This was a year of two halves for the property market. In January, real estate investors were brimming with confidence as a post-Covid economic recovery looked as though it would see workers return to their desks, consumers return to the shops and money continue to chase warehouse assets. Meanwhile, the imbalance between housing supply and housing demand appeared as if it might well offset the impact of slightly tighter monetary policy.
Then, Russia invaded Ukraine and the resulting economic fallout hit the property market the way Mike from Ernest Hemingway’s novel The Sun Also Rises went bankrupt: gradually and then suddenly. The value of the real estate investment trusts (Reits) and housebuilders began to slide as higher inflation took hold and jeopardised what had already been quite a fragile recovery. An Amazon profit warning began to deflate the warehouse bubble and by May Savills (SVS) was predicting a 1 per cent fall in house prices for 2023.
Next came the sudden part. On 23 September, former prime minister and former chancellor Liz Truss and Kwasi Kwarteng’s now infamous “mini” Budget shocked the markets with its promises of billions in unfunded tax cuts. The cost of government debt rocketed as a result, which meant the yields on such bonds became more attractive relative to those on property. This hit warehouse and office assets hardest, but soaring interest rates meant that all real estate was impacted.
According to analysts MSCI, October was the worst month on record for returns in UK real estate. The -6.5 per cent return from its index was worse than the -4.75 per cent posted during the depths of the 2008 financial crisis and -2 per cent both immediately after the Brexit referendum result and the opening month of the pandemic. Nor did the residential property market escape. By October, Savills was predicting a 10 per cent drop in house prices for 2023 and by December, Nationwide month on month figures were in the red, and falling faster than expected.
So, what should we expect from next year after such a tumultuous 2022?
1. Housing delivery slowdown, commercial pause
Despite house prices falling, housebuilders will keep building homes – albeit at a much reduced rate. Persimmon’s (PSN) trading update last month spoke volumes about the state of play for listed housebuilders. Demand has been sapped by rising interest rates, which means cancellation rates from customers have risen from 21 per cent to 28 per cent in just three months. The company admitted that completions would fall and, though it has not said by how much, the fact that it also said it expects land additions to be “significantly lower” in 2023 implies that it is not confident about future building projects as it stands. Put another way, Persimmon will build out the projects it has already got lined up but it won’t be rushing to add more to its plate. Expect other housebuilders to take a similar tack.
It is a similar story in commercial real estate. Since the 2008 financial crisis, interest rates have been historically low and in parts of Europe turned negative. The result was a debt environment that was so cheap almost any property play was a guaranteed winner. As Peter Rose, UK head of property valuation software company Forbury, put it back in October: “When interest rates were low... you could have thrown a dart at a dartboard and made money.”
That era is now over, meaning that property development is now much more risky. This does not mean developers will stop building, but it does mean many will avoid it. Tom Scott, an investment director at Savills, predicts development will “pause” next year as it will be harder to finance and harder to sell. Meanwhile, the imminent recession combined with the existential crises facing office tenants (as they decide what sort of post-Covid workplace they want) and retail and warehouse tenants (as they try to figure out how much online shopping future consumers will desire) will make property developments harder to lease, adding further risk to development.
2. Disposals
The rout in the property market means some funds and real estate companies have already started selling assets to raise cash at a time when it is sorely needed. This will continue next year. The question is who will buy those assets. Private equity investors and overseas pension funds with deep pockets is the obvious answer, but it is looking more and more likely that some Reits will get involved as well.
This seems counterintuitive. Reits should not want to take on any more debt, few are flushed for cash, many of their own assets are falling in value and a depressed equity market is not a great place to raise funds. Some such as AEW UK (AEW) and LondonMetric (LMP) have already expressed an interest in buying, but the question remains where will that cash come from.
Industrials Reit (MLI) told Investors’ Chronicle last week that joint ventures could be the answer. It said it wants to team up with an investor so as to take advantage of the current bear market, and it expects other Reits will be looking to do the same thing.
3. Another cladding hit?
This prediction depends not on the machinations of the market but the machinations of Westminster. Since June 2017, when the Grenfell tower block fire killed 72 people, government, the property industry and residents of high-rise flats have been at loggerheads over who should front the cost of replacing the kind of unsafe cladding chiefly responsible for the fire. Stories of residents being forced by unscrupulous property companies to cough up cash are sadly all too common. The government has had a back and forth attitude on how much responsibility the property companies who own the buildings should take.
Rapid personnel change offers one explanation for this flip-flopping. The current housing minister Lucy Frazer is the 14th since 2010 and the current housing secretary Michael Gove is the ninth since 2015 – a number that includes Gove’s previous tenure in 2021/22. Gove is seen by many in the industry as tougher on the cladding issue than his predecessors, and since his reappointment companies such as Persimmon have upped their cladding costs compared with their initial estimates. As such, it is not outlandish to expect that other housebuilders will wind up handing over more cash for cladding fixes in 2023.
4. ‘Green shoots of recovery’
CBRE said in its most recent UK property market report that it expects to see “green shoots of recovery” towards the tail end of 2023. This makes sense to a degree. Property valuations have already sunk and for some assets – such as shopping centres – it is difficult to imagine their values falling much lower.
This is not exactly something to celebrate – or rather, it is too far away to do so just yet. There could be an awful lot of pain to come before then; the recovery won’t be a stonking one even it is does come next year; and some are warning that it won't – with the CBI predicting a year-long recession to start in 2023.
5. Recession-resistant assets
Some asset classes may be immune – or more immune than others – to all of this. Our prediction is that student accommodation, supermarkets and big warehouses will be three of the sturdier. All benefit from rental income that is not as cyclical as other asset classes. Office, retail and smaller warehouse landlords either suffer from a dependence on tenants whose interest in a lease is heavily connected with how the economy is faring, tenants who want flexibility in their lease arrangements, or both.
By contrast, student accommodation and big warehouse leasing activity is being driven by two trends beyond the domestic economy: the former by increasing number of international students interested in studying in the UK while the latter by a need for retailers to shift their retail activity to online shopping. Supermarkets are slightly different, in that they are an asset whose continued value comes from the fact that, though individual companies' fortunes may rise and fall, a good supermarket building remains an asset that is well-located and well-needed. Supermarkets are ultimately little changed since their inception because what we want from them has barely changed either.
This does not mean any of those three asset classes are a guaranteed bet. Should studying in the UK become less attractive – for instance, if the government pushes through some of the hardline restrictions on foreign students it is reportedly considering – or if the demand for accommodation falls short of the supply being developed by Unite Group (UTG) or Empiric (EMP), that asset class will be in trouble. The same supply and demand basics apply to warehouses and supermarkets as well. Still, on balance, those three sectors are likely to fare relatively well during a year when it is hard to see any section of the property market escaping unscathed.
