COMMENT Investment volumes across UK commercial real estate in 2021 were more positive than expected. The strong rebound in economic activity and employment supported a pick-up in investor sentiment, fuelling a release in pent-up demand, particularly across core assets. The reopening of international borders encouraged the return of foreign capital and, by the end of the year, yields were falling across most asset classes.
But headwinds are appearing. In particular, the precipitous rise in inflation in the second half of last year caught everyone off guard. In February 2021, the Bank of England expected inflation to return to its 2% target by the end of the year. By November, it was forecast to peak at 5% in April this year. In the end, neither forecast aged particularly well, and the Monetary Policy Report published in February expects inflation to breach 7% and remain above target throughout 2022.
In its defence, the BoE was not alone in missing this surge in inflation. But the result is that it has been forced to bring forward plans to tighten monetary policy from the ultra-loose stance maintained since the onset of the Covid-19 pandemic. It has already increased interest rates twice, and financial markets expect the policy rate to rise to 1.5% by the end of the year, the highest level in over a decade.
Bracing for the inevitable
Higher interest rates, all else being equal, would be expected to reduce investment returns. Real estate is typically financed through a combination of equity and debt. And as higher policy rates feed through to market rates, borrowing costs will inevitably rise. There has already been a notable tightening in financial conditions in the UK; the five-year SONIA swap rate, typically used as a benchmark for commercial property debt, rose by around 100 basis points over the course of 2021, primarily driven by future interest rate expectations alone.
Higher interest rates will also reduce the risk-adjusted returns for commercial real estate against more liquid, less risky financial assets. And for international investors into the UK, the cost of hedging against exchange rate volatility will increasingly act as a drag on returns. This is particularly true for European investors, who typically account for around 20-25% of inbound capital, with the European Central Bank not expected to raise interest rates until later this year. This may squeeze some investors out of the UK market, particularly for lower-yielding assets.
Favourable recovery
An added complication is that the BoE is tightening policy into a cyclical downturn in economic growth. Real estate is intrinsically a play on the wider economy – office take-up is a function of urbanisation and employment, while retail is underpinned by consumer spending, for example. So on the face of it, high inflation, rising borrowing costs, and slowing growth would represent the worst possible scenario for UK commercial property.
But this perspective over-simplifies the outlook, and the fundamentals remain robust amid positive supply and demand dynamics. Firstly, economic growth should remain above trend for the next few years as output returns towards the pre-pandemic trajectory. Many households and corporates are coming out of this crisis in a much healthier financial position than when they entered it, largely thanks to the extraordinary response by policymakers. Positive hiring intentions will continue to support the labour market, and investment intentions are indicative of an upcoming boom in capital expenditure, with firms expected to take advantage of a very generous tax deduction.
The UK’s post-recovery plan also compares favourably with other economies – underpinned by a strong vaccine roll-out and high uptake by the population, high e-commerce penetration levels, and flexible working practices, which should limit the economic fallout of any new outbreak.
Secondly, the real estate market does not display any of the signals that would typically be associated with an impending downturn; oversupply, overheating or over-exuberance. Yields across most asset classes are high enough to absorb increasing interest rates and still maintain a healthy risk premium, while also looking attractive relative to competing European cities.
Chance for the UK to shine
And while London will always maintain its allure, there is potentially more value outside of the capital city. Regional cities have been underfunded for years, however, this could change if the government is ambitious with its levelling-up agenda, providing an opportunity for investors looking for higher returns. The UK also has a flourishing alternatives sector – particularly in life sciences – for investors with a higher risk appetite.
And finally, the shift in travel policy to a system based on vaccination status rather than destination, and the relaxation of isolation rules, will help boost inbound travel flows. This should encourage a return of long-haul capital, which was largely missing from the 2021 recovery narrative.
Oliver Salmon is a capital markets analyst & director in world research at Savills
