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Prospect of calmer waters ahead as rates curve flattens

Sonia forward curves suggest that we are at or very close to the peak in base rate. They also suggest that remain close to todays level for a prolonged period, dropping back by just 100bp over the next five years. At face value, this outlook should remove one major complication from an investor’s assessment of an asset’s value. If investors feel confident that rates are going to remain broadly where they are for the next few years, they can spend less time worrying market-wide yield shift and more time focusing on the individual merits of specific sectors and assets. This is perhaps most true in the secure income part of the market where idiosyncratic returns are relatively predictable, but market returns are highly sensitive to interest rates. The buyer of a supermarket or distribution warehouse with a strong tenant, a long lease and contractual uplifts can predict with a fair degree of confidence what that assets income return will be, and in a stable interest rate environment this is far less likely to be eroded, or even wiped out, by softening yields.

Across the rest of the property market returns are still likely to be heavily impacted by yield shift, but this will be dictated by the growth prospects of the sector and location rather than the existential threat of a volatile monetary environment. If an investor is confident in occupier demand and has a good idea of market rents, they can start to model with some degree of confidence what returns they can expect. This in turn makes the pricing of assets more straight forward, if every potential buyer isn’t having to factor in the risk that rates keep moving materially higher. On this assumption of a stable rates environment, an investor can have some confidence that the effort they put into letting up vacant space, regearing leases and negotiating rent reviews will deliver their reward in terms of value. In short, a stable interest rate environment would mean that the fundamental skills of stock selection and asset management will once again be the key drivers of return, rather than the somewhat capricious influence of Central Banks.

Commercial property returns

• The MSCI Monthly Index continued to drift downwards in September, taking the cumulative average decline to 22.4% since June 2022. The rate of decline picked up slightly in Q3, with values down by an average of 1.6%, compared to just 0.4% in the previous quarter. Growth was weaker across all sectors in Q3, albeit Industrial values still edged up by 0.5%.
• The Office sector is now the clear underperformer, with values off by 5% over the last quarter, and by almost 12% in the year-to-date. Inner South East markets have been hardest hit, down by 8.2% in Q3, 20% Year-to-date and by 36% since Jun ’22. London City is not that far behind; down 7.4% in Q3, 15.8% YTD and 28% from their June ’22 peak.
• In contrast, Industrial values continue to rise, albeit at a slower pace than in Q2. The cumulative recovery over the last 7 months is 2.3%, with capital values still 26% off their June ’22 peak. However, rental values have continued to rise steadily and are up by 9.3% since last June. Rental growth has been broadly consistent across regions and formats
• Retail values, which had appeared to be stabilising earlier in the year, are now drifting downwards again. Rental values have edged up marginally over the year, except for shopping centres, where rents are off by 1.6% year-on-year and by around a quarter since 2018

Investment market activity

• According to Real Capital Analytics, £2.8bn of deals transacted in September, broadly in line with August and well ahead of the all-time low of £1.2bn in July. Nonetheless the Q3 total of £6.8bn is down by 30% on the previous quarter and less than half the level of Q3 2022.
• Investment in the student sector rebounded dramatically in September, with £580m transacting in by far strongest month so far this year. The bulk of this investment came via the £500m forward funding of Cain International’s PBSA platform. The deal covers over 2,400 beds across five assets, in Liverpool, Nottingham, Manchester, Leeds and York.
• US investor Realty Income continued to dominate the out-of-town retail market, paying around £200m to acquire the Ediston retail park portfolio. The portfolio comprises of 11 parks, mostly of which were valued off yields of 7-8%. Within the last 3 years, Realty Income have invested over £2bn into retail parks and supermarkets across the UK
• The Central London office market picked up slightly after a couple of very weak months. The most notable deal was the sale of Bloom in Farringdon by the developer HB Reavis for a reported price of “just under £240m”. That price would reflect a yield of around 5%, illustrating both the quality of the asset and the growing appeal of the Farringdon sub-market.
• Praxis Capital continue to back their regional offices strategy with the £170m acquisition of five buildings on the Brindley Place campus in Birmingham. The assets which were previously bought by HBSC Alternatives for £260m in 2017, produce an initial yield of 11.4% reflecting a number of significant short-term lease events

