The UK’s inflation-induced economic slowdown is expected to dampen fourth-quarter activity in the real estate sector as investors and lenders reassess the rapid reversal in monetary policy, the outlook for occupier markets, investor appetite, and financing liquidity.
UK markets have entered a period of calm after one month of historic political and financial market instability, against a backdrop of elevated energy prices and broader inflationary pressures. While the appointment of Rishi Sunak as the UK’s third prime minister in less than two months has eased market tensions, he warned of “profound economic challenges” ahead. On Thursday (3 November), the Bank of England (BoE) is expected to increase interest rates by at least 75 basis points to dampen demand and tame inflation. The pace of the transition from the ultra-low interest rate environment to a new regime of “higher-for-longer” has caught most by surprise, including the central banks that instigated the shift.
Some economists believe the UK is already in a recession which could endure into mid-2023. For example, Goldman Sachs forecasts a fourth-quarter cumulative decline in GDP of 1.6% and a “significant” recession.
Investors and lenders adopt cautious pivot
Over the final quarter of this year, and into 2023, the path of inflation and interest rates will dictate the severity and duration of the UK recession and related risk-off environment. Real estate investors and lenders have pivoted to a more conservative posture: vendors and buyers are typically cautious when asset prices are declining, while lenders closely re-evaluate existing loan books.
Third-quarter real estate transactions in UK markets slowed to £11.5 billion, 33% less than last year, when Covid-19 markets stifled sales, according to Real Capital Analytics (RCA) data. However, over the year to date, UK activity was up 4% to £50 billion, compared to last year, comfortably ahead of second-place Germany (YTD: £34.6 billion) at the top of the investment leaderboard.
Yields across real estate sectors have started to move out from record low levels. At the same time, properties transacted diminished month-by-month through the third quarter, according to RCA, possibly signalling that a real estate correction has already begun. At the end of September, the volume of pending real estate deals across the UK and mainland Europe was the lowest by value since 2013, RCA data also showed.
Many of the secular macro challenges have a direct impact on tenants. For example, inflation adds to corporate operating costs, softening consumer demand. This can trickle down to reduced hiring plans and, eventually, reduced headcounts, as occupier markets initially slow, then contract. Together, these forces reduce tenants’ ability to pay rent, while higher borrowing costs increase debt servicing costs and further reduce free cash flows. In this environment, tenancy default risk increases. Higher borrowing costs also reduce the prevalence of highly leveraged investors, as the increased cost of capital dilutes investors’ risk appetite and, in turn, market liquidity. At the same time, the weakening economy tends to reduce construction, which is highly sensitive to the cost of capital, while capex budgets for existing assets and refurbishments is often reduced, delayed and shelved.
Lenders are also reassessing risk appetite in the context of existing loan exposures, future occupational demand and the outlook for rents, which underpin cashflows and inform appropriate debt service coverage ratios. As softening yields reprice valuations lower, lenders need to ascertain borrowers have sufficient headroom to afford loan payments. In risk-off environments, lenders become more selective about who they lend to while imposing higher margins and lower loan-to-values (LTVs). Overall, this will create opportunities for lenders to be more selective on refinancing, restructuring, development finance, as well as finance for asset repositioning.
In the three years to H1 2025, more than £110 billion worth of commercial real estate loans will fall due, staggered evenly on an annual basis, according to the recently published Bayes UK Commercial Property Lending Survey. Within this maturity wall, some loans will default, accelerating the pipeline of refinancing and restructuring.
Financing liquidity is expected to remain available across sectors and markets, supported by secular demand drivers, where investors have ESG at the heart of asset business plans. However, there will be some bifurcation, such as in the office sector. For example, amenity-rich offices will continue to draw occupier demand and competitive financing bids. In contrast, traditional legacy offices are expected to experience sharp repricing, and lender appetite will continue to recoil. This will present opportunities for lenders to selectively offer capex loans to experienced investors to refurbish assets to meet rising ESG standards. However, many legacy office assets will be too expensive to modernise, with landlords forced to choose between equity financing and expensive debt to refurbish. For some, neither will be possible, and some disposals may follow.
Development finance also wanes during recessionary periods. But, there may still be selective opportunities in residential and affordable rental housing where a long-term structural undersupply remains. However, finance liquidity will be much more limited and expensive. When markets come through the other side of this economic slowdown, the much-reduced development pipeline will be a fillip to the occupier market, supporting rental growth. The challenge is enduring the recession and capitalising on the improved fundamentals after the reset of supply-demand dynamics. It will likely be a dumpy few quarters with a downward bias.
If your company would like help navigating real estate refinancing and restructuring options, or tenancy defaults in your property portfolio, do not hesitate to contact our team today.