Overriding economic and political themes influence all markets and this has perhaps had a bigger overall impact than the 2020/21 disruption from Coronavirus – and manifested within a similar timeframe. Over the last six months, these repercussions have been most evident following the sharp increase in interest rates and the resultant cost of property finance.
As active agents and advisors in the Scottish market, we are committed to recognising and predicting trends. Some of these are data-backed facts and some are born out of what we glean from our network of investor and professional contacts. The current market is somewhat mixed and has potential to change fast, there is a greater pricing spread and a change in liquidity. This market snapshot gives an insight into what we see and hear.
The biggest change in 2022 was the sharp adjustment in debt availability and cost in May/June, new “all-in” commercial debt quantified at 5.00%-6.00% for certain commercial property investors. UK political turmoil added more pressure with a similar sharp increase on domestic mortgage lending following the commercial trend. This has had an immediate impact on pricing and liquidity across the whole market. It was 2009 when the Bank of England base rate was last above 1.50%. At the time of writing, base rates sit at 3.00%. SONIA rates (the modern daily equivalent of LIBOR) for overnight commercial interbank lending sit at 2.93% (December 2022) compared to 0.94% in May 2022 and 0.05% in May 2021. Economic historians will note we are somewhat out of sync with an eight- to 10-year property / economic cycle. A tough bucking of the trend to ignore for many.
Politics and Legislation always play a part in property decisions. The question of Scottish independence formally raised its head again in 2022. The legal ruling from the UK Supreme Court found that the Scottish Government did not have the power to implement a second independence referendum bill. The delivery of independence is questionable and most property investors remain aware of the risk. Generally, markets don’t react to perceived uncertainty. We anticipate the recent ruling provides more positive certainty and, therefore, a more stable landscape. From previous experience of providing advice amidst an independence debate, strong property opportunities tend to outweigh the political uncertainty. We also see potential for stark change in regulation in terms of rent control in the residential private rented sector (PRS) which has attracted a weight of institutional money in recent years. This stems from the cost-of-living crisis and long-term lack of supply around new housing.
Well reported and unprecedented inflation is a real issue across the UK. There are various mechanisms in property investments to hedge against inflation, but there is often a lag. Those investors with property rent reviews which track inflation (RPI/CPI) will benefit from positive rental uplifts, but there is a cautionary tale. Consistent fixed uplifts can create over-rented property, which doesn’t support good valuation fundamentals. High rents will drive value, assuming a stable yield, but a high rent is only useful if a tenant can afford it.
The UK industrial and distribution market has seen stellar performance over the last five years of rental growth combined with yield compression. It remains an attractive sector. Pricing in the south has cooled as prime yields hit 3.00% in Q4 2021 / Q1 2022. It took less than three months to see an absolute pricing change in the industrial sector. There are still many strong elements to this sub-market but pricing was at an all-time high, so the negative impact perhaps feels greater. The weight of global institutional money targeting the sector seems to have sustained, indeed with some funds sighting a new rationale, and being more opportunistic following the softening of yields. We anticipate continued performance in the sector through rental growth, fundamental supply and demand imbalance, and the relatively low value of standing stock versus new build cost.
Retail remains polarised, market challenges were emphasised during Covid. The high street (including leisure) struggled while accessible modern format retail warehousing prevailed. Footfall is down and this isn’t a new trend, but we have seen, subject to softer rents, some very exciting progress in prominent high street and Central Business District locations. Retail warehousing and parks are still attracting strong yields (5.50% - 6.50%) and seen as defensive income. Shopping centres have suffered with a major price adjustments from historic highs. That said, investment volumes are surprisingly positive in 2022 and we expect to see profitable performance recorded within the sector going forward where specialist asset management is executed.
With such a broad pricing spread, prime high street retail is back in favour in certain cities, but we would suggest this is due to geography and core fundamentals, especially where full buildings can be bought and where rents have been re-based. Secondary retail remains a challenge and generally out of favour for many.
The real challenges and diversification route for city and town centres are more varied than this snapshot article allows, but the crux of the matter is that we must not forget the inherent value and opportunity of core property, especially retail in Central Business District (CBD) locations. Flexible landlords who are willing to work more closely with their tenants will succeed in this arena, as will property owners who have the finance available to re-purpose their properties.
The office market faces its biggest change since working from home (WFH) practices were introduced during lockdown and is a heavily debated sector. We see a notable spread on pricing in the current market. Quality CBD assets range from 4.50% to 8.50% headline yield pricing from what sometimes seems like a minor differential at first glance.
Social change and expectations means utilisation of the office has to change. Occupancy has been reported as down, but over what timeframe? Property or leases are not able to fluctuate with daily or weekly occupancy. As agents in the Scottish office market we have seen a stark increase in occupier accommodation budgets, with a huge focus on quality and productivity of office space. This sits neatly with many corporate Environmental, Social and Governance (ESG) agendas. The prime market has seen solid rental growth at the same time. Moving away from prime, and with an eye on inflation and talk of recession on the horizon, we also see a place for cheaper secondary stock which could perform quite well. From a pricing perspective though, owners and investors need to be mindful of regulation around energy performance ratings. Legislation in England is more prohibitive than Scotland, but in both regions it is going to be difficult to lease or sell buildings that don’t hit a certain energy performance rating. Professional office investors are well aware of this and modernisation costs must be factored in from day one when looking at new acquisitions. This is already evident in office sales launched in 2022. We are confident the office sector will remain a peak performer in the UK market and a key part of our diverse urban conurbations.
Alternative Sectors all need quite specific thought and advice, but generally we anticipate a consistent demand with potential for limited yield volatility. Sectors such as Student, PRS, Hotels, Motor-trade, Long Income and Ground Lease investment have provided excellent diversification and attracted good interest when openly marketed. With a diverse buying pool most assets attract strong liquidity if priced correctly and can be key tool in any portfolio.
These property market cycles and sub-market trends are easy to assess retrospectively, especially with reliable and well-managed data. There are arguments for and against a focused specialist investment approach compared to a traditional portfolio theory, which includes diversification. In a changing market, with a broader spread of pricing, it is a lot harder to see or anticipate correlation. Perhaps, with faster market fluctuations, a narrower or specialist approach is more risky? Equally, decisions and investments have to be made and often the wise business owner, tenant or investor takes a step back and considers property decisions with a longer-term perspective.
Overall, we saw transactional volumes slowed and completions stalled drastically over the summer, mainly due to the sharp adjustment in debt terms coupled with a traditional summer slowdown. We don’t anticipate reporting a Q4 2022 bounce back in trading volumes as many investors review allocation strategies.
We can now prove a general negative shift in pricing and liquidity but, as always, this is a generalisation and it comes down to individual property specifics. Property risk premium and debt arbitrage will be back in play with a very real future “pricing in” for ESG compliance.
We anticipate a good release of stock for sale in H1 2023 but vendors should have an eye on purchaser track record and performance over and above highest price. The landscape of higher yields and expensive debt could be very advantageous for UK institutions, who have been relatively quiet for a number of years, but this is contingent on them having cash allocations available. The potential deployment of this equity across the different property sectors will depend on their own forecasting and research papers.