UK inflation rate and Bank of England policy rate forecasts
UK economic outlook
Activity: UK real gross domestic product (GDP) contracted by 0.1% month-on-month in May and can be partly attributed to the extra bank holiday for the coronation – a one-off factor. However, the monthly profile of activity continues to be volatile and bounced around as a result of various quirks, including the pattern of industrial strike action across sectors. Looking through this monthly volatility, the underlying trend is one of stagnation. The bulk of the impact of past and forthcoming monetary tightening is yet to be felt and it is hard to see how the economy ultimately avoids a recession.
Inflation: In welcome news, the June UK inflation report surprised on the downside as the headline rate came in at 7.9% year-on-year. This was lower than consensus expectations of 8.2%, and well below May’s reading of 8.7%. The headline rate is expected to drop again in July because of a sharp fall in energy bills. The core rate – which had been expected to remain flat – also declined from 7.1% in May to 6.9% in June. This follows a string of upside surprises in the measure over the past few months. However, falling core and services rates suggest underlying inflationary pressures are no longer accelerating, but both measures continue to be elevated and the risks of an extended period of stickiness remain.
Policy: In a surprise decision, the Bank of England increased the Bank Rate by 50 basis points to 5%. The abrdn Research Institute (aRI) believes the Bank will have to push rates to at least 5.5% to tackle underlying inflation pressures. However, aRI remains sceptical that rates will follow the market curve, which sees the Bank Rate climbing above 6%, given the risks of significantly overtightening policy. Further hikes are anticipated to tip the UK economy into recession and, as a result, an easing of monetary policy is forecast to begin during 2024. The weaker macroeconomic backdrop continues to weigh on UK real estate performance. However, any improvement in the economic outlook should support a recovery in real estate sentiment.
UK economic outlook
Source: abrdn June 2023
Forecasts are a guide only and actual outcomes could be significantly different.
UK real estate market overview
The UK recorded a significant correction in real estate pricing during the second half of 2022 and into the first quarter of 2023, as the weaker economic backdrop and higher rate environment weighed on performance. However, pricing began to stabilise in the second quarter of 2023, particularly in those areas of the market that saw the greatest capital declines.
According to the MSCI Monthly Index, all property capital value growth fell again in June 2023 by 0.5%. This followed a flat reading in May 2023, and rises of 0.1% and 0.2% in April and March 2023, respectively. The industrial sector was the only sector that recorded positive growth during the month at 0.3%. The residential and retail sectors both recorded negative capital growth of 0.1% in June 2023, while offices continued to drag on performance, with capital values declining by 2.2%.
Total return performance also improved during the second quarter of 2023, with all property posting a total return of 1% in the three months to June 2023. The residential sector led the way with a return of 3.9%. This was followed by the industrial and retail sectors, which posted returns of 2.4% and 2%, respectively, over the same period. On a three-month basis, all sectors (with the exception of offices, where returns dropped to -2.8%) recorded positive total returns.
While performance improved, transaction activity remained muted in the second quarter of 2023, as investors continued to take a more cautious approach to UK real estate. Transaction volumes were £5.6 billion in the second quarter, down 64% on the same period a year earlier and 63% below the 10-year quarterly average. Limited good-quality investment stock has come to market so far in 2023, which has suppressed transaction volumes. A gap between the pricing aspirations for buyers and sellers remains. Given lower conviction on asset pricing on the back of a weaker macroeconomic environment, we are likely to see a further slowdown in activity during the summer months.
UK real estate market trends
The office sector remains under structural pressure as evolving working habits and economic uncertainty weigh on the sector. In London, supply levels are rising. Over 10 million square feet of new accommodation is expected to be completed this year, according to Deloitte – the highest level in over 20 years. Rising supply and weakening demand are forcing the vacancy rate higher, with the Central London vacancy rate now in excess of 9%, according to CoStar data. Such a scenario is expected to dampen rental growth prospects and expedite the bifurcation in sector performance.
Investor demand for UK offices remains weak amid a poor outlook for the sector. Headline investment volumes hide a lack of real liquidity in the office market, and anecdotal evidence suggests that secondary office assets are coming to market at material discounts to previous valuations.
Pockets of distress are expected to appear in the office sector during 2023, as falling values and heightened debt costs prevent accretive refinancing opportunities for asset holders. As a result, further capital value declines, particularly for secondary assets, are expected across the sector. Best-in-class accommodation, in locations that benefit from a robust supply/demand dynamic, will likely prove more resilient, but won’t be immune to the pressures the sector is facing.
