Property carries more emotion than most asset classes; tangible and durable, it reassures. Our homes and the cities we work in seem solid, even when the pandemic questioned everything. But does that feeling of permanence blind investors to the risks? Softening office valuations and weakness in real estate funds – often trading at wide discounts – point to the challenge as work patterns evolve. Bubbles often unwind in stages, over time. Are sector analysts right in thinking values have now reached a floor?
In the UK, property weakness accelerated in the second half of 2022 with industrial values falling by more than a quarter, and even more in London. Averaged across the whole UK property market, the decline was one-fifth, with investors in many REITS and other property vehicles faring worse as discounts widened. Rental growth was limited, much behind inflation. It is not yet clear if property values have stabilised this year. It will take more property transactions to evidence price discovery.
Weak economic growth will likely limit scope for future rental growth, giving little offset to the risk of another spike in bond yields. Not only is there uncertainty on the short term outlook for valuation, but the liquidity squeeze will put further pressure on the cost of capital. That makes it possible that some real estate vehicles continue to destroy value, with returns falling below their average cost of capital. It would be surprising if such a long period of cheap money had not drawn property into the bubble, alongside private equity and technology.
Part of our emotional response to property is its historic resilience. The London office market has confounded its critics over the years, adapting to each crisis. Currently, it is shortening lease lengths and moving flexible offices into the mainstream. The best assets, with sustainability credentials, are in demand, despite overall relatively high vacancy rates. The market is polarising; key is modern green offices with the right amenities.
Might the UK follow the US real estate trends in big city office properties? Changing work patterns, combined with a higher cost of capital, have forced some US landlords to offload properties cheaply or rethink strategy. Some lease extensions during the pandemic simply pushed the problem further down the road, and US delinquency rates on commercial mortgage-backed securities have risen. Debt on real estate is an issue. There is a growing pipeline of assets that need to be refinanced – not easy in an environment of softening rents and weaker values. Even for those not selling out, the squeeze makes it harder to fund building improvements and amenities. As the US bank problems have shown, the Federal Reserve is continuing an extremely tight monetary policy.
Can we be sure that this is not the future for the UK’s big cities? Repurposing buildings is not cheap, and it will take time if the eventual solution is to convert more to residential. Councils that should be rejuvenating city centres are strapped for cash, delaying new schemes. Changing demand patterns have devalued many older buildings – they are simply not capable of being remodelled to suit current needs. Hybrid working is here to stay and the pressure for sustainability will persist even if energy prices ease.
On the positive side, the Blackstone offer for Industrials REIT recognises value with a bid premium of over 40%. But that had some unique characteristics that may not carry over into other REITs. Discounts persist across a range of vehicles, reflecting the search for liquidity by some investors and questions about value and outlook. Property performance in recent years has given warm feelings, but the unwinding of a bubble is no place for sentiment.
A version of this article was published in Citywire on 01.06.2023