Investors Eye Inflation And Recession Indicators As UK Outlook Starts To Brighten

The third Wednesday of every month is a day that is currently ringed in red on the calendar of every investor in UK real estate. 

That’s the day the UK's Office of National Statistics releases inflation data. And how that data moved the previous month matters enormously for real estate prospects over the next year because where inflation goes, interest rates follow. 

“Markets had started to price in big interest rates falls at the end of last year. It was just a case of when, by how much and which central bank went first,” Savills Head of Global Cross Border Investment Rasheed Hassan said.

“That has tempered a touch in the first few weeks of this year, but the notion that we are past the worst remains,” Hassan added. “Despite the slight retrenchment, the difference in five-year SONIA from high to low was in the order of 200 basis points in the last couple of months and yields are still high. If investors are going to take a cyclical position, it is feeling like a good time to try and do it.”

With the UK economy expected to be sluggish — EY is predicting gross domestic product will grow by just 0.9% this year — 2024 is not going to be one to tell the grandkids about for UK real estate. 

But falling inflation leading to falling interest rates is a vital component to bringing both domestic and international investors back to a market that last year saw its worst investment volumes since 2012, with figures not much better than the trough years of 2009 and 2010. 

A signal of how crucial inflation data has become to real estate sentiment? When inflation dropped more than expected at December’s announcement, real estate shares shot up. When it rose slightly when figures were released in January, real estate shares dropped sharply. 

The difference in what the data meant for anticipated interest rate movements this year is not huge.

In December, financial markets were factoring in five interest rate cuts in 2024, and now they are factoring in four. Real estate investors are not changing their strategy on a month-to-month basis. But a small inflation bump was enough to quell any hopes that 2024 could see a big pickup in values and volumes. 

Some investors will have no choice but to sell as 2024 progresses, Hassan said. Funds facing redemption requests from investors need to liquidate assets. And while borrowing costs are falling, they are still higher than in the period from 2018 to mid-2022.

That means many investors facing refinancing this year will need to either put up new equity or sell. The stream of sales resulting from refinancing has been a trickle, not a flood, but it was nonetheless precipitating sales, Hassan said.

Expectations have cooled slightly since the pre-Christmas bounce in share prices and rate-cut predictions. Even so, the outlook for UK real estate is undoubtedly better than at any point since the early autumn of 2022, when interest rates jumped sharply. 

In a blog posted late last week, MSCI pointed to the fact that its index of listed real estate stocks made an annual total return of 7.5% after a strong finish to 2023, noting that where the listed real estate sector goes, the direct market for buildings often follows. 

Valuations for UK assets should bottom out in the first half of 2024, fund manager Schroders said in its outlook for the sector. With UK real estate having fallen in value by 24% since June 2022 compared with 17% in Europe, UK assets are looking like good value.

But how interest rates move will play a big part in that. 

“The optimal scenario is that gilt yields keep falling,” Schroders Capital Investment Director Jessica Berney said. “We need that yield gap and for debt costs to fall because it brings international investors back to the market.”

For more than a decade, real estate was a favoured asset class for investors, drawing capital away from the bond market in particular. When bond yields fell close to zero, real estate yields of 3% to 4%, while historically low, looked attractive on a relative basis. 

Yet, when bond rates moved quickly up to 5%, it had a double impact. First, higher-yielding bonds looked more appealing than real estate. Then there was the denominator effect in which the proportion of an investor's portfolio held in real estate rises because the value of everything else drops more quickly. Asset allocation rules at big pension funds and insurance companies often bar them from investing more in real estate when this happens, causing new capital to the sector to dry up.

With 10-year UK government bond rates having fallen to around 4%, Berney said real estate at yields of 5% and above are starting to look attractive again, especially in sectors with resilient income. The manager’s top sector picks for 2024 are light industrial, self-storage and student accommodation as well as top-quality offices in London and large regional cities like Edinburgh. 

Schroders is not forecasting a recession, which would impact the resilience of income and rental growth in the UK. But for some investors, the focus has been too tight on interest rates rather than the underlying rental performance of property in the UK and beyond. 

“We are in an unusual period,” Prestbury Chairman Nick Leslau said. Leslau just oversaw the merger of LondonMetric and LXi REIT to create one of the UK’s largest listed companies. 

“For decades, interest rates have been dislocated from commercial property price inflation. Only since the huge hike in rates over a year ago has the market responded both irrationally and slightly hysterically to every comment on the outlook for inflation and rates,” Leslau said.

“I subscribe to the view that in the medium-term, GDP is the most important determinant of commercial property price inflation, not rates, and so I am always looking for solid sustainable economic growth, well above interest rate movements.”