OUTLOOK 2023
Capital markets
UK capital flows in 2023
We expect the opening months of 2023 to be a challenging time for the property market, with low sales volumes and yields moving up. This reflects the difficult macro-economic backdrop forecast for the first half of the year. However, investors typically aim to anticipate the turning point for the economy when re-entering the market. Consequently, we are predicting opportunist capital and well-funded investors with long-term horizons to begin to re-enter the market from Q3 onwards, as the economy returns to growth again.
Pricing gap
By the autumn of 2022, the UK commercial property market was displaying many of the hallmark signs of a cyclical downturn. Sales volumes had started to slow, some open-ended funds announced restrictions on redemption payments, and the gap widened between purchaser and seller expectations on pricing.
2022 was a year in which inflation rose faster than expected, leading to much higher interest rates. These factors resulted in financial market volatility and more expensive debt. With the five-year Swap rate at 4.5% in late October 2022, versus 1.3% a year earlier, the financial environment has changed dramatically. The UK having probably entered a recession during H2 2022 has been widely acknowledged by policymakers, from the Treasury to the Bank of England.
All this points to a difficult environment for property as we move into 2023. Investors are in wait-and-see mode whilst monitoring events. Those who are cash-rich know they will be in a strong position to press hard in negotiations with vendors when the time is right to buy.
5YR SWAP VS ALL PROPERTY YIELD
Source: Macrobond, MSCI
Market correction
Consequently, our forecast is the first half of 2023 to be a time of lower real estate transaction volumes and correction in pricing in varying degrees, according to sub-sector, quality and location. UK commercial property yields have a strong time-lagged (one year) correlation to BBB corporate bond yields of 0.7%. Over the course of 2022, BBB yields increased significantly, so there is a 70% chance that property yields will rise in the coming months. With many buyers currently on the side lines, afraid of ‘catching a falling knife’, we believe prices softening in early 2023 is highly likely for most sub-sectors.
Source: Macrobond, MSCI
“It is our view that the price correction will be far less aggressive than in the 2008-2009 market downturn. That played out to the backdrop of a systemic crisis for the financial system, with real estate in the eye of the storm.”
Natasha Patel, Head of Innovation and Insight
It is though our view that the price correction will be far less aggressive than in the 2008-2009 market downturn. That played out to the backdrop of a systemic crisis for the financial system, with real estate in the eye of the storm. Property has entered the current downturn with lower loan-to-value (LTV) ratios than was typically the case pre-2008. Nor did peak pricing in 2022 feel as over-extended as was the case just before the Global Financial Crisis (GFC).
Furthermore, a significant amount of the opportunity fund money that was raised during the Covid pandemic has not yet been deployed, providing a waiting pool of dry powder. We see GDP growth in 2023 holding up better in North America than in Europe, and presently the US and Canadian dollars are strong relative to European currencies. This should provide another source of opportunistic inbound capital targeting UK property.
Quality and location
The extent of the price correction will vary according to quality and location. On quality, high ESG accreditations are now a major consideration in the property market, so we see pricing for the greenest buildings holding up best. On location, the lifting of Covid restrictions has led to a gradual revitalisation of the major UK city centres, with steadily rising commuter numbers and a revival in urban social and cultural scenes. Going forward, we believe city centre property will be on the right side of a return to the office trend, and further urban revival, as Covid-era habits fade. That development pipelines in most locations for almost all sub-sectors have been thin lately will also limit pressure on prime yields.
For secondary stock, we see greater pressure coming on pricing, with ESG regulations and high building costs as major factors. The EPC rating necessary for a commercial building to operate is set to be gradually hiked in the coming years to a minimum B by 2030. Capital will be needed to bring poorly rated stock up to standard, but high material and construction costs are at present an issue. When the investment market does reach a turning point, and build costs moderate, we do see a major opportunity emerging to buy up these older assets and modernise them. This will probably appeal to investors with more experience of development, particularly as pipelines are relatively thin at present.
Turning point
Oxford Economics are forecasting UK GDP to level out in Q3 2023, before returning to growth on a quarter-on-quarter basis in Q4, and typically investors try to buy in anticipation of turning points for the market and economy. It should be noted that some commentators who are quoted as saying the UK will be in recession throughout 2023 are using the 12-month comparison for GDP, not the 3-month figure which tends to be the preferred measure for analysts and investors in Britain. The quarter-on-quarter GDP growth figure is probably more useful to property investors, as it highlights inflection points for output sooner than the more heavily time-lagged annual figures.
We believe that H1 2023 will mark the darkest hour for the current downturn, although by Q2 we expect to see more buyers conducting due diligence and market research before executing purchases in Q3. This gradual turnaround reflects the nature of property investment where the transaction process, from initial research to completing the deal, typically takes months.
We are forecasting the turning point for property sales in Q3 will probably be driven by opportunity funds who, as already mentioned, have capital that is ready to deploy at short notice. Also, cash rich investors who have very long-term horizons – such as sovereign wealth funds – often enter the market at the bottom of the cycle to buy trophy assets or large portfolios.
Assuming continued momentum in the economic recovery, our forecast is for investment demand to broaden in Q4 2023, as a wider range of companies take comfort from rising sales volume data in Q3 and re-enter the market. 2024 is predicted to see economic growth strengthen, and it is our expectation that will also be the case for property investment activity over the medium-term.