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Through the looking glass where the only good news is bad news

In recent months there have been a series of mini spikes in the share prices of the listed REITS. What caused these sudden, but usually short-lived, bouts of optimism for property companies? Was it news on dividends, or a profitable asset sale, or perhaps even bid interest from deep pocketed global investors? In most cases it was none of those things. Indeed, it was usually nothing directly related to the companies in question or even the commercial property market more broadly. Most often it was the emergence of some downbeat piece of economic data. The latest GDP growth data was weak, unemployment was up, house prices were down. All these ostensibly negative bits if data had one thing in common; they caused investors to believe that the peak in interest rates may be sooner and lower than previously thought.

Of course, interest rates are of critical importance for property companies; they set the benchmark against which all their assets are valued and impact directly on their medium-term borrowing costs. However, something is not right when seemingly the only investment case for property companies is that the Bank of England will ride to the rescue with a more dovish outlook on rates. In many ways we are now seeing the mirror image of the mindset that held sway for much of the post-GFC economic recovery. Then, any piece of disappointing economic data could be spun as a positive, as it delayed further that inevitable but unwanted day when interest rate would have to rise from the floor. If that was a Panglossian world where all news was good news, we are now in the dystopian version where the only good news seems to be bad news. Inflation is of course the one piece of data that does seem black and white. A decline in inflation is unequivocally a good thing, not just for how that feeds into the thinking of the MPC, but also for the real world impacts on costs, profit margins and the propensity to invest. However, lower inflation alone is not a panacea for the property market. After all, a little bit of inflation accompanied with a resumption of economic growth would be more fertile ground for property returns than the deflation caused by a deep recession.

Commercial property returns

• The MSCI Monthly Index drifted down again in July, taking the cumulative average decline to 21.6% since June 2022. The year-to-date decline of 2.1% masks a very wide variance between the Industrial sector which is marginally up over that period, and parts of the office sector which have recorded double digit declines.
• Industrial values have been edging up for the last five months, as valuation yields have stabilised, and rental values have continued to grow. The average industrial yield in the MSCI index is now 6.0%, up from 4.15% last June. Rental growth has slowed, from an annual rate of 12.9% a year ago to 7.2% today, but remains firmly positive, at a quarterly rate of 1.5%.
• In contrast, the performance of the Office sector has deteriorated. The 5.3% quarterly capital loss is the worst since February. The West End of London still looks relatively resilient – down 2% over the quarter – whilst other regions have been hit far harder, notably the City of London (-7%) and the Inner South-East region (-9.2%).
• The picture is mixed for Retail, but value declines have been notably less severe than for other sectors. Retail Warehouses appear to be the most robust format, with some hardening of yields and some very moderate rental growth contributing to marginal capital appreciation so far this year.

Investment market activity

• According to Real Capital Analytics, barely £1bn of investment transactions closed in July. Even allowing for seasonal factors, that is a very low level of activity, making it one of the weakest months for investment activity ever recorded. The YTD total of £21.2bn, is just under half the total from the same period last year.
• The largest individual transaction was for Lion Plaza, a City of London office block, which sold to private Vietnamese investors for £205m (a 6.0% initial yield). It had initially been marketed in January at £260m, reflecting an initial yield of 4.75%. The eventual sale price was almost identical to what the vendors paid for the asset back in 2005.
• LondonMetric completed two portfolio disposals in July ahead of their acquisition of CT Property Trust. A retail warehouse in Durham, an industrial estate in Sutton and a London retail unit were sold to Tydus Real Estate for £25.3m. Two industrial units were sold to M&G for £17.5m.
• Newcore Capital moved well outside the mainstream commercial sectors with £25m of acquisitions for their Special Situations Fund V. The fund targets social infrastructure, and the opening investments included nurseries, a mortuary and petrol stations with EV charging facilities.
• Palace Capital continued its recent programme of disposals, with the sale of an office in Liverpool to the tenant for £12m, and another in Maidenhead for £9.6m. Palace sold its entire industrial portfolio to Clearbell Capital in May and has further office assets on the market in York and Manchester.

