic – factors like employment and occupancy. And hence there's a long lag before it actually hits the building and the building's performance. This time around, everything is front loaded, because it's all about the finance market and it's all about yields; the economic impact of the recession is not here yet.

Yes, people are coping with the cost-of-living crisis and high inflation, but economic growth has remained positive. Unemployment is at a record low in Europe. The recession, when it comes, is going to be perhaps this quarter or likely early next year, but at that point the finance markets may be more stable. So, we've actually got quite an interesting mix of factors in this cycle compared to a normal cycle.

But it certainly means the cycle has been very frontloaded on repricing. And, as a result, we are starting to see situations emerge where there’s some advantageous repricing for new buyers. And it isn't really a particular geography or a particular sector, it's just driven by who is the current owner and what situation they've got – maybe they have a refinancing coming up, or they have a fund end approaching. Maybe they want to change their strategy and reallocate money into a certain other part of the market. Then they're a motivated seller.

Aren’t there a lot of investors who may feel like the other economic shoe hasn’t dropped quite yet?

Absolutely. But for good quality property, the demand is being maintained and development has fallen because of the increased cost of construction and the shortage of materials. The pipelines for new space have fallen away, so that supply squeeze is going to be maintained. And perhaps the short-term growth is going to be less, but in most markets [the recession impact] is unlikely to be severe. If you look at London, for instance, it's more likely that the prime rent would move sideways and then start to increase. It all comes down to the quality of the property.

If we saw yields move out by 25 basis points (.25%), then you might say “that's not enough to compensate me for the economic risk going forward”. But, in reality, they are moving out further in response to the volatility of interest rates. So, there is potential for a property to offer a good risk-adjusted return, but so long as you are focused on the property that tenants actually want to be in.

Has the current situation nudged UK investors away from the UK and more into foreign markets?

Only to a limited extent. Most investors won't just be driven by the exchange rate. The exchange rate will impact the pricing they can pay if they're hedging, and it will impact on the timing of their investment. But if they’ve decided that they need to diversify into Europe or into America, then they'll stick with that strategy. There is a particular nuance to what's happened in the UK, but the UK is not on its own. The price correction is happening everywhere. But what's more notable is that, because of the negative news for the UK, there have been some international investors who were thinking of coming here that are now saying, “I need to wait on the sidelines and see what happens.”

But those investors, of course, are balanced by other investors that see the benefit of the exchange rate. And with the money blowing into a market like London, the exchange rate does become more important. So, it certainly may have altered the mix of investors looking to be active in a market of that scale.

Which sectors do you anticipate will come back the most quickly and with the greatest vigour?

I think in the short term it will actually be the office sector.

Simply because they're having to reprice quite aggressively, as people are worried about the underlying forces of demand. But [at C&W] we actually see the demand for offices being pretty good, as long as they are modern offices. So, if you were looking in London, Manchester or Oxford and you've seen yields increase by 50 basis points, I think that will create a good entry point to come into an undersupplied market.

That's looking at the short-term position. The medium-term position will go straight back to logistics and build-to-rent because those are dramatically undersupplied markets. But I think people will hopefully be a little more selective, realising that not all logistics is in the right place and is the right quality and meets ESG criteria. And the same for build-to-rent.

Property has always been seen as a hedge against inflation. But with the issue of a looming recession and increasing cost of financing, how are those forces balancing each other out?

Even though the structural demand is very good, you are going to see less expansion demand because of the state of the economy and the result of that is that rental pressures must abate, and affordability becomes a question. Even if you are able to raise the rent, is it actually affordable [over the long-term]? Or are you actually going to undermine your own occupancy further out?

What we are tending to see is that the aggregate picture tells you that real estate is a good inflation hedge, but when you dig into that, in any cycle, and certainly in this one, you tend to find it is some property that provides the hedge, and some property doesn't. And so, again, it's about being invested in the right property with the right lease.

Do you think the present situation makes things even more challenging for smaller entrepreneurial investors?

I think it is where they are in the market competing with the bigger investors. If you look at a large city, you'll tend to find one of the factors suggests that the property is Grade B or below is going to be its scale and its age. So, when you find that smaller property, there's often a good reason why it's smaller in lot size.

But if you move to a different geography where those big players aren't, then you can find a smaller lot size, which is actually a good asset in a good location in that market. So, I think it's a question of finding the right market for the lot size that you are investing in.

And also looking at the right sector. Office properties typically need to be of a certain scale in a big city. But for residential, last mile logistics or retail, it could be a much smaller property. So, there are still those opportunities in the biggest cities. And I think particularly if you focus on alternative sectors like self-storage, you can be talking about quite small lots compared to the hundreds of millions that might be spent on an office block. If you try and compete head-to-head in a gateway city with big institutions, you will be on the back foot. But there are plenty of opportunities in other sectors and in and in other locations.

Anything else you’d like to add that we haven’t touched on?

We've had this shock to the system, but we hope it's not a fundamental change in the UK’s economic and fiscal position. It was just an event which has happened. So, we're looking forward to the situation actually stabilising in the next few weeks and going back to normal – even if that normal is not what it was a few months ago.

This interview has been edited for concision and clarity.