UK economic outlook

Activity

The UK economy contracted over the second half of 2023, with gross domestic product (GDP) shrinking over the third (-0.1%) and fourth (-0.3%) quarters. Despite briefly entering a technical recession, the UK economy is expected to return to moderate growth over the course of 2024. Indeed, monthly GDP estimates for January were positive at 0.2%. Housing activity is picking up, while the return of positive real income growth has helped to boost sentiment and spending. Additional support via fiscal policy announced at the spring budget will aim to increase GDP by around 0.3% per annum. However, this exacerbates the already poor fiscal inheritance of any future Labour government and will likely require some offsetting at a later date. The effects of past tightening will also continue to define the economy, keeping supply growth muted.

Inflation

The annual consumer price index declined to 3.4% in February, down from 4% in January and a peak of 11.1% in October 2022. We expect headline inflation to fall well below 2% by the middle of the year, because of base effects and lower energy prices. That said, underlying inflation pressures are likely to remain stickier. Additionally, an imbalance between wage growth and productivity growth, and the pending increase in the national living wage, provide a further risk of upward inflationary pressure as the year progresses. We believe the idea of the UK being an outlier on the upside of inflation is over, as the focus now shifts to the Bank of England (BoE) and the timing of its cuts.

Policy

At its March meeting, the BoE showed it’s more aligned in its direction to maintain monetary policy pressure than during prior months. The monetary policy committee voted 8-1 to keep borrowing costs at 5.25% and commented encouragingly on the positive direction of the UK economy. The prospect of further rate hikes has largely left investors’ minds, with the first cut expected in June. A cumulative reduction of 100 bps in the policy rate is expected during 2024. It’s worth noting that very poor supply growth means the current policy stance is more restrictive than it would normally suggest. Over time, this is likely to drive policy rates even lower to maintain productivity targets.

Source: abrdn, March 2024
Forecasts are a guide only and actual outcomes could be significantly different.

UK real estate market overview

The decline in UK real estate capital values moderated during 2023. Despite further pressure on values, pricing movements were nowhere near the levels seen in 2022. We expect clear winners to prevail in the current environment. Meanwhile, sectors facing structural and thematic headwinds will experience sustained struggles.

According to the MSCI Quarterly Index, capital growth for all property was -2.2% over the final quarter of 2023. Offices were the biggest drag on the index at -4%, while the more resilient residential and industrial sectors led the way at -0.6% and -1.2%, respectively. Yields showed greater signs of stabilising over the first two months of 2024, according to the MSCI Monthly Index, although some further outward movement is expected to filter through, particularly in out-of-favour sectors.

Total returns dipped to -1% over the fourth quarter of 2023, driven by declining capital values. They have notably improved since the start of 2024, recording positive annualised performance over both January and February of 0.1% and 0.3%, respectively. Total returns have improved for eight consecutive months, although offices were the obvious outlier. Within all sectors, though, secondary space will continue to significantly underperform as vacancy rates remain elevated.

The investment market remains subdued as investors are waiting for the rate-cutting cycle to begin. Quarterly investment volumes were down 34% year on year, according to Real Capital Analytics. However, these volumes could pick-up quite rapidly when conditions are more favourable during the second half of this year. So far, UK investment volumes have reached £9 billion. The living sector is growing in popularity and contributed 26% of this total, while hotels were the next biggest contributor at 20%. Transactions have been particularly muted as liquidity has become a major limiting factor. Investors are waiting for an improvement in the macroeconomic environment and for more attractive stock. We expect this pattern to continue over the first half of 2024, as most investors who are not facing liquidity pressures have little motivation to sell.

We expect any areas of distress to be quite localised as debt maturities filter through, rather than because of any systemic breaches in covenants. These pockets of stress will largely be focused on poor-quality assets with significant capital expenditure requirements. Such assets could provide opportunities for cash-ready investors as the outlook for the wider market improves.

UK real estate market trends

Offices

The office market struggled during 2023, facing strong thematic and structural headwinds. The final quarter offered little relief with total returns declining a further 2.9%, according to the MSCI Quarterly Index. Demand from an occupational perspective remains extremely limited outside of best-in-class assets, with strong environmental, social and governance (ESG) credentials in favourable locations. The current active requirements for these high-specification assets are driven by demand for large floorplates, of which there is a limited pipeline.

Apart from some near-term completions, there is a lack of appropriate supply from 2025 onwards across London and the big six regional markets. A limited appetite exists for secondary space, and we do not see this appetite returning to significantly relieve elevated vacancy rates. Balancing these supply dynamics with the sector’s thematic drivers, we see a relatively low ceiling for rental value growth. Certain sub-markets, such as London’s West End, will perform better due to supply constraints and local market dynamics, but these localised instances are few and far between.

The decline in office capital values accelerated during 2023, falling 4% in the final quarter. Secondary space is seeing far greater capital declines than prime space, but the latter is not immune. As debt costs remain elevated, borrowers with secondary assets will struggle to refinance on accretive terms and could face liquidity issues. Although we don’t expect a significant wave of distress, a higher risk of defaults and extended capital declines for these secondary assets will likely persist during 2024. Overall, investor appetite for the sector remains muted and capital will be slow to re-enter the office market while the outlook remains bleak.