Market yields

• Although interest rate expectations have softened slightly over the last month, JLL report that sentiment remains negative across much of the commercial property market. Across the 50 market segments covered by their monthly analysis, JLL assess that yields are on a weakening trend in 35. The Industrial sector, where yields are perceived as stable, is a notable exception.
• Sentiment for the office sector is particularly weak, with JLL assessing that yield benchmarks are trending weaker in all markets except the West End. City yields, which moved out by 25bp in July, are expected to soften further, as they are in Outer London and the South East, whilst regional prime yields drifted by 25bp in August. Most benchmarks are out 150bp since last June.
• Retail yields have been relatively resilient in this cycle, but dominant regional and city centre shopping centre yields are perceived to be under further upward pressure, as are retail parks. Solus retail warehouse and supermarket benchmarks appear to have found some support at current levels having not been moved out for the last six months.
• The Living sectors have been far more resilient than mainstream commercial to date, but JLL now perceive that there has been some demonstrable softening of Build to Rent yields. This is most clear in London where yields are well below the prevailing risk-free rate. JLL consider that Inner and Outer London benchmarks moved out by 25bp to 3.75% and 4% respectively.

Auctions

• August is a slow month for auctions, and leading auctioneer Allsop have taken time to look back over the last year. They report that they have sold almost two thousand lots over that period, highlighting the value of the auction market as a source of liquidity for smaller lot sizes. The average sale price is around £750k, but lots up to around £3m are regularly traded.
• Allsop report that there has been some drop off in buyer activity as the year has progressed, with active buyers down by around a quarter since Q1. This has led to a softening of pricing, with Retail yields, which had been around their long-term average of 7% drifting “significantly higher” in recent months.

Market forecasts

• The last IPF Consensus forecasts were collected in the Spring and published at the start of summer. The outlook in Spring had improved somewhat from last Winter and the predicted decline in capital values had been wound back from 5.5% to 3.2%. We will soon see whether this relative optimism has waned again when the Summer Consensus is published in the next few weeks.
• Respondents (on average) expected a moderate recovery to start from next year, with steady capital growth of between 2.2% and 2.7% per annum between 2024 and 2027. However, it’s worth noting that even this relatively benign path would imply that capital values would still be 16% lower at the end of 2027 than they were in June 2022.
• The consensus remains for the Industrial sector to outperform, with flat values this year followed by growth of almost 8% over the subsequent two years. In contrast, office values were expected to decline by 7.3% this year and to remain lower at the end of 2027 than they were at the start of this year.
• The outlook for rental values remained relatively benign, with only marginal declines for Shops, Shopping centres and City offices whilst West End office rents are expected to deliver moderate growth and Industrial rental growth is predicted to remain robust at 4.8% this year and 3.3% p.a. over five years.

Looking forward

Anyone seeking to predict the future path of interest rates might look at the yield curve. Yet the peak implied by the curve today will be different to what it was last week and very different to what it was a week before that and a month before that. The curve is after all nothing more than the sum of lots of guesses, which are themselves buffeted on an almost daily basis by an endless stream of data. The most we can be fairly confident of when it comes to rates is that over the medium-term they are likely to be closer to where they are today than where they were 18 months ago. We must therefore seek medium-term returns that correlate with that outlook. If the UK government are prepared to guarantee you 4.4% per annum interest for lending them money for 10 years and sitting on your hands, then you should demand a significant premium in excess of that for spending those 10 years managing property assets.

The good news is that, according to valuers, prime yields exceed that level for most sub-sectors today. Therefore, investors should not need to hope for an economic miracle or take too much risk to achieve their required returns. For example, if a warehouse or a supermarket yields 5.25% on day one, rental growth of just 2% per annum would deliver a return comfortably in excess of the risk-free rate. For neighborhood retail or a provincial office yielding say 8%, maintaining rental income at current levels would be sufficient. For the residential assets, where yields may still fall short of the risk-free rate, growth requirements are more significant, but with earnings growth running at 8% that should not be a tall order. Of course, obsolescence is a very real risk and cap ex requirements should never be underestimated. However, commercial property pricing has adjusted materially to reflect the new interest rate environment, and one does not have to make heroic assumptions to believe that it remains a more lucrative prospect then lending to the UK government.

For further information please contact:

Author – Tom Sharman, Head of Strategy, Real Estate Finance, NatWest Group

For further info contact:

Ross Ironside
Coutts & Co - Head of Commercial Real Estate
E-mail: Ross.ironside@Coutts.com

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