UK inflation has fallen steadily from the highs reached last autumn. As of July, the Consumer Price Index (CPI) measure stood at 6.8%, down from a peak of 11.1% in October 2022.
July saw a particularly big decline in inflation as falling household bills and a retreat in food price inflation took effect. However, underlying inflation has proved more stubborn. Core CPI inflation, which strips out the volatile energy and food components, was 6.9% in July, a little different from the recent peak of 7.1% in May. And services inflation, which the Bank of England (BoE) focuses on as an indicator of domestically generated inflation, rose to 7.4%, the highest since 1992.
Stubbornness in these underlying measures, which partly reflects the impact of strong growth in pay, means that while Oxford Economics expects headline inflation to continue falling this year, the CPI measure is forecast to decline to only around 5% by the end of 2023. And inflation is not expected to return to the BoE’s 2% inflation target until early 2025. This has two implications for monetary policy. First, the BoE is unlikely to be at the end of the current rate-rise cycle. Oxford Economics expects another rise in bank rate when the BoE’s Monetary Policy Committee meets in September, taking the official policy rate to 5.5%. Second, while a September hike should prove the peak for interest rates, bank rate is not expected to be cut until late 2024, several months later than the US and the eurozone.
Financial markets currently take a more bullish view of what persistent underlying inflation and strong pay growth mean for interest rates and expect a peak in bank rate of around 6%. Although too high, as it stands, market interest rate expectations will have a meaningful impact on the already high cost of debt facing commercial real estate (CRE) companies. And they add further risk of CRE distress as interest coverage ratios move into dangerously low territory, which is particularly concerning for those with higher loan-to-value ratios with fixed-rate loans maturing this year and in 2024.
Stickier-than-expected core inflation has also pushed up the discount rate used to discount future cashflows back to their present value. A decent proxy for this is the 10-year nominal forward rate. This was up by 40 basis points to 4.5% in July, higher than the October 2022 spike and on par with the average over 2010 to 2014 and the decade preceding the global financial crisis. The increase in the discount rate has not been priced in by valuers to date, so if it persists over the coming months, we think a further reduction in capital values may be warranted.
In contrast, CRE valuations modestly recovered between March and May, with month-on-month capital growth returning to positive territory for all major sectors except offices, according to MSCI. We think this is a temporary reprieve, with further falls to come as tighter credit conditions, rock-bottom sentiment, inadequate risk premiums and high debt costs all continue to weigh on the outlook.
In fact, we had already heavily downgraded our outlook in March on the expectation that the banking turmoil would tighten global credit conditions. As such, we have maintained our below-consensus forecast for a 7% fall in UK all-property capital values this year, followed by growth of just 0.6% next year.
By sector, we expect the largest corrections to capital values will be in the office and industrial sectors. Much of this fall in values has already occurred for industrial assets, but there is still a substantial adjustment to come, particularly for offices.
Although some high-profile companies have issued return-to-office directives this year, the majority continue to follow a hybrid policy, which will gradually lead to a reduction in required floorspace. This, in combination with a declining working age population later this decade, presents a challenging outlook for the office sector at an aggregate level.
By contrast, residential has had the smallest overall correction in values, but we expect the bulk of the adjustment to occur this year as the broader housing market re-prices.
Mark Unsworth is associate director, real estate economics, at Oxford Economics