Industrials and logistics

Not immune to wider market pressures, the more resilient industrials and logistics sector slowed over the course of 2023. Total returns over the final quarter nudged into negative territory at -0.1%, though the sector still beat the wider market by a sizeable margin. However, fundamentals remain solid and we expect to see continued outperformance from this sector.

Availability remains tighter than other asset classes and is particularly competitive in the larger (over 200,000 square feet) logistics segment. That said, a sizeable amount of incoming supply may tamper rental growth potential in certain regions, as the market becomes more in line with pre-pandemic norms. Despite vacancy rates increasing over 2023, they remain well below the long-term average. Although absorption has been slowing of late, resilient demand from ecommerce retailers and long-term growth drivers will support the sector’s relative performance.

The outlook for logistics and industrials remains positive, despite elevated incoming supply levels. There has been a notable slowdown in construction starts as higher build-cost inflation deters development. Constraining the future pipeline will lend further support to the sector over our forecast horizon. The sector is particularly favoured by investors looking for long-term rental growth prospects, although tenant covenant strength is vital given economic pressures. Furthermore, assets with appropriate ESG credentials are becoming more imperative from an occupational and investor perspective.

Retail

UK retail sales surprised on the upside in January and February. Retail sales volumes recorded 0% in February 2024, ahead of consensus expectations of a 0.4% fall. This followed a strong reading in January, where retail volumes increased by 3.6%. Clothing sales had a particularly strong month in February, as consumers invested in the new season’s collections. In addition, online retail sales increased, particularly for clothing, as a mild but very wet February discouraged consumers from shopping in-store.

An emerging trend from recent company reporting is the more challenging trading environment for bulky and big-ticket items. This area of the retail market is intrinsically linked to the residential market, with a 9–12-month lag between housing activity and do-it-yourself (DIY) sales. With residential transaction activity stagnating in a higher interest-rate environment, consumers have opted for small home improvements as opposed to investing in large projects. With a more favourable interest-rate environment on the horizon, we expect more residential activity. This should result in a better trading environment for DIY stores.

Within the retail sector, there is a preference for retail parks. Favourable footfall trends, an incredibly constrained supply pipeline, and a sub-2% vacancy rate support this outlook. As inflation continues to fall, rising real household incomes should provide some support for retail sales in 2024.

Living

The UK’s private rented sector (PRS) has recorded strong levels of rental value growth. In the 12 months to the end of February 2024, rents grew by 7.5% in the UK. Although this marks a slowdown from the 9.9% recorded a year earlier, it remains high in a historical context. London recorded the largest slowdown in rental value growth at 4.8%, down from 12.4% a year earlier, according to HomeLet data.

While the supply/demand imbalance in PRS supports the sector, the gap between tenant demand and available supply has narrowed in recent months. This is primarily because of weaker demand, rather than any major expansion in supply, as affordability constraints weigh on rental inflation.

We are still forecasting positive rental value growth for PRS, but at a more normalised level. Real earnings are expected to remain positive this year, as inflation falls closer towards its target rate of 2%. But, perhaps more importantly, supply is expected to remain very constrained, which provides support for rental value growth for the sector. Investor interest in the wider living sector remains robust, buoyed by the favourable supply/demand dynamics exhibited across all sub-sectors.

Outlook for risk and performance

UK real estate looks poised for a modest recovery following a collection of positive movements in the economic landscape. With inflation seemingly under control and the first interest-rate cuts expected in the summer, we expect to see a material increase in UK real estate performance in 2025. This period doesn’t come without risks, as any surprise in inflation data or economic activity may deter confidence in the BoE’s current path for monetary policy. In turn, real estate pricing would likely see further volatility.

Given the current environment, we expect to see investors largely remain on the sidelines for the first half of 2024. In the meantime, existing investor appetite will remain focused on high-quality assets that are benefiting from long-term thematic growth drivers. Any significant wave of distress is looking more unlikely, as occupational demand remains quite robust and strong rental growth has helped anchor real estate yields. Instead, pockets of distress are more likely within localised sub-markets or from assets suffering high vacancy rates and those requiring significant capital expenditure.

As construction costs remain elevated against real estate returns, declining levels of new supply will help to drive rental growth and performance across our forecast horizon. The polarisation trend in asset quality is set to define sectors. We expect further capital declines over 2024 from poorer-quality stock and within sectors facing headwinds. In particular, the bifurcation of offices is most apparent as secondary space has quickly fallen out of favour. In general, prime space in key locations will see the strongest rental growth, as tenants recalibrate their occupancy needs and standards during a period of slower economic growth.

Pricing should begin to look more attractive to investors in the second half of 2024. That said, monetary policy and a UK general election are still risks. We expect to see 100 basis points of rate cuts by the end of the year, encouraging investment to return to the market. Over a three-year outlook, all property returns are forecast to return to healthy levels.