Source: abrdn, October 2023

Forecasts are a guide only and actual outcomes could be significantly different.

UK economic outlook

Activity

Sizeable revisions to gross domestic product (GDP) data suggests the economy recovered more quickly from the pandemic shock than was originally thought. The economy suffered a slightly smaller supply-side shock and productivity growth was better. However, the revisions do little to change the near-term outlook for the economy. Indeed, with weakness in the services sector, which dragged the September composite flash purchasing managers’ index down to 46.8, the risk of the economy entering a formal recession even earlier than we had expected is increasing. Monetary policy tightening is starting to bite in earnest, with the full impact still to be felt.

Inflation

The annual rate of inflation fell to 6.7% in August, with broad-based disinflation helping to offset an increase in fuel prices and duty. Significantly, core inflation fell from 6.8% to 6.2%, while services inflation fell from 7.4% to 6.9%, well below the Bank of England (BoE)’s forecast of 7.2%. This suggests that underlying inflation pressures are starting to recede. Headline inflation should fall further during the rest of the year, as food-price growth continues to fade and large energy base effects take effect in October. However, wage growth is still running well above a target-consistent rate.

Policy

We think the BoE’s decision to keep interest rates on hold at 5.25% means that the bank rate has peaked. If wage growth and services inflation were to surprise on the upside, then a hike in November is still possible. But we think these conditions are unlikely to be met. The BoE wants to guide market expectations towards a ‘Table Mountain’ profile for interest rates, which sees rates staying elevated for an extended period. This view is designed to keep a grip on current financial conditions and we expect rate cuts to start around the middle of next year.

Source: abrdn October 2023
Forecasts are a guide only and actual outcomes could be significantly different.

UK real estate market overview

UK real estate pricing has been stabilising during 2023, following the significant correction in the sector in late-2022. However, performance has been asymmetric across sectors, with those benefiting from structural and thematic tailwinds proving more resilient in the face of a weaker macroeconomic environment.

According to the MSCI monthly index, all property recorded capital value growth of -1.6% in the third quarter of 2023. The industrial and residential sectors led the way with positive growth of 0.5% and 0.3%, respectively, over the quarter. Conversely, the office sector continues to drag, and recorded capital growth of -5.0% in the third quarter of 2023, as the sector struggles with changing working habits and a higher-rate environment.

Total return performance has also improved, with All Property recording returns of -0.2% in the third quarter of 2023. The residential sector led the way at 1.8%. Over the previous six months, total return performance has been positive for most sectors, again with the exception of offices, which continue on a negative trend and recorded performance of -6.4% in the six months to September 2023.

While performance has shown tentative signs of stabilising, the investment market has remained muted as investors have taken a risk-off approach towards the sector. In total, there have been approximately £24 billion worth of UK real estate transactions so far this year (to the end of September), according to Real Capital Analytics. This is 54% lower than the same period a year earlier. It demonstrates slower investment volumes as investors have stepped back from the market. Investor appetite has remained robust for industrial assets, which accounted for 25% of total transaction volumes. Demand for the living sector continues to grow, making up 21% of volumes so far this year (to the end of September), versus just 6.7% in 2013.

However, a lack of good-quality investment stock being brought to market has helped to suppress transaction volumes, so far this year. In many cases, asset holders remain unwilling sellers, given the significant disconnect that exists between buyer and seller aspirations. As a result, investors who are not required to sell at this point are unlikely to do so before an improvement in the wider macroeconomic environment.

Given the market backdrop, there is little indication that activity will substantially improve over the remainder of the year, with greater activity likely to be prompted by further clarity on the direction of UK monetary policy. However, given the threat of rates staying ‘higher-for-longer’ and a significant number of debt maturities due in 2024, greater transactional activity may be spurred by pockets of stress forming.

UK real estate market trends

Offices

As expected, office performance weakened during the third quarter of 2023, as the sector remained under pressure from new working habits and a weak economic climate. Investor appetite towards the sector remains poor and transaction volumes have fallen, as a result. Demand, from both an occupational and investment perspective, remains focused on best-in-class accommodation in strong locations, and on assets that meet current environmental requirements. The availability of such space is low, which is allowing for instances of positive rental value growth.

That said, speculative development pipelines across both central London and the big six regional office markets are elevated. With vacancy rates already trending upwards, rising supply at the same time as weakening demand are expected to dampen the potential for meaningful rental value growth. The growing availability of ‘grey’ and second-hand space, as occupiers rationalise operational estates, is also placing pressure on secondary rental values.

Office capital values have seen further falls and the outlook for capital growth remains negative. Falling capital values are placing pressure on debt-financing covenants. With the cost of debt remaining highly elevated, some stress is expected to appear in the office sector during the remainder of 2023 and into 2024, as borrowers struggle to refinance on accretive terms. Secondary assets are most at risk of default and, given limited investor demand, this is likely to spur greater capital declines. Good-quality assets will be more resilient, but not immune in this scenario.