Industrial and logistics
Improved sentiment returned to the industrial and logistics sector during the second quarter of 2023, as pricing and performance demonstrated tentative signs of stabilisation. While the longer-term outlook remains positive, the sector is anticipated to face more short-term pressure as higher debt costs and fixed-income yields dent investor confidence on current pricing.
That said, the sector continues to benefit from structural and thematic tailwinds. In the longer term, we expect continued positive performance, principally driven by robust rental growth, albeit at more normalised levels. While the UK vacancy rate has increased since the start of the year – with ‘big box’ vacancy rates rising to 4.9% in the second quarter of 2023, according to DTRE – it remains near historic lows. Any new supply is unlikely to satisfy current occupational demand, which should help sustain rental growth.
Occupier and investor demand remains focused on the best-quality assets, with investors targeting those assets with strong rental growth potential. This is anticipated to result in polarisation in performance between good-quality and secondary accommodation, with best-in-class assets outperforming the wider market. Tenant covenant strength and security of income are expected to grow in importance as we enter a recessionary environment.
The retail sector has been more resilient than many had expected over the first half of 2023. According to the Office for National Statistics, retail sales in the UK unexpectedly expanded in May, boosted by spending on summer clothing and outdoor goods. However, it is important to highlight the difference between the quantity of goods purchased (volume) and the amount spent (value). Retail volumes are now 0.8% lower than pre-Covid levels, while retail values are 17% higher. It is a clear illustration that consumers are cutting back on the number of items purchased, while higher inflation means it is costing more to purchase these items.
While the presence of discount retailers in the UK is not new, changes in consumer shopping behaviour have propelled them to the top of the wish list for many UK retail schemes. Discounter retailers have been a key beneficiary of a more cost-conscious UK consumer. Retail parks with a strong discount-orientated line-up remain in high demand for UK institutional investors, as a result.
The private rented sector (PRS) is being buoyed by a severe supply and demand imbalance. Rents for new lettings grew by 10.4% in the 12 months to June 2023 – the 15th consecutive month of double-digit growth, according to Zoopla data. Over the longer term, rental growth is very closely correlated with wage growth in the UK. While regular pay in the UK grew by 7.2% in the three months to the end of April 2023, the supply and demand imbalance is resulting in rents growing at a faster pace than earnings.
From an affordability perspective, rents now account for 28.3% of gross earnings, on average, versus a 10-year average of 27%. We expect rental growth to remain positive, but to moderate from current levels, as affordability constraints reduce the level of rental inflation.
Investor sentiment towards the purpose-built student accommodation sector remains positive and underlying occupational demand for the sector is robust, as illustrated by strong booking momentum for the 2023/2024 academic year. Like PRS, there is an acute shortage of supply, particularly for the strongest university towns, which supports rental value growth for the sector. Investment volumes are down over 80% year-on-year for the sector. However, this is primarily due to a limited amount of investment stock being brought to the market, as opposed to any softening in investor sentiment towards the sector.
Outlook for risk and performance
While more positivity returned to the market in the first half of 2023, the outlook for UK real estate has clouded on the back of a weaker macroeconomic climate. Upside surprises in UK inflation data have prompted a more aggressive monetary policy stance from the Bank of England. This has spooked markets, with SONIA swap rates and UK gilt yields rising.
Gilt yields are anticipated to remain volatile in the third quarter of 2023 and any further rise in gilt yields will result in a tightening margin between UK real estate and gilts. That said, the previous repricing of UK real estate has softened the impact of weaker gilt prices. Rising interest rates will also maintain pressure on real estate pricing, as debt costs become increasingly dilutive to performance. More positively, debt financing remains available and lender appetite remains for good-quality accommodation.
Investors are likely to remain risk-off and to focus on good-quality accommodation. These assets should prove resilient in the face of weaker economic conditions and benefit from more robust supply/demand dynamics. Polarisation within sectors is expected to intensify, with secondary rental and capital values under further pressure. While prime pricing may not be immune, the performance gap between prime and secondary assets is expected to widen. Occupational performance is expected to be the predominant driver of real estate returns in the near term. As a result, occupier covenant strength and the resilience of income will be paramount.
Any substantive improvement in real estate performance is now not anticipated until early 2024, as the path of UK monetary policy becomes more accommodative. The risks to the timing of this recovery remain elevated, however, given the strength of underlying inflation and the associated risk of higher interest rates.
UK total return forecasts from June 2023