We have seen this movie before. Monetary tightening leading to recession and then monetary easing.
The blockbuster version starred Alan Greenspan and played out over the noughties leading to the global financial crisis (GFC) followed by 12 years of extremely loose fiscal policy.
We are potentially at the turning point of the current remake and the language being used by central bankers at the end of 2022 has become more dovish. The UK (and probably the Eurozone) is already in recession and with that backdrop it is likely that inflation will start to recede as it is already in the US. The direction of travel for oil, which is down $40 a barrel since June 2022, is a fair indicator of both inflation and demand. While oil prices will fluctuate due to the war in Ukraine, the trend is very much down with a medium-term target (mid-2023) close to $60, as Western world demand reduces due to the likely long, albeit shallow, recession we are about to experience.
On that basis, we could be closer to peak interest rates in the UK (the consensus now seems to be an absolute peak of between 3.5% and 4%) with the possibility that the Bank of England will reduce UK interest rates from Q3 2023.
The shallow recession and resultant impact on interest rates will have an interesting effect on the UK and European real estate markets. We are entering an era where the creation of new real estate supply is going to be limited due to the lack of development finance, increasing construction costs, planning restrictions and the impact of embodied carbon. The relatively quick reversal of the monetary policy by the central banks will likely stop there being a major reversal in the real estate markets.
There is no doubt that if you want to sell today, the price could be discounted by up to 20% against peak Q1 valuations. However, few groups are forced sellers, as much of the debt across the market is either swapped or capped. Investors hedging positions have value, which offsets some of the capital losses, but more importantly it means that for much of the market, the interest rate rises have not actually had much of an impact yet.
Should interest rates fall, the hike in rates will have bypassed much of the market. Having said that, there are some investors that are experiencing some distress, namely those facing refinancing or losses elsewhere in their portfolio. The difference between 2008 and this market is that during the GFC there was a general liquidity shortage exacerbated by the hedging of interest rate positions. The very reverse of what we see today. Currently, there is not a liquidity crisis (due to QE and there being plenty of equity on the side lines) though there is some specific investor distress.
Turning to a specific opportunity in this market, I am firmly of the view that the office is not dead, far from it. What has changed is the desire for a long-distance mass transit commute, so the mantra will, in part, move towards working near home rather than from home. Despite current headwinds, the lack of new supply will ensure that for the right product there will more than likely be rental growth as the ESG credentials of buildings become more stringent and the market battles supply reductions caused by obsolescence or use conversion. The conversion of brown to green offices will be one of the most interesting plays of the next cycle.
Richard Croft is executive chairman of M7 Real Estate
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