H1 2O23 Market Update
H1 2023 Market Update
We entered 2023 anticipating a moderate recession, with inflation and interest rates putting downward pressure on growth. However, while the UK economy has thus far avoided a recession, it remains overshadowed by persistent inflationary pressure and the prospect of interest rates remaining elevated for longer than originally anticipated.
As expected, the markets have been more challenging for the real estate sector due to higher debt costs which have resulted in historically low investment volumes in the first half of the year. Against this background, real estate sectors can be differentiated by long term trends and short term dynamics which influence growth prospects and performance potential.
UK Economy Remains Volatile
Inflationary pressures have been unrelenting in global economies as well as in the UK, where the Consumer Price Index (CPI) reached 11.1% in October 2022 before reducing to 7.9% in June 2023. Core inflation reduced in the same month to 6.9%, which perhaps marked a turning point albeit with fluctuations still likely in the months ahead.
This new period of inflation, initially caused by the reopening effects after the pandemic and then the war in Ukraine, is still being fuelled by strong domestic wage growth with a shortage of workers to fill jobs, high costs of food, and energy shortages with a reliance of natural gas to generate power. Despite a further increase in the Bank of England Base Rate to 5.25% in July 2023, inflation appears to be easing, improving the prospect that rates will soon peak, and will potentially start to fall towards the end of 2024.
The disastrous “mini-budget” and resulting spike in UK bond yields in Q3, 2022 had a dramatic impact on the property market which itself had already begun to soften due to earlier inflationary pressures in the economy. In H1 2023, we have since seen bond yields remain high, fluctuating around c.4.50%, which along with other economic challenges, places continuing pressure on property prices and yields. The current premium of all property yields over 10-year gilts of 2.2% is above the long term average prior to the 2008 global financial crisis. In other words property assets have been re-priced to provide potential value and a healthy risk premium over gilts.
According to CBRE’s monthly data index, capital values for commercial real estate saw little change in the first part of 2023, following a fall of c.20% in the latter half of 2022. Real estate yields have since stabilised, with a degree confidence returning to sectors of the market showing the strongest occupational strengths.
However as expected, H1 2023 has seen historically low investment volumes, with a gap persisting between vendors’ willingness to sell and buyers seeking value. With many investors waiting on the sidelines with a “risk-off” approach during the ongoing economic uncertainties, the lack of market activity is understandable, with investors waiting for signs of stability before committing significant levels of capital.
Value from Prime vs Secondary Assets
Despite the ongoing economic environment, demand for prime and sustainable assets delivering long term income is expected to remain robust, reflecting a polarisation between prime and secondary assets, which can be clearly seen in current relative yield pricing. As has always been key to Barwood’s investment strategy, well located properties regarded as secondary due to the lack of management or level of obsolescence, provide very good opportunities to deliver strong returns by reducing the yield gap through planning, development, repurposing or substantial refurbishment and improvement of the income quality.
Long term economic, consumer and technology trends accelerated by the pandemic continue to underpin strong occupational demand (and rental growth) in the right locations with the highest sustainability credentials. Conversely, we are increasingly seeing opportunities in “sustainability obsolescence”, where owners are unable to invest in capex programmes to improve properties, and face the prospect of declining values as a result, thereby creating strategies to divest from such assets.
In summary, at the 2023 mid-year point the market is still facing uncertainties. However there remains a large weight of capital looking to re-enter the market with an expectation that real estate will offer positive returns in 2024 and 2025 as inflationary pressures continue to ease, interest rates stabilise and confidence returns to the economy.
Industrial & Logistics
The value of warehouses fell more sharply in 2022 compared to other sectors, which was more a function of a correction from its stellar run over recent years than the underlying fundamentals of the sector. There is still demand from online retailers, logistics operators and low carbon industries seeking well-located, flexible and high quality logistics and distribution warehouses, although take-up in Q1 2023 was 18% down year on year as occupiers became more cautious and decision making slowed down. The vacancy rate increased to 2.7%, up from 2% in Q4 2022, driven by an increase in secondhand availability and speculative completions. The vacancy rate remains significantly below the long-term average due to supply being exhausted during the Covid-boosted demand period.
The relatively low availability and favourable demand/supply balance is still expected to drive rental growth over the coming years. In terms of structural changes, the market continues to see logistics occupiers pivot away from just-in-time management to more regional and domestic supply chains and increasing the use of technology to make operations more agile, as well as strong demand for last-mile logistics and multi-let assets.
