2023 Was A Near-Record Low For UK CRE. 2024 Will Be Better, But Only If Values Drop

It lacked the noise, the panic and the blood on the streets, but 2023 was almost as bad a year for UK real estate investment as 2008 and 2009, the nadir of the Lehman Brothers-induced crash.

Next year is set to be better, but there's a catch: Investment volumes will go up, yet only because values are likely to fall. 

“In some respects, next year will be better. In some respects, it will be worse,” Green Street Managing Director and Head of European Research Peter Papadakos said. “Better because there will be more activity and transaction volumes, as people become more confident on how to underwrite the macro environment and where short-term rates are going.”

Worse because the refinancings many owners need to undertake are all a year closer, and there will be a realisation that the funding gap is real, he said: “Volumes can go up, but valuations will come down.”

UK real estate was on track to have a slightly better year for investment volumes than 2008 and 2009. Volume was pacing slightly ahead of the £24B 2009 nadir as of mid-December, though well below the next lowest year, the £33B invested in 2012, MSCI Head of EMEA Real Assets Research Tom Leahy said. 

This year's dismal total is a function of how quickly interest rates rose between mid-2022 and mid-2023, making debt too expensive for buyers that usually borrow and allowing institutional investors to find better returns in the bond market. 

On average, UK property investors lost money in 2023, with average negative total returns for UK property coming in at 0.4% for the year, according to the Investment Property Forum. Those that invested in industrial fared OK, making a 4.5% return. But those investing in City of London offices saw an average value drop of 16% and an average negative total return of 12.3%.

A group of investors polled by the IPF forecast that UK total returns would average 5% next year, with industrial atop the pile, returning 7.3%, and City offices again bringing up the rear, albeit improving to a positive return of 1.4%. Oxford Economics is slightly more bearish but in the same ballpark, predicting a 4.4% all-property return next year. 

For the market to start functioning again, the gap between what buyers are willing to pay and what sellers expect needs to come down significantly in the UK, especially in the London office market, Papadakos said. Green Street has pegged the bid-ask divide at about 15% on average in the UK.

The chart below shows how buyer expectations, as measured by Green Street's index, have fallen further than valuations, as measured by the European Association for Investors in Non-listed Real Estate Vehicles, or INREV, fund valuations. Valuations in the public market have fallen much further. 

Year-end revaluations will bring values down to some degree, but the main factor will be banks pushing for sales when borrowers are unable to refinance at higher interest rates. CBRE anticipates that the funding gap between the debt needing to be refinanced in Europe and the amount of debt available for refinancing is £151B between 2024 and 2027. Of that gap, about £8B relates to UK loans that need to be refinanced in 2024.

“I think you will see valuations decline throughout the year,” Papadakos said. “You will see motivated sellers and that will push volumes up, but values will have to decline to tempt buyers back to the market.”

On the whole, there will be little in the way of new inflows of capital to real estate until it looks cheap compared to other asset classes like bonds, he said. 

Real estate shares rose sharply last Thursday, the day that the Bank of England announced a decision to hold interest rates steady at 5.25%. The excitement was spurred by data released the previous day indicating that the U.S. Federal Reserve would start to cut interest rates in 2024. Bond markets are now factoring in a 75-basis-point cut to interest rates in 2024 despite a warning from Andrew Bailey, BoE governor, that inflation is far from tamed. 

If rising interest rates caused real estate values to decline, then the inverse should theoretically be true — falling rates should help valuations and investment volumes. That thinking likely led to the average 5% rise in real estate stocks on Thursday.

But there are reasons to be cautious about overly simplistic formulations. 

“The bond markets have been very aggressive about pricing in rate cuts, but central banks have been saying, ‘Not so fast,’” CBRE Investment Management Chief Economist and Head of Insights & Intelligence Sabina Reeves said. “They have been indicating that a ‘Table Mountain’ scenario, of rates staying higher for longer, is more likely.”

Investors have been happy to sit on capital raised and wait for prices to drop, Reeves said.

“Pricing in the UK adjusted faster than anywhere else in the world, but investors have been happy to sit on the sidelines, and the same may well be true at the start of 2024,” she said. “It’s a shame because it’s impossible to perfectly time the market, and the research shows that even if you’re a quarter or even two quarters early, it’s still possible to make outsized returns.”

For MSCI’s Leahy, there are signs that things are starting to unwind. He pointed to a recent deal that saw a joint venture between Dutch developer Edge and Japanese investor Mitsubishi Estate buy 125 Shaftesbury Avenue in the West End for £150M, more than £100M less than the previous owners paid in 2018.

“You're seeing those forced sellers emerge and the price discovery you need to get the market moving again,” he said. “In some sectors, like industrial, you’re starting to see competitive tension in sales processes, and in London, industrial prices are starting to move up again.”

But even without the stresses and strains of a Lehmanesque crisis driving things, UK real estate is likely to face another tough year. 

“There is more downside risk to pricing than upside,” Papadakos said. “I don’t think you’ll see a ton of new capital coming into the market.”