UK commercial property has adjusted to the sharp rise in interest rates faster than any other market in the world, though a recovery from the trough remains on a knife edge.

Since the market peak in June last year, UK real estate values have fallen an average 21% across all asset classes, institutional investor M&G Real Estate said in a report this week, citing data from MSCI. But returns have started to rise again as values approach a possible nadir.

That fast drop puts the UK in a good place to bounce back, M&G said. Its analysis came with a caveat, however: Debt costs are likely to hinder a broad recovery, and high household mortgage costs and sticky inflation could create a recession that drags the sector back down.

“Significant increases in policy rates and the disastrous ‘mini-budget’ in October have led to the UK seeing a much starker real estate repricing than elsewhere in the world,” M&G wrote in the report.

“Sentiment has been evolving from gloom and doom to burgeoning optimism and values look to be finding a floor, while other global regions are pencilling in further falls, but is this optimism misplaced?”

M&G's view that the UK has repriced faster than other markets is based on MSCI data showing that in the first quarter, total returns — the combination of capital value change and income return — were positive.

Yet they were positive by the tiniest amount possible, just 0.1%, with capital value falls of 1% offset by income returns of 1.1%. That still meant the UK was the only market in Europe that saw a positive return in Q1.

MSCI data in April showed UK values had fallen at a faster pace than during the 2008 financial crisis before seeming to find a floor, raising the prospect of a shorter, sharper downturn than after the Lehman Brothers collapse.

“At just eight months, the slowdown is, as it stands, of much shorter duration [than the 2008 crisis],” MSCI said.

A big part of that speedy fall is the result of a decline in previously stratospheric industrial property values. Those fell by 28% between June 2022 and February this year, but have now started to tick up again.

By contrast, office values had fallen 18.5% by the end of April and are still declining. Rented residential was the most robust sector, bottoming out at a 5% drop in December and now standing just 2% below June 2022 highs.

“Taking a glass half full view, the UK economy has seemingly swerved a widely-anticipated recession and, while the economic outlook appears muted, sentiment points to growth, supporting occupier demand,” M&G said.

Investor sentiment has also strengthened, it added.

“Where yields have substantially repriced — with value re-emerging — and there is a strong narrative around long-term viability, notably for multi-let industrials and retail warehouses, there are already early signs of a return to yield compression,” the report says.

The living sector remains in favour, too, supported by a buoyant rental growth outlook, a trait likely to be prized in an environment of high inflation.

Even so, M&G was careful to hedge its bets amid uncertainty. The idea that the UK market has reached bottom is far from certain. Higher mortgage payments for households, coupled with high inflation, could lead to prolonged public sector strikes. Strikes could, in turn, lead to a recession, it said.

Then there is the real estate-specific matter of elevated debt costs.

In a chart, using data from Knight Frank, M&G highlighted that the all-in cost of debt is higher than the yield offered by almost every property sector, making it unprofitable to invest using debt. The negative yield ranges from 240 basis points for retail parks and 220 basis points for outer London build-to-rent to 130 basis points for City offices and 70 basis points for regional offices.

“If debt costs for commercial real estate in the UK rise further — meaning the numbers simply don’t add up — it could be a major roadblock for the asset class’s recovery and potentially lead to renewed falls in capital values across the board,” M&G said.

“This would particularly be the case for parts of the market that are already under pressure, notably non-core offices or assets that do not meet environmental standards. The potential for further banking volatility poses risks that should not be ignored.”