Life is coming back to the commercial real estate sector after a “record pricing correction” last year, according to MSCI, as sellers have copped lower valuations on the chin and returned to the market. A raft of recent discount real estate investment trust (Reit) disposals reveals that sellers are now accepting much lower prices – but the recovery in commercial real estate values looks as though it is still a while away.
Figures from real estate agency Savills (SVS) and analytics firm PropertyData show that this January was the worst opening month for investment activity since 2009 and provisional data for this quarter indicates it, too, is likely to be one of the worst since 2009. Some are predicting that the deals from recent weeks have set the market on a path to recovery, however, as the market has quickly shifted into the price discovery phase of the cycle.
The biggest Reit transaction this month came from Tritax Big Box (BBOX), which sold three warehouses for £125mn “in line with the 31 December 2022 valuation”, implying a hefty price drop from the 30 June 2022 valuation as the trust’s net asset value (NAV) plunged a quarter over the same period.
Other deals from this month include LondonMetric (LMP) selling a portfolio of assets – comprising a warehouse, a supermarket, a self-storage asset, a trade unit, a hotel, and a car wash – for £34mn at “an average discount of 4.7 per cent to 30 September 2022 book value”; LondonMetric also sold three multi-let warehouse assets for £46mn “slightly above book value as at 30 September 2022”, implying a discount to their 31 March 2022 value considering the 11.5 per cent drop in its NAV over that period; and Capital & Regional (CAL) sold The Mall shopping centre in Luton to Frasers Group (FRAS) for £58mn after putting it on the market for a reported £81mn last year.
Some price discovery happened even earlier than this month. At the end of January, Landsec (LAND) sold City office asset One New Street Square at a 3.67 per cent discount to its 30 September value.
The Landsec deal shows how the speed of the fall in valuations and subsequent price discovery has been much faster during this most recent downturn than in 2008. According to analysts at MSCI, it took four quarters during the last financial crisis for values to fall the same amount as they have over the past two quarters in this downturn. It said this was “perhaps because interest rates have risen so quickly and from a much lower base”.
There is another explanation. Changes to Royal Institution of Chartered Surveyors’ (RICS) valuation guidance since 2008 means that valuers can now recognise changes in value much more quickly than before. In the past, valuers were only able to price assets based on a limited number of factors, such as deal activity and leases. Now, by contrast, RICS valuers are able to include other factors, such as the deals that failed to happen, into their pricing.
A buyer’s market
Whatever the reason for the speed of the price discovery, experts say value recovery won’t be quite as swift. Earlier this month, Savills said the continuing interest rate environment “raises the prospect of some further upward movement in prime commercial property yields [rental income as a percentage of the value of an asset] over the next six months”. In other words, there is scope for even more buyer-friendly deal activity as transaction volumes rise but real estate values stay weak.
This is bad news for the Reits and their investors who will potentially be faced with another six months of falling NAVs as they offload assets into a depressed market. Ediston Property Investment Company (EPIC) said this month that it is keen on “a merger with one or more Reits” after struggling to raise money in the equity market and added that it would also consider selling the business. The timing of this announcement looks likely to work against EPIC as activity increases while values carry on decreasing.
However, Reits do not necessarily have to be sellers in this cut-price environment. This month, British Land (BLND) snapped up £120mn of retail parks at much higher rental yields than the market average, suggesting it negotiated some very favourable deals. At the end of last year, other Reits – including LondonMetric, AEW UK (AEWU), and Industrials Reit (MLI) – said they too would be keen to buy discount assets, with the latter pointing to joint ventures as one avenue for this.
Those Reits won’t have the market to themselves, though. Agency BNP Paribas Real Estate calculates that there is £41bn-worth of “investor dry powder” looking to buy central London offices and retail assets this year alone, and they are seeking values “ideally at around 75 to 80 per cent of last year’s pricing”.
BNP Paribas Real Estate is looking at three types of buildings: “Ultra-prime ESG assets that suit long-term buyers and tenants seeking out the best green buildings, opportunities to upgrade less fit-for-purpose buildings in a yield play, [and] obsolete stock in a repurposing play to secure operational returns that the likes of a residential or a hotel asset can provide”.
The latter two options could prove particularly popular. At the end of this month, tougher energy efficiency regulations mean it will be unlawful to let a commercial building with an energy performance certificate (EPC) below E and forthcoming regulation means it will be unlawful to let a building with an EPC below C by 2027. BNP Paribas Real Estate calculates just half of all London commercial stock currently meets the 2027 target, paving the way for those assets to be acquired and then brought up to standard.
Shopping for shops
Retail assets could be another popular acquisition target. CBRE (US:CBRE) data shows that the valuation hit for retail assets has been less severe than for industrial and office assets in part because retail assets have already taken such a significant price battering over the past decade thanks to the rise of online shopping. This suggests that while commercial property as a whole could continue to lose value, retail assets’ pricing might remain stable.
This has fed through to Savills and Property Data transaction figures, which show warehouse and office trading activity falling off a cliff in the most recent downturn, but consistent activity for retail and leisure assets. So far this quarter, the provisional data shows more money has been invested into shop units as an asset class than warehouses.
That number will change as the data for this quarter becomes clearer over the next couple of months, but it still paints a picture of where the market could be headed. Oxford Economics is predicting that retail assets will recover in value much quicker than any other asset class.
Investors can therefore expect a lot of retail asset trading activity over the next six months, and Reits won’t necessarily be the only listed companies involved. Last week, Frasers bought a shopping centre in Dundee as part of its “ongoing investment and commitment to the long-term future of physical retail”. Frasers’ bullishness is a sign of just how popular and lucrative buying retail assets on the cheap could be this year.
This spring thaw for the commercial real estate market may not bring on a rapid return to prices seen in mid-2022, but it’s at least a sound basis for recovery.
