‘A rising tide lifts all boats’ commonly described recoveries in real estate in the 1990s and 2010s, when most sectors experienced sharply rising capital values.
However, the current thawing of the market is far more nuanced. A more appropriate description for what we are witnessing now – with higher interest rates, inflation and structural dynamics causing greater dispersion between sectors and individual assets – might be chair of Berkshire Hathaway’s Warren Buffett’s oft-quoted line: “Only when the tide goes out do you discover who’s been swimming naked.”
Last autumn’s ‘mini-Budget’ turned a likely three-year slide in values into a three-month collapse. While confidence appears to be returning following the sharp repricing at the end of 2022 – and more quickly than perhaps expected – all signs point to increased polarisation in the market.
According to CBRE, UK capital values fell by 13.2% and annual total returns by 9.1% in 2022. Values are continuing to fall this year even before banking collapses in the US and the hastily arranged acquisition of Credit Suisse by UBS in Europe threatened to suck more liquidity from the sector.
We believe the market has entered a `K-shaped’ recovery where polarisation will become more pronounced. Some assets will improve in value more quickly; others will see an accelerated decline. The UK is further ahead on its repricing journey than many European markets, so its recovery is likely to be relatively quicker. As a result, the UK is starting to offer better relative value, particularly on a short-term basis.
We are used to seeing sectors fall and rise in lockstep. Last year, retail values fell by 8.1%, offices by 12.1% and industrial by 21%. Yet even this variation between sectors disguises diverse performance within them.
The next phase of the cycle will require investors to be more discerning, with valuations more closely aligned to the macro cycle and structural dynamics.
We believe the market has entered a `K-shaped’ recovery where polarisation will become more pronounced.
Offices are likely to go through most change and have remained remarkably resilient, fooling many. Our expectation is for a prolonged repricing, with two critical considerations not yet adequately priced in: net zero compliancy and structural demand changes. Assets with the best environmental credentials will likely be spared but others, stranded by demanding regulations and a change in demand, will fall behind.
If owners don’t refurbish assets or adequately price climate risk, they will face chronic underperforming assets over the longer term.
We like single-family residential from an investment and environmental, social and governance perspective. There is a huge economic and social need for homes, particularly those that can make the residential sector more environmentally conscious. With increased mortgage rates forcing some families to put homebuying plans on hold, it is important these schemes also tick the ‘affordable’ box for those on average incomes.
The bottom half of our residential K shape comprises build-to-rent developments lacking amenities and failing to create a community. Invariably these will be overpriced and struggle to attract renters. There may be demand for housing – but only at rent levels people can afford.
Retail parks that thrived during the pandemic due to ease of access and click & collect points will, we expect, continue to perform well, alongside outlet malls providing the experience today’s shoppers crave.
In the lower half of the retail K will be shopping centres that do not cater to shoppers’ experiential demands. These places are likely to find retailers unwilling to pay the rent required to justify the capital expenditure needed to ensure the property’s survival.
Perhaps surprisingly, warehouse values have fallen more sharply than other sectors, but this is more a function of the sector’s stellar run over recent years than its underlying credentials. Strong structural currents support these assets, with trends accelerated by the pandemic. We remain keen on well-located, flexible and high-quality warehouses, remaining an active and opportunistic buyer for assets in the upper part of the K.
The lower portion of the K is secondary units in poor locations, badged as `urban logistics’ but now looking unaffordable to tenants struggling in a flatlining economy.
There will undoubtedly be a recovery in UK real estate. Critical will be asset selection, with the recovery creating greater returns dispersion. As we take advantage of our position as a strategic buyer – we have earmarked £750m for the right opportunities – it is assets in the top half of the K we will be investing in.
These will already incorporate thematic trends into their design and philosophy, putting them in the strongest position to deliver best long-term value and performance.
Ben Sanderson is managing director of real estate at Aviva Investors
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