Market yields

• Medium-term interest rates have edged down over the last month, with the market predicting that rates are at or very close to their peak. Nonetheless, benchmark yields across a whole range of sectors are still perceived to be softening. Even the Living sectors are now under steady pressure, leaving Industrial as the only sector where pricing seems to be broadly stable.
• Sentiment for offices remains weak. Although Central London yields are perceived to have stabilised following recent outward movement, evidence to back this up remains scarce. Outer London and South East yields are now expected to soften further from 6.75% and 7.0% respectively, whilst prime regional yields outside the major cities moved out by 25bp to 7.5%.
• Whilst Retail yields were less exposed to the sharp rise in interest rates give their higher starting point, they are now experiencing renewed upward pressure. The benchmark yield for dominant shopping centres is perceived to have shifted 25bp to 7.5%, having been stable for the preceding nine months. In contrast, the prime supermarket benchmark remains stable
• The Living sectors have been far more resilient than mainstream commercial to date, but JLL have been gradually moving benchmarks in tiny increments. Over the last 12 months, prime benchmarks for BTR have moved out by 75bp in Inner London, 50bp in Outer London 25bp in the regions. Yield benchmarks for direct-let student accommodation have seen similar trends

Auctions

• Over the first nine months of the year Allsop’s commercial auctions have raised total proceeds of £309m. This is down by 30% from the £442m raised over the equivalent period last year. Sums raised at the September auction reached £40m with post sales, yet this compares to £117m a year earlier.
• Allsop’s highlighted some of the most in demand lots from September, where multiple competing bidders pushed achieved prices well beyond guide prices. As ever, long income and a residential angle were popular. One lot that had both, a Tool Station in Lewisham with flats above, attracted 15 bidders and sold 51% ahead of guide price

Market forecasts

• Independent forecaster PMA released their Autumn forecast update at the end of September. The main changes from the previous forecast are that they expect this year to come in slightly stronger than previously expected. They now expect average values to end the year down by around 6%, from almost 9% previously. The recovery from next year is still expected to be tepid.
• Offices are expected to be the clear underperformers in the short-term. All markets except London’s West End are expected to see double digit declines across 2023/24, albeit that with values already off 15-20% this year, the implication is we may not be far from the bottom. Notably, only very marginal rental value declines are expected, with none in Central London.
• For the Retail sector PMA’s forecasts imply a further 5% decline or so over the next 12 months. The exceptions to this are shops in small towns and secondary shopping centres, with PMA predicting a persistent downwards trend in values for the foreseeable future.
• Industrial values are expected to recover from next year, with growth strongest for smaller (sub 100k sq ft) units in and around Greater London. Following the minor declines in value being seen this year, the residential investment and student accommodation sectors are expected to return to growth from 2024.

Looking forward

Looking forward investors are broadly faced with two choices. They can choose to go with the consensus view on sectors such as industrial and residential where rental values are widely expected to rise, or they can take a more contrarian approach and take a chance on the office and retail sectors. In the case of Industrial, yields moved rapidly in the second half of last year and prime benchmarks are now up to 200bp higher than they were at the top of the cycle. Yet with prime industrial assets yielding roughly 5%, there is little short-term premium over what could be achieved on a risk-free basis. The sector is therefore priced for growth, and at risk from a correction if that growth disappoints. Nonetheless, the fundamentals of the sector suggest that moderate income growth should be very achievable over the next three to five years. Yields in the residential sector are even lower, and this is undoubtedly challenging for investors reliant on leverage, but from an equity perspective returns should be attractive even if rental growth is likely to fall back from the excessive levels of recent years.

At the other end of the spectrum, retail rents have on the whole been drifting downwards for years, and pricing largely reflects that. Investors willing to take the plunge in the sector therefore only need to convince themselves that they can maintain income at today’s levels to deliver a decent return. In some cases of course even that modest ambition represents a major challenge, and turning round underperforming shopping centres still seems like a pastime best left to those with a very high tolerance for risk. The same might be said for offices, where the price of poor stock selection could be very high indeed. However, when a whole sector is tarred with the same brush opportunities arise, and it is against the popular perception of the sector that robust rental growth is still being delivered in corners of the market. The margin between winners and losers will be wider than ever. Caveat emptor.

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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