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No one rings a bell at the bottom of the market

Even with the benefit of hindsight, identifying the very bottom of the market is not as simple as it looks. Taking the last cycle for example, the MSCI/IPD Monthly Index would suggest that July 2009 was the optimal time to enter the commercial property market. The capital value index was at it’s lowest point, and was about to start a steady rise, climbing about 15% over the following 12 months. However, the valuations on which the MSCI index are based do not necessarily reflect the level at which properties transact at that point in time, most notably so around turning points in the cycle. In a rising market eager buyers will typically have to pay ahead of valuation to encourage reluctant vendors to sell. Whilst in a falling market, assets may have to be sold below valuation to attract wary buyers. At the turning point in a cycle, perceptions of value are particularly volatile as the battle between fear and greed swings back and forth.

If it’s not simple to identify the exact bottom of the market 15 years after the event, what hope do we have in real time, through a fog of contradictory indicators and hot on the heels of a 25% decline in values. Looking through a momentum lens might suggest that we are close to the bottom, given that the rolling 3-month capital decline has slowed to almost nothing, from a nadir of -15.6% in the final quarter of 2022. Yet that measure turned positive before, in Spring last year, and was swiftly followed by a further lurch downwards over Winter. The reality is that there will be no one moment that marks the bottom. One available option is to wait for clear signs of recovery, but this only guarantees that you miss the optimum entry point. This will be an acceptable trade-off for some, but the sensible approach for long-term investors is to focus on their own return requirements and act when market pricing supports them. Those who wait for the market to get cheaper still, may get a better price, or they may simply end up chasing assets in a rising market.

Commercial property returns

• According to MSCI, commercial property capital values were flat in April, ending a run of 11 consecutive months where average values declined. Values are on average, 25% lower than they were at the market peak in June 2022, although the picture varies widely by sector.
• The Office sector, which is now the clear underperformer, continues to slide, with average capital values down by 3.4% so far this year, and by 31.4% since June 2022. However, the rate of decline has at least slowed in recent months, whilst annual rental growth is a fairly healthy 2.3%.
• The Retail sector, which was for a long time the poor relation, has been relatively resilient in this part of the cycle, and values have been stable in recent months. Retail warehouses have outperformed other formats over this period, with values edging up since the start of the year, supported by moderate rental growth running at about 1% p.a.
• The nascent recovery in Industrial values last Spring and Summer ran out of steam over Autumn and Winter, and values have essentially gone nowhere over the last 12 months. However, rental growth remains solidly positive at an annualised rate of around 5%. As a result, of these diverging trends, average yields are out by over 200bp since mid-2022.

Investment market activity

• April, taking the year-to-date total (excluding the all-share merger involving LXi REIT) to £11.8bn. This is c20% below the equivalent period last year and almost 40% down on the five-year average.
• By far the largest deal to close in April was the £1bn acquisition by Mapletree of the Cuscaden student portfolio (of which c£964m related to UK assets). The portfolio includes the Student Castle and Capitol Student businesses, comprising 8,093 units across 29 UK assets. The deal takes Mapletree’s UK student platform beyond 17,000 beds.
• “Beds” sectors accounted for half of total investment in April, with other notable deals including the sale of the ME hotel on the Strand for circa £185m, the purchase by L&G of student assets in Glasgow and Exeter for £122m, and the £100m sale the Hartford care home portfolio.
• The largest deal single asset deal in April illustrates the enduring appeal of prime London retail, with Blackstone paying £227m (3.5% initial yield) for 130-134 New Bond Street. The asset, which comprises 31,000 sq ft of retail space, occupied by Breitling, Smythson and Church’s, was sold by a JV between Oxford Properties and Richemont.
• Activity in the office sector remains very limited, although a range of mid-sized London offices did transact in the month. The largest of these was the purchase by LetterOne of 20 Grafton Street, in Mayfair for £100m. The vendors Pramerica acquired the asset in 2010 for £48m.
• The largest office deal outside London was the sale of Oxfam House, on Oxford Business Park, by Sutton County Council for £37m. The purchasers Greyarc are planning to convert the office for Life Sciences use.

