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Real estate turmoil attracts countercyclical buyers

Property values have nosedived, and some early-cycle buyers already spy an opportunity
October 14, 2022
  • Reits and listed housebuilders' share prices tumble
  • Weak pound attracts overseas capital

T

he UK real estate market is in freefall. In reaction to the government’s mini-Budget, gilt yields and interest rates have spiked, creating a toxic cocktail that has caused the values of all types of property assets to plummet. Real estate investment trusts (Reits) and listed housebuilders are plunging in value as shareholders sell off holdings. House prices are tipped to fall by double-digit levels in the coming years after over a decade of uninterrupted growth, and Goldman Sachs predicts that commercial real estate prices could drop by as much as 20 per cent by the end of 2024, pointing to British Land (BLND) and Hammerson (HMSO) as two Reits that will be hit hard. Experts warn that the end result will be immense quantities of real estate assets – from houses to office blocks – dumped at huge discounts.

It all sounds impossibly gloomy. Yet, for every seller there is a buyer. And for those lucky enough to be able to buy in the current climate, the distress in the real estate market represents a big opportunity. Take Australian construction and property giant Lendlease’s (AU:LLC) most recent trophy purchase. At the end of last month, it snapped up 21 Moorfields from Land Securities (LAND) for £809mn – a 9 per cent saving on the City office block’s £890mn valuation from March this year.

That deal was agreed earlier in the year, but many in the real estate market believe a wave of similar deals is coming from those banking on the eventual recovery of the market. These countercyclical opportunists are predicted to be foreign buyers such as Lendlease that will benefit from the double deduction of cut-price UK real estate assets and a historically weak pound. High-net-worth individuals and private equity funds fuelled by cash rather than debt are also understood to be sniffing around for bargains. Whoever they are, they all have one thing in common: they have the market to themselves right now.

 

The great reversal

Peter Rose, UK head of property valuation software company Forbury, says the situation for the UK real estate market is simple. “The megatrend of low interest rates has reversed,” he says, arguing that much of the market is “in denial” about what this means.

For years, low interest rates have meant cheap debt for would-be buyers of residential property and commercial real estate alike. Meanwhile, the investment yield on commercial and residential property remained comfortably above the yields for government debt, making it an attractive investment prospect. Rose argues that this created an era of easy returns for real estate.

“When interest rates were low [...] you could have thrown a dart at a dartboard and made money,” he says.

Following the government’s fiscal event, all of this has fallen apart. Steep rises in gilt yields have made real estate a less attractive investment by comparison, causing investors to dump shares in Reits. Meanwhile, the increase in interest rates has meant that the debt that had for years been the commercial and residential market’s fuel has dried up. Lenders pulling residential mortgages from the market last week is only the start of the story – now comes the era of pricey borrowing for both commercial and residential real estate buyers.

In other words, the number of buyers has decreased. In the residential market, shares in housebuilder Barratt Developments (BDEV) dropped 8 per cent last week after it revealed that interest from new buyers was down by a third over the past three months. In the commercial market, Lambert Smith Hampton said last week that quarterly transactional activity has hit its lowest ebb since the third quarter of 2020 when Covid had ground the market to a halt. James Abrahams, a City of London office agent at Allsop, says there are few UK buyers at the moment and the international capital that is available will only pounce when asset values sink. “Right now, we’re right in the eye of the storm,” he adds.

It is, in short, not a great time to be selling real estate. However, the rising cost of debt combined with falling share prices mean some Reits may have little choice but to sell assets to raise cash. What’s more, one real estate financier notes that fire-selling assets at a discount looks desperate, especially if the strategy has not been clearly communicated to shareholders, and could in turn see Reits’ share prices fall further as investors are scared away by the move.

Jefferies real estate analyst Mike Prew has told The Times that the share price sell-off could get so bad for Reits that it will mean more than just asset sales; he predicts a swathe of them will be snapped up entirely by private equity.

It might not turn out as bad as all that. Marcus Phayre-Mudge, fund manager of property equities investor TR Property Investment Trust (TRY), does not foresee a run of public to private takeovers because, as with so much else in real estate, many in the past were funded by cheap debt. Although he agrees that there will be forced sales and “dramatic price corrections” in the real estate market, he doesn’t foresee that there will be much of this activity in the listed space. The reason for this, he says, is that Reits tend to have lower leverage than their peers in the private equity space because they are more risk-averse. He stresses that the listed property space is a far cry from where it was in the lead-up to the 2008 crash.

Yet, even if Reits are not forced into a position where they have to sell, Phayre-Mudge says that some will feel the pinch through the ordinary course of recycling capital by selling assets as planned. “There will be businesses that want to sell assets as part of day-to-day business but won’t get yesterday’s price,” he says.

As for who will buy those assets, the pool is small and cash-driven. Helical’s (HCL) sale of TikTok’s London headquarters for £159mn to Chinese private equity last month and Great Portland Estates’ (GPE) sale of Inmarsat Global’s London headquarters to a German family office for £190mn reveals the appetite from private equity and overseas buyers. Phayre-Mudge says private equity tends to jump into depressed markets first because it has a greater appetite for risk. Overseas buyers, meanwhile, will be attracted by the pound’s relative weakness.

 

According to Investec, a lender that works with many overseas and private equity buyers, these deals also reveal the type of assets countercyclical opportunists are likely to be most attracted to: prime London offices. William Scoular, head of private client lending, says this sort of activity will further exacerbate the ‘flight to quality’ trend whereby, following the existential crisis for office real estate caused by the Covid work-from-home boom, only the highest quality office real estate will be attractive. “It’s the polarisation of the London office market into top quality and everything else,” he says.

Of course, not every buyer of real estate needs to be a well-heeled private equity fund or foreign investor looking to buy a trophy asset. All a buyer needs is cash rather than debt. As such, Abrahams from Allsop observes that “the best barometer for the real estate market is auctions” where the halls are filled with cash buyers from all walks of life looking to snap up homes, shops, offices and distressed property assets of every flavour. It is there where he recommends those wanting to get a better understanding of the market should look.

Given the opportunities available for countercyclical buyers, it should perhaps come as no surprise that last month Allsop recorded its best commercial auction since December 2016 when Brexit caused a similar disruption in the market. It recorded £120mn in transactions with retail and leisure assets making up the bulk of the activity. The biggest deal was a building let to PureGym in Leeds, which sold for £3.4mn at a 7.4 per cent yield. This is great news for buyers who are able to buy retail and leisure assets at bargain basement prices and sky-high yields, but not so much for the vendors.

As it goes for commercial property, so it goes for housing. Here, too, the pound discount will attract international buyers looking to snap up prime property with cash rather than debt – hence why Knight Frank is predicting a mere 3 per cent fall in prime London real estate over the next two years compared with almost10 per cent for the UK as a whole. For those who can afford to buy without too much leverage, housing is a buyers’ market.

Reits need not be a victim of this discount buying. In theory, those with strong enough balance sheets could go and buy up cheap assets themselves, but those balance sheets would have to be strong indeed. Care home developer Target Healthcare Reit (THRL) has a net debt/asset ratio of 28 per cent. In normal times, this would be plenty of headroom to buy new assets, but the company, which has lost a third of its value since the government’s fiscal event, tells Investors’ Chronicle that “now is not a time to be doing a lot” investment-wise. Many Reits are likely to be playing it just as cautiously – leaving the opportunistic buying to other players.