H2 2023 Market Update

Challenging macro-economics, persistent inflation and rising interest rates were the dominant themes of 2023 with the Bank of England (“BoE”) raising interest rates for the fourteenth time to 5.25% in August. Having kept rates unchanged in November, expectations of further rate rises to as high as 5.75% have since diminished. Voting at the BoE’s latest February 2024 meeting provided justified optimism for rate cuts in 2024. When exactly is anyone’s guess but some consider that it could be as early as May.

Headline CPI inflation stepped up from 3.9% in November to 4.0% in December 2023.  Whilst a further small increase was expected in January 2024, it remained steady at 4%. This defied the forecasters who all anticipated a small rise (to 4.2%) and ultimately provided relief for the BoE and also Prime Minister Rishi Sunak, ahead of a pending general election.

Due to strong employment data, persistent service cost inflation and the increase in the energy price cap, the overall inflation trend has been steeply downwards from the double-digit rates that characterised late 2022 and early 2023. The sharp falls in oil and wholesale gas prices, and a series of food and core goods inflation figures have come in below expectation, leading to forecasts that the target 2% rate of inflation could be reached in H1 2024. The latest inflation data should reassure the Monetary Policy Committee (MPC) that the time to start cutting interest rates is approaching.

Whilst the BoE held firm at 5.25% in February, investors have added to their bets on the BoE cutting interest rates this year, roughly putting a 72% chance of a first reduction coming in June. This has increased from just 40% prior to inflation data being released.

GDP growth forecasts similarly fluctuated during 2023, and whilst a technical recession was avoided, growth was flat and this is likely to continue during 2024.

As we head into 2024, investor confidence is improving as the economic outlook brightens, with increasing competition and a greater depth to the buyer market.  There is still, however, uncertainty for inflation which remains sticky, the economic recovery relating to global conflicts and the upcoming UK general election later in the year. In this environment, the ongoing growth in certain real estate sub-sectors (e.g. industrial, self-storage, later living and student accommodation) should provide both attractive returns for current investments and good buying opportunities in what is anticipated to be a more liquid market than was seen in 2023.

Real Estate

2023 was a difficult year for real estate. Persistent inflation and interest rates reaching a 15-year peak, had a negative impact on economic growth. This led to a significant reduction in commercial real estate investment transactions. 2023 saw the lowest real estate investment volumes for over a decade at c.£37bn. In Q4 2023 the market was influenced by intensified geo-political risk aversion, economic uncertainty and an occupier and investor hiatus. Whilst there were a small number of exceptionally large deals, underlying activity was weak, with the quarterly volumes at a low of £9.6bn, and the lowest number of transactions since 2011.

All Property annual total returns, however, improved sharply from -7.9% in October 2023 to near zero in the latest December 2023 data. In particular, valuation yields for industrial and retail were stable during the year and even improved slightly in Q4 2023, with the industrial total return at 5.1%, contrasting with -11.8% overall for offices.

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.

Industrial & Logistics

Occupier take-up was 11.9m sq ft in Q4 2023, up 4% on Q3, but notably lower than the corresponding period in 2022. Total demand in 2023 was the lowest since 2017 and 16% below the 10-year average. Against a challenging economic backdrop, occupiers continue to adopt a more cautious and cost-sensitive approach.

The speculative development pipeline is set to be much lower over the medium term than it has been over the past few years. The quarterly volume of speculative development starts across the UK was 2.5m sq ft in Q4, the same as Q3, but 64% lower than a year earlier. The volume of speculative space under construction at the end of 2023 was the lowest since Q3 2021 and activity is likely to remain subdued through 2024.

Set against this, there are growth pockets of demand, including automotive, renewable energy, nearshoring and occupiers linked to e-commerce that will support this. 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

Looking to the listed sector and notable operators of scale – Big Yellow, Safestore and Lok’n Store - profitability has grown significantly over the past three years. Referring to a recent research paper from Peel Hunt,  Lok’n Store has experienced compounded growth of 16% per annum.

Whilst some of the occupancy boom generated during the pandemic has retrenched slightly, pricing growth has shown no signs of abating. Over the past three years, Big Yellow has seen its net rent increase by 28% with Safestore not far behind at 24%.

The self-storage sector also benefits from low operating costs and has the potential to reduce this further. Online reservation, digital remote access and sustainable initiatives including PV panels and EV charging can all be adopted to enhance EBITDA.

These positive financial indicators have captured the attention of the Federation of European Self Storage Associations (FEDESSA). Self-storage is now one of the preferred sectors for private equity seeking portfolio diversification. FEDESSA has observed an increasing level of interest for quality self-storage facilities from both investors and existing operators who aspire to expand their portfolio. Couple this with low levels of supply and other barriers to entry (such as planning constraints), the facilities that do come to the market are sought after and pricing is competitive.

Offices

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 of “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.

Later living

Positive statistics continue to support the investment case for this sector. The number of people aged over 80 in the UK is forecast to increase by 1.1m between 2022 and 2032, to 4.5m which creates a supply requirement of 144,000 beds over the next 10 years. Since 2020, just 14,500 have been delivered across 320 schemes and with a weighting towards London and the South East.

As at September 2023, Savills note that 132 care homes are in development that will add a further 30,000 beds to the overall supply. Whilst positive, this is still some way short of the 144,000 beds required and presents a strong case for increased development activity, especially outside of London and the South East.

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.

Residential

According to the ONS, the average UK house price was £285,000  in December 2023, £4,000 lower than 12  months ago and £8,000 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.

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.

Looking forward - 2024

Investor confidence is definitely improving as the economic outlook improves, with increasing competition and a greater depth to the buyer market.  There is still, however, uncertainty for inflation which remains sticky, the economic recovery relating to global conflicts and the upcoming UK general election later in the year. In this environment, the ongoing growth in certain real estate sub-sectors (e.g. industrial, self-storage, later living and student accommodation) should provide both attractive returns for current investments and good buying opportunities in what is anticipated to be a more liquid market than was seen in 2023.