Self-storage is an industrial sub-sector which has seen increasing demand and growth over recent years, which according to Cushman & Wakefield, is expected to exceed £1 billion in 2023 with c.6,000 new stores coming on stream by 2025. In terms of revenue growth, the market has moderated somewhat in H1 2023, however the sector is now established as a key target for large institutions attracted to its resilient and diverse income streams based on the “four Ds” that drive demand: death, divorce, dislocation and downsizing.
The office sector is still adjusting to any permanent trends in hybrid working, with employers still struggling to implement effective strategies to encourage or compel staff and workers to spend more time in the office. Changes to longer term occupational requirements are being seen with size, accessibility, flexibility, amenities, and sustainability coming to the fore. There are now numerous examples of employers re-locating to significantly smaller offices which has created large vacancies an “grey space”, still let but unoccupied.
The office sector is likely to go through the most change with a prolonged repricing underway, as structural demand adapts and occupiers require attractive, energy efficient work places with a focus on sustainability to attract and retain staff. Despite this, offices have still seen rental growth with opportunities for repositioning selective regional stock to the best product as well as repurposing of obsolescent assets. There will undoubtedly be opportunities to re-position office assets, or re-purpose them for alternative uses where a value crossover point makes this attractive.
The retail warehouse sector emerged as the most resilient retail sector during the pandemic both from an occupational and investor perspective due to properties’ ease of access and appeal as “click and collect” points. Furthermore, opportunities exist for re-purposing assets where industrial rents and yields offer very attractive value add investments as well as mixed use destinations. This area of the sector is in stark contrast to some shopping centre and high-street shops that have plummeted in value as retailers are unwilling to pay the level of rents required by landlords facing high capital expenditure and business rates costs.
Barwood has for a number of years now benefitted from opportunities in the care home sector, where the UK’s ageing population continues to drive demand for care home beds and for a wide range of later living options. As referred to on previous occasions, the challenges facing the care home market during the pandemic acted as a catalyst for care home operators to review their portfolios and identify properties for re-provision. They have ongoing and highly targeted requirements for modern purpose built stock, as demand for and affordability of bed spaces continues to drive demand for the right accommodation in under supplied locations.
In the wider housing market downturn, senior housing developers continue acquisition programmes targeting more locations to increase turnover and market share. Market conditions for participation in the sector continue to be excellent, predominantly from land trading, especially in connection with larger sites which are capable of sub-division to provide a range of end uses.
Alternatives, including care, later living, life sciences, leased hotels, key worker and student accommodation amongst others, are now an established part of the UK property market. A core reason for investors targeting alternatives is the shortfall of other institutional quality, modern, purpose-built assets which also provide opportunities for sustainable investment.
The residential market as a whole was hit by the uncertainty in H2 2022, when consumer confidence nose-dived as inflation expectations and gilt yields rocketed after the mini-budget. The most immediate effect in the interest rate increases brought a fast change in the affordability of mortgage debt. In turn this dampened the buying power of many buyers, as the much higher costs of debt reduced transaction levels, putting downward pressure on prices.
According to the ONS, the average UK house price was £288,000 in June 2023, £5,000 higher than 12 months ago, but £5,000 lower than the peak in November 2022
A potential difference to the level of price falls seen in previous economic downturns in the early 1990s or 2008, is a combination of relatively low unemployment and lenders’ restraint in terms of repossessions. Borrowers have also locked into fixed rates with more rigorous stress testing by lenders. Further price falls are inevitable, with estimates from Halifax and Nationwide indicating between 5% to 10% in 2023 at a national level although average growth of 4.25% still predicted by Savills from 2024-2026.
For the Barwood development schemes in the BRIP platform, where the majority of sales are to equity buyers or buyers requiring low mortgages, pricing has held up owing to the quality of new product in excellent locations where there is a shortage of supply. First time buyers and mortgaged buy to let investors are most affected, whereas the prime housing markets are expected to be less affected by increased costs of borrowing.
A downturn in the housing market however, comes at a time when Help to Buy was brought to an end in March 2023, build costs and development finance have become more expensive and development levies have been increased. Similar to the commercial sectors, the residential development market therefore provides a number of opportunities for the right product against a backdrop of downward pressure on land values and falling housing delivery.
Capitalising on a Volatile Market
With the dramatic market correction over the last 12 months, ongoing uncertainty and potential areas of landlord distress, we believe that more opportunities will emerge to invest in regional growth sectors which will drive investor returns.
By applying a value add strategy combined with an opportunistic approach to asset selection, now is an optimum stage in the cycle to take advantage of depressed values to deploy capital from a prudent risk/return basis.