UK Capital Markets: CRE continues to weather storm, despite moderating economic outlook
As the world continues to deal with higher inflation and a moderating economic outlook, UK commercial real estate has so far weathered the storm.
5 minutes to read
Commercial real estate (CRE) markets in the UK have shown momentum in the first six months of the year. Investment volumes have surpassed £24bn year to date, which is 14% above volumes over H1 2020, 11% higher than the first half of 2019 and 9% above the long-term average for this period as well. With a week of the month left, this gap is likely to widen even further.
Robust H1 for the office and industrial sectors
While we are waiting for full month volumes for June, office investment has already recorded its best H1 since 2018, and the Industrial sector has had its second best H1 on record with c.£6.1bn invested. Office investment has been supported by overseas capital, which has accounted for £5.7bn or 73% of total UK office investment year to date, a 5% increase on cross border investment in the first six months of last year. Additionally, the Industrial and specialist sectors have seen investment in H1 2022 110% and 7% above the H1 average, respectively.
Volumes this year have largely been driven by a robust Q1 where £17.2bn was invested, a 46% increase on investment in the first quarter of both 2021, 5% higher than Q1 2020 and 45% above Q1 2019. Both office and Industrial sectors saw record first quarter investment in Q1 2022, with volumes reaching £6.0bn and £4.6bn, respectively.
Meanwhile, retail recorded its strongest first quarter investment since 2017 at £1.7bn. UK shopping centres contributed to this, with £831mn invested in the subsector, its strongest first quarter since 2016 and 1,008% above investment in Q1 2021.
Provisional numbers for Q2 show a slowdown in investment overall, with £7.1bn invested in UK commercial real estate. However, this number is likely to be revised higher as more deals feed through. Even so, investment in Q2 2022 remains 43% above where it was in Q2 2020.
An early cut of the Q2 data shows that specialist sectors (£3.3bn or 46% of total investment) overtook offices (£1.7bn) as the most invested sector in Q2 2022. Meanwhile, £1.4bn and £645m was invested in industrial and retail assets, respectively in the second quarter.
What could drive commercial real estate investment for the remainder of the year?
1. Riding the uncertainty wave. Higher inflation, the global economic outlook downgraded, supply chain pressures and the conflict in Ukraine has caused a high level of global uncertainty, which the UK is not sheltered from. When volatility and uncertainty is high, investors typically move away from riskier assets such as equities. Year to date, the FTSE 250 and US S&P 500 are both down 20.4%. Furthermore, over the last 12 months FTSE 250 total returns are down -19.3%, whereas the All UK property total return was 25.3% in the 12 months to May. Here, investors seeking an income producing asset with strong return profiles could turn to property as a safe haven asset, in an uncertain world.
2. Property as an inflation hedge? The UK has also not been able to hide from the global issue of higher inflation. Currently, inflation has topped a 40-year high of 9.1%. The Bank of England (BoE) projects inflation to peak at 10.2% in Q4 2022, before paring back close (2.1%) to its 2.0% target by Q2 2024. Investors looking to circumvent these higher rates of inflation could turn to commercial real estate, with strong growth potential, particularly assets with indexation, as a means of doing so. UK All property market rents increased by 4.3% in the 12-months to May. Over this same period, UK Industrial rents grew by 12.1%.
3. Cross border investors may capitalise on weaker sterling. Economic uncertainty and market views on inflation has led to currency volatility, with sterling recently depreciating as low as $1.22, before appreciating to $1.23 at the time of writing. ING forecast sterling could fall to $1.20. Meanwhile, hedging benefits for US dollar denominated investors into the UK are currently at 0.78% p.a. on a five-year basis, up from 0.31% p.a. in January. With sterling depreciating and hedging benefits improving, UK commercial real estate provides potentially more relative value for some overseas capital. This is supportive of our Active Capital research, which expects the UK to remain as the second-largest global destination for capital in 2022. In particular, our forecast expects US private equity companies to be the largest deployer of capital, targeting a wide range of UK sectors.
4. Higher cost of debt. Following five successive rate rises, the Bank of England base rate is currently 1.25% and economist consensus forecasts expect the interest rate to rise to 1.50% by the end of this year and to 1.75% by the end of 2023. However, there is relatively wide variation in forecasts, with Capital Economics expecting the UK interest rate to hit 3.00% by the end of 2023, for example. In response, UK SONIA interest rate five-year swaps hit their highest level on record, at 2.92%, although they have since seen some moderation. There remains a question of whether heightened cost of debt might have a (lagged) impact on yields and this may lead to increasingly polarised performance of real estate. A higher cost of debt may also encourage a rotation towards equity-backed investment.
5. Polarisation: In an uncertain and volatile outlook, the case for UK real estate remains, however, we expect increased polarisation in performance. UK commercial real estate which offers one or more of; inflation hedge properties, growth potential, diversification benefits, income and / or relative stability, is expected to see strengthened interest from investors looking to achieve these aims.
Read more or get in contact: Victoria Ormond, head of Capital Markets research
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