We are probably all returning to our desks by now after the very hot summer. It was not just the record temperatures across Europe that were broken nor the drought that caused concern during the break. The economic news and energy challenges kept giving and the forecasts remained pessimistic and depressing reading. Inflation at 10 percent per annum and forecast for 13% by year end and interest rates raised to 1.75% with estimates varying between 3% by the optimistic commentators to a worrying 5% to 7% by some think tanks. Sterling is also being put under pressure by a flight to the Dollar and the Swiss Franc, being c.15% down year on year. The Aperol certainly felt more expensive than usual on the Riviera!
We also have a major crisis in terms of energy pricing within the UK and Europe as a result of the ongoing war in Ukraine with the UK OFGEM price cap rising to £3,549 with effect from 1 October 2022 an 80% rise from the current level. Strike action, fuel poverty and political instability create the perfect storm for recession, stagflation and a major headwind for investment portfolios and wealth managers.
So against this maelstrom of economic news what is the short term outlook for asset pricing in the UK real estate sector? If past trends repeat in this cycle then there will be little noticeable change. It has historically taken around 14 months for capital values to react to economic downturns because of the valuation process is based upon historical comparable evidence and property owners will not come to market unless compelled by external factors or near time refinance obligations.
Logically an increase in base rate and finance costs has a direct inverse effect on property yields and thus capital values. In the residential market the increase in Buy to Let or personal mortgages will see a reasonably quick decline in transaction volume and values. The current estimate is a 7% decline in value over 2023/24 period, however, given the stress on personal income we suspect this will be deeper and quiet rapid. On the commercial side the prime and institutional market will remain stable but with a noticeable transaction volume decline. Professional investors will adopt a sit and wait strategy. It will be the secondary and tertiary markets that will see a more noticeable yield decompression and also higher tenant failure.
Energy and raw material costs together with wage inflation and corporation tax rises will put considerable stress on the SME sector. The contraction of disposable household income currently forecast at 10% by the Office for National Statistics and Resolution Foundation will hit the leisure and hospitality sector particularly hard, but equally the retail sector.
There is no denying that this is a very difficult moment in the investment cycle. That said real estate is a long term investment and therefore for patient capital selective stock picking should be considered now. Falls in value within the commercial sector will be slow as there is still a healthy supply of capital in the investment market. We do not foresee the discounts seen in the Global Financial Crisis as leveraging is far more conservative and a “dead cat bounce” effect will establish itself as new capital comes into the market as small discounts emerge.
We therefore remain optimistic for the future performance of commercial property and will look at what sectors we think will be good opportunities during these subdued times.
Chris Horler
CEO, TREIO