Market yields

• Medium-term interest rates have bounced around over the last month as markets have reacted to every new bit of data. The latest CPI cut disappointed markets, by coming out at 2.3% instead of the predicted 2.1%, and five-year swaps abruptly moved out 20bp to 4.25%.
• Nonetheless, there have been tentative signs that market pricing may be stabilising. Of 52 yield benchmarks monitored by JLL, they only consider 5 to be on weakening trend. This compares to 41 at the end of last year. The remaining outliers include Outer London and South East offices, as well as the largest City offices (>£125m).
• In contrast, benchmarks for secondary retail parks have come in by 50bp to 8.0%, whilst prime benchmarks for supermarkets, retail parks and solus retail warehouses have all been brought in by 25bp. The latter two are considered to remain under further inward pressure.
• Office values remain inherently uncertain due to the low level of market activity, but JLL have become slightly more confident for some prime benchmarks in recent months. This is most notable for small (<£40m) and mid-sized (£40m-£125m) City lots, where an emerging pipeline of deals provides evidence, and JLL expect the current benchmark of 5.5% to harden.

Auctions

• Allsop’s commercial auction in May showed a continuation of previous trends, with sales rates remaining at a moderate level, but with an growing number of higher value lots. The highest price achieved was for an unbroken parade of nine retail units with flats above on Seven Sisters Road, London N15, which sold for £7.6m. 14 of the 55 sales were at prices of £1m or more.
• Retail with resi uppers in London is consistently appealing to private investors, and despite being vacant, one such asset in Queensway sold for £2.2m (£733 psf). Supermarkets also remain popular, with a newly built Asda in Sutton Coldfield bid up to £1.6m (5.2% initial yield) by six competing bidders, reflecting 13 years of CPI-linked income.

Market forecasts

• The IPF Spring 2024 Consensus forecast - collated between March and May - reflects a broad confidence that we are at or close to the bottom of the market cycle. Average capital values are expected to end the year marginally higher than they started it, with a gradual but sustained recovery expected to add c10% to values over the subsequent three years.
• The outlook is most positive for Industrial, with contributors expecting an average of 4% per annum capital growth over the five-year horizon. This would leave values 20% higher than they are today, taking them back to their 2022 highwater mark by the end of 2028. The forecast is underwritten by the expectation that rental values will grow by 3.2% per annum over the period.
• The forecasts for offices are less optimistic, but nonetheless a decline of c4% this year is expected to be followed by a moderate recovery from 2025, delivering net growth of c4% over the five-year horizon. Rental growth is predicted at 1.8% per annum, implying softer yields.
• The outlook for the Retail sector is mixed, with shopping centre values expected to move sideways, whilst shops and retail warehouses deliver capital growth of 8% and 10% respectively over the five-year period. All formats are expected to record moderate rental growth.

Looking forward

The sign that many investors are waiting for is for the MPC to fire the starting gun for base rate cuts. Expectations have been tempered, from as many as half a dozen cuts this year, to just two, with hopes for a June cut having almost evaporated. This has taken the steam out of any recovery in the investment market, with activity even lower at the start of this year than the depressed levels at the start of last. However, waiting for the first rate cut to actually happen is unlikely to give investors any more information about the rates environment through the term of their investment than they have now.

Rather than worrying about the exact timing of the first interest rate cut or how many cuts will happen this year, investors would be better off focusing on the known aspects of a potential deal. Is the asset or portfolio well let? Are the current tenants fully utilising their space? What lease events are coming up? Is there any leasing evidence that supports ERVs? Are there any service charge arrears? Are there any obvious cap ex requirements? The answers to such questions are likely to be far more consequential to the performance of an investment than the short-term path in base rate.

The good news from a potential investor’s perspective is that asset values have rebased materially, whilst rental values and occupancy levels have, on the whole, held up surprisingly well. Rental values in the industrial sector may not be rising at the extraordinary rates seen in recent years, but they are still rising and there is plenty of reversion still to work its way through the system. Retail rents, after a very prolonged period of adjustment, may finally be edging upwards again, and even the much-maligned office sector has been setting record rents for the best stock in cities across the country. No one rings a bell to mark the bottom of the market, but there is every chance that for the best assets that moment is already upon us.

For further information please contact:

Author – Tom Sharman, Head of Strategy & Insight, 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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