Investors Praying Inflation Has Peaked In UK Market As Deals Evaporate

Watching the monthly inflation figure announcement has been a depressing but necessary pastime for UK real estate investors over the past six months.

Compared to other big economies like the U.S. or eurozone countries, high inflation has been much more persistent. High UK inflation means rising interest rates, and those rates mean falling property values and a frozen investment market. 

At the start of the year, hopes were high that inflation might have peaked or would do so by the end of the summer, and that by the end of the year, the cost of debt might be falling again, freeing up investment markets.

By late spring, with inflation still rising, that began looking like a vain hope. Until now.

“People were nervous in May and June that maybe UK interest rates would start with a six, and psychologically, that was a big deal,” CBRE Investment Management Chief Economist Sabina Reeves told Bisnow.

The Bank of England’s interest rate is 5%, up from 0.5% last year, and by June, with inflation more and more difficult to bring lower, bond markets were pricing in rates rising as high as 6.25%.

“Rates haven’t started with a six since 1998, which is before a big portion of people working in real estate now started their careers,” Reeves said. “That is why last week brought such a sigh of relief.”

That sigh was heard when the Office for National Statistics revealed that June UK inflation, as measured by the consumer price index, fell to 7.9% from 8.7%. That marked the first time in five months that inflation came in lower than analysts had expected — a long time to wait for a positive surprise. 

“One swallow does not make a summer,” Reeves said.

But financial markets and UK real estate shares in particular reacted positively to the news, and investors can now start to — very tentatively — sketch out a plan for how to invest in UK real estate in a new reality where money doesn’t come as cheaply.

“Small shifts in inflation numbers are creating huge volatility, and having a big impact on real estate,” Savills Global Capital Markets Researcher Oliver Salmon said. “Inflation numbers were 20 basis points better than expectations, but that created a sharp shift in bond yields [policy rates are now predicted to top out at 5.5-5.75%, down 50bps from early July] and a recovery in equity markets. It’s hard to make long-term investment decisions, where you might be investing for 10 years or more, in that kind of volatile environment.”

In terms of why high UK inflation has been so persistent, Salmon and Reeves pointed to unique factors in the country. They include a particularly tight labour market, with Salmon highlighting the impact of Brexit on the availability of workers. The way the UK regulates energy prices, with a government cap going up or down at three-month intervals, also means that falls in wholesale energy prices have not yet been passed on to the consumer. 

With expectations for interest rate rises peaking in June, real estate investors that month took an even bigger pause than had been the case in the winter and spring. UK investment volumes dropped 60% in the first half of 2023, MSCI data showed, but the figure for June fell further to 71%.

 “It’s not just the cost of debt, it’s also the alternative things investors can do with their money,” Savills Head of Global Cross Border Investment Rasheed Hassan said. “Groups who have the luxury of flexible investing are looking at bond yields and even rates on cash deposits and in many cases questioning why they should be buying real estate in the short term at lower yields, when it is less liquid. However, real estate is much more nuanced than bonds or cash and investor horizons and drivers vary enormously ”

In spite of the higher-for-longer inflation and interest rate environment, the UK market hasn't looked that much worse than some large global peers because most markets have problems right now.

“The UK looks worse in macro terms, but the U.S. looks worse off in real estate terms,” CBRE IM’s Reeves said. “In the UK, the issue is policy rates. In the U.S., it is the problems among lenders and the repricing in the office market. 

“Also, the UK has repriced a lot more quickly than the U.S. or any other market in the world — the UK has already [felt] the pain, whereas there’s a perception that in the U.S., investors haven’t taken their marks yet.”

CBRE IM is looking at buying UK assets that could be beneficiaries of inflation, such as logistics facilities with short leases, residential assets and some retail assets where leases have inflation protection, she said. 

The focus on logistics, residential and timeline was one shared by lender Birchwood Real Estate. 

“The savviest investors will be less focused on those cash-on-cash returns you saw when rates were low, more looking at long-term value, rental increases and buying into structural rather than cyclical real estate changes,” Birchwood CEO Lorna Brown said. 

“We’re also focusing on slightly shorter-duration loans — it’s hard to underwrite a loan for 10 years at the moment,” she added. “So in those value-add situations where you think the income stream can improve, you’re lending to people for three to five years.”

With the spectre of inflation continuing at very elevated levels receding slightly, Hassan said investors are starting to look at certain sectors of the UK market with a different outlook.

“It’s a simplistic view, but if you think we’re past peak inflation, and you can find assets where yields have risen and prices have dropped only because rates have risen as opposed to any structural changes, then now Is the time to consider buying again,” he said.

“Because if we’re past peak inflation, then rates will at the very least stabilise or indeed go down, and the value of those assets will rise. Now of course investing in real estate is more sophisticated than that, and there is more at play in making the decision to step back in, but some investors are starting to get there.”