Industrial and logistics

The industrial and logistics sector has been buoyed by resilient occupier demand and positive rental growth during 2023. While the vacancy rate in the sector has trended upwards during the year – now around 4% according to CoStar – it remains low in a historical context. In addition, the supply of good-quality space, which occupiers have been targeting, remains low. With the development pipeline being constrained by rising build-and-debt costs, the availability of accommodation is expected to remain tight.

Industrial pricing and performance have stabilised, so far this year. But polarisation between best-in-class and secondary accommodation is growing, as both occupiers and investors focus on good-quality accommodation in strong locations. Robust rental growth continues to be recorded on such assets and investors are attracted by the opportunity to unlock further rental growth potential. However, the weaker economic environment is placing pressure on occupiers. We recommend an increased focus on tenant covenant strength and security of income in this environment.

The longer-term outlook for the sector is positive, supported by structural and thematic growth drivers. Investor sentiment remains strong, as a result. While the investor pool remains smaller than before, due largely to elevated debt costs, there have been tentative signs of yield compression in some areas of the market. However, any improvement in pricing is fragile, given current economic headwinds.

Retail

During 2023, consumer spending has proven more resilient than first forecast in the face of a cost-of-living crisis. Indeed, consumer sentiment has also been improving as inflationary pressures have started to ease. Recent data from the British Retail Consortium has shown the first monthly drop in food prices for over two years, indicating that the pressure on consumers’ pockets may be beginning to ease.

Polarisation is growing more apparent in the supermarket sector. Discounters have expanded their market share at the expense of more established names. A focus on ‘clubcard’ deals, which provide access to cheaper prices for members, has proved a successful policy for Tesco and Sainsbury’s. Both companies recorded marginal increases in market share over the last 12 months, as consumers continued to seek cost savings. We believe the supermarket sector will keep recording polarised performance, with highly levered operators underperforming discount- and investment-grade retail names.

Amid a weaker economic environment, investors are expected to increase their focus on retailer covenant strength. Further insolvencies are likely in the sector as operators remain under pressure, and as covenant risk is expected to be reflected in asset pricing. Investors will remain focused on good-quality, discount-led retail warehouse schemes, which are forecast to provide more robust performance and the opportunity for rental growth in select locations.

Living

The living sector is benefiting from structural and demographic growth drivers, resulting in sentiment towards the sector remaining robust despite wider macroeconomic weakness. Strong occupational demand for both the private rented sector and purpose-built student accommodation, amid an acute supply shortage, has resulted in robust rental-value growth being recorded across both subsectors. This rental growth, combined with more resilient asset pricing, has subsequently attracted investors to the sector.

Transaction volumes have fallen significantly year-on-year. This is mainly because asset holders remain unwilling sellers, rather than because of any fall in investor sentiment towards the sector. Volumes are likely to remain muted over the remainder of 2023. Any good-quality investment stock that does make it to market is likely to garner strong investor interest. This will help to support asset-pricing levels across the sector. Investors will remain focused on well-located, good-quality schemes with strong environmental, social and governance credentials – all of which are key in attracting tenants. Student accommodation schemes, affiliated with top-tier universities, are also anticipated to remain near the top of investors’ wish lists.

Looking forward, the living sector is forecast to return positive performance. This will be driven by rental value growth, albeit at more normalised levels as affordability concerns weigh on investors’ ability to drive rental values upwards. Greater investor focus on the longer-term affordability of schemes is essential to ensure the security and stability of asset-income profiles.

Outlook for risk and performance

While the outlook for UK real estate remains fragile, an improving economic picture as we move into 2024 is likely to help spur an improvement in UK real estate performance. While some headwinds remain, such as weak national and global economic activity, falling inflation and an end to the BoE’s monetary hiking cycle is likely to help revive investor sentiment towards the sector.

That said, any negative surprise in economic activity or inflation data will spook investment markets and may result in further instability in real estate performance and pricing. As a result, investors are expected to remain risk-off towards UK real estate, with investor appetite remaining focused on those sectors that benefit from longer-term thematic growth drivers. These sectors are forecast to provide more robust performance, even in the face of a weaker macroeconomic environment. Additionally, investors will be narrowly focused on good-quality accommodation within these sectors, which provide the opportunity to capture rental growth.

In response, polarisation in performance is anticipated to accelerate from both a sector- and asset-quality perspective. Sectors that face structural pressure (such as offices), and secondary assets that don’t meet current occupational demand, are expected to record further capital value declines and weaker performance. Occupational performance is forecast to be the main driver of returns in the near term. Given the nature of current occupational demand, good-quality accommodation is expected to prove more resilient.

Although the outlook for monetary policy appears more positive from this point, a meaningful improvement in UK real estate performance is not expected until the second half of 2024. In the face of a weaker economic environment and with the risk of the bank rate staying higher for longer, investors will retain an overall risk-off approach towards the sector. A rate-cutting cycle should then encourage investors to return to the market.

UK total return forecasts from September 2023

Source: abrdn October 2023
Forecasts are a guide only and actual outcomes could be significantly different.