Commercial real estate: the best and the rest

COMMENT Along with falls in numerous other asset classes in 2022, UK commercial real estate values fell by a staggering 20% over the second half of 2022 – the second sharpest six-month correction in history. During the first half of last year, in the face of rising inflation and interest rates, real estate looked increasingly expensive relative to other asset classes. While this pattern was true of many global real estate markets, the impact of September’s mini-Budget turned modest decline into something more extreme. Market liquidity became challenging; investment volumes dropped 40% below their historical averages and low-yielding asset classes (with low cashflow risk or strong growth potential) proved particularly sensitive to rising interest rates. Pressure on investors The pace of value reduction started to slow in December 2022 and by March 2023 values had increased by a modest 0.2%. Some market commentary suggests values have bottomed out, but we remain cautious for 2023. Our yield models, for instance, suggest market interest rates and penal real-terms rental growth will keep the pressure on real estate’s relative value. We expect more asset disposals from maturing defined-benefit funds, with pressure on some investors looking to refinance properties bought, or financed, in 2018 or 2019. Many of these investors face the biggest swing in finance costs recorded, necessitating injections of equity to reduce leverage. Where the building or income quality is lower, or that equity is unavailable, we believe there will be pressure to sell quickly. Sector risks There are specific sector risks too, in our view. Offices remain exposed, not only to new ways of working, but also to rising management and refurbishment costs necessary to attract occupiers. But the sector “only” corrected by 15% in the second half of 2022. We expect recessionary conditions to accelerate occupier decision-making. And, as deadlines to meet sustainability legislation near, additional capital expenditure requirements will create a toxic combination for certain assets. By contrast, the pricing correction in certain sectors has moved expected returns more in line with investors’ target rates. Real estate debt returns have been boosted by high interest rates, while reticent traditional lenders have left a gap in the market for others to exploit, subject to underwriting. More specifically, build-to-rent and purpose-built student accommodation have proved to be resilient over the past 12 months and, we believe, offer good rental growth prospects for well-managed and well-located assets. Parts of the industrial market, in particular self-storage and multi-let industrial, look good value too, based on higher yields and consistent expectations for long-term income growth. We also believe there is value in good-quality, well-let assets with income protection – prices of long-income real estate with indexation that were hit hard in the second half of 2022 owing to interest rate sensitivity. To some extent, the pricing correction seen in the second half of 2022 punished “the best”. This year is set to be much more challenging for “the rest”. Bill Page is head of real estate research at Legal & General Investment Management Photo courtesy of FTI Consulting