The UK commercial real estate debt and equity markets face their toughest challenge since the onset of the Covid-19 pandemic, with almost £2.5bn wiped off the value of the biggest REITs and funding deals suffering as volatility spreads through the sector after last week’s mini-Budget.
LXi REIT’s £500m Sainsbury’s portfolio deal has already been scrapped in the days since the new government announced wide-reaching tax cuts that shocked economists and fuelled talk of emergency interest rate hikes. The pound has hit a record low against the dollar and the FTSE 100 index has plummeted. The Bank of England is buying up government bonds. The International Monetary Fund has said that with inflation soaring, it does not recommend “large and untargeted fiscal packages at this juncture”.
The real estate lending market had staged a notable recovery from the lows of the pandemic, but Nicole Lux, senior research fellow at Bayes Business School, said activity is now set to slump as the cost of debt rises and lenders prepare to face tough stress tests.
“They are trying to build up reserves and are already planning to have higher-risk capital allowance for possible downgrades on their loan book,” she said. “Development loan facilities will become more expensive because of uncertainties and some of the investment loans as well, where interest coverage ratios are declining. All this will affect their risk capital, which means a lot of them are now saying there is no appetite until the end of this year for much new lending – they have to put so much more capital now as a buffer that it makes no sense to look at new borrowers.”
At Atelier, an M&G-backed development lender focused on the residential space, joint chief executive Chris Gardner said the team had already seen signs of a “cooling market” in recent weeks.
“There are still plenty of residential developers who are actively looking for sites to build on, but some are finding it hard to make the numbers work for them,” Gardner said. “Developers’ margins have been under pressure ever since build costs took off, first during the post-pandemic boom and then again after war broke out in Ukraine. Now, with rising interest rates increasing the cost of finance, the squeeze on margins is increasing.”
Gardner said that while developers had found a profit on cost of 30% “achievable” back in 2019, “these days 20% is aspirational”.
“As a result we are seeing more creativity and collaboration between vendor and developer, and greater uptake of mezzanine finance and equity, in many of the deals that come across our desk,” he said.
Stock worries
The public markets have been in turmoil, with the share prices of many blue-chip corporates tanking. Between 23 September – the day of the mini-Budget – and the close of the market on 27 September, FTSE 100 REITs British Land, Landsec and SEGRO saw almost £2.5bn wiped off their combined market capitalisation.
LXi REIT, which earlier this year merged with rival Secure Income REIT, had planned an equity raise to finance its deal with Sainsbury’s, but with its share price dropping sharply, analysts said the transaction no longer made sense given that it would not be accretive to its net tangible asset value.
Nonetheless, Dominique Moerenhout, chief executive of EPRA, said the outlook for UK real estate and its funding markets is “relatively positive in spite of challenging external conditions”.
“Since the economic crash of 2008, UK real estate has taken important steps that have made it more robust and therefore put it on a stronger footing when facing economic headwinds,” Moerenhout said.
“A huge part of this has been due to a reduction in the sector’s level of indebtedness, which will help it deal with future rate rises.
“The average loan-to-value for the UK listed real estate sector stood at 28% this summer, which is substantially lower than the 49% level recorded in 2007-08.”
He added: “Furthermore, the vast majority of the sector’s outstanding debt is contracted at a fixed interest rate with maturities above five years. This means that most companies are not compelled to refinance in the near future, sparing the sector vastly increased debt-servicing costs in the short term.”
Congestion and slow down
Concerns about government and central bank policy add further uncertainty to an already-volatile market.
Speaking ahead of the mini-Budget, Sander Grunewald, global head of real estate advisory at KPMG, said geopolitical worries, as well as rising inflation and interest rates, mean institutional investors in Europe are “holding their horses” when it comes to putting capital into real estate projects and investments due to uncertainty over values.
“My glass is half-full, although in Europe we see an almost perfect storm,” said Grunewald. “We have an extremely ageing population, we have still the remainders of Brexit and, of course, we have Russia closer by [than other markets]. My belief is that 2023 is the year to reset and resettle.”
Ongoing uncertainties will “definitely impact and cool down the real estate market” over the next 18 months, according to Grunewald. “Equity and higher risk-taking and private investors and owners might have an interesting year ahead, whereas developers might experience congestion and slowdown in the chain,” he said. “And more institutional investors are already holding their horses.”
Grunewald said institutional investors are in no hurry to start additional projects or investments owing to uncertainty over how far and how quickly values will fall. “Yields were already pretty low. And then when interest rates are increasing, it becomes less and less attractive as an asset class,” he said. “You start to reanalyse your options. That’s a very logical development due to all the factors we have – including the rising costs of materials and rising interest rates.”
Andy Pyle, head of real estate at KPMG in the UK, said deals in the works for “prime, good-quality City of London offices” have already seen yields move from 4% to 4.5%. “Yields have already gone out, prices have come down,” he said, adding that this could spell opportunity for some investors.
“They are saying to us, ‘We’ll probably start buying because we see ourselves as a through-the-cycle investor in real estate and there will be some buying opportunities soon.’”
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Additional reporting by Julia Cahill
julia.cahill@eg.co.uk or tweet @EGJuliaC or @EGPropertyNews
