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Real estate investment markets will emerge from a period of uncertainty. Pricing should stabilise and activity should return but conditions will remain challenging for the deployment of equity and debt capital and will require investors to adapt.

Key Takeaways

  1. Real estate prices should stabilise in 2023. It is hard to predict where real estate yields will settle, but we do not anticipate that they will rise to the same extent as government bond yields. This suggests that the spread over gilt yields going forward will be tighter than in the last decade.
  2. Income returns, rather than capital growth, is likely to drive commercial real estate returns in the year ahead. This means more focus on asset management, and on the financial performance of occupiers as key factors that affect income and occupancy at the asset level.
  3. The performance of other asset classes will affect capital flows to real estate, and multi-asset investors may enter 2023 relatively underweight in bonds and overweight in other assets (including real estate), as a consequence of how yields moved in 2022.
  4. We forecast transaction volumes to fall in 2023, but the UK benefits from a diverse and internationalised investor base. Constraints impacting some investors means opportunities for others, and private capital awaiting deployment could be one of the beneficiaries.
  5. The debt market should remain resilient as UK real estate is less leveraged than in the Global Financial Crisis and features a wider range of lenders. Yet higher debt costs, together with lower asset values, will pose challenges for investors that need to refinance next year.

Pricing adjusts to a new economic environment

Real estate investment performance was affected by economic uncertainty and rising interest rates at the end of 2022. The brunt of the impact was borne by capital values, with income left to prop up total returns as the year ended. The impact was felt most in the industrial sector, where positive rental growth could not offset rises in yields, and values fell sharply.

Where next for yields?

A key issue is whether, and for how long, real estate yields will continue to rise, or whether 2022 marks the worst of any upward rerating of yields and, consequently, downward rerating of real estate values. If interest rate rises bring inflation under control relatively quickly, and confidence returns to investment markets, values should stabilise, but it is hard to predict exactly where real estate yields will settle.

One factor that often attracts comment is the spread between commercial real estate yields, and those of UK Government bonds. At an all-property level, the spread has narrowed considerably as gilt yields have risen, but this spread was abnormally high in a historical context because of the effects of quantitative easing implemented after the Global Financial Crisis.

We do not anticipate that real estate yields will rise to the same extent as Government bond yields have done, which implies that a narrower spread over gilt yields will prevail in future. However, yields in specific sectors, and for individual assets, will be sensitive to perceptions of risk and prospects for cash flow growth going forwards.

Figure 4: Trends in prime yields, 2019-2022

Source: CBRE Prime Rent & Yield Monitor

Where will returns come from?

While we expect that real estate yields will stabilise in 2023, rental growth will be impacted by the weaker economic outlook, so capital growth is unlikely to drive returns as a result. Therefore, performance must be driven by income return, placing the focus on asset management to deliver such return.

Asset management has risen in prominence as the UK market has transitioned to shorter leases, and as lease events and tenant financial performance have come into sharper focus. But the ability to maintain income return will also depend on how occupiers ride out challenging economic conditions in the months ahead.

Better times ahead?

Once real estate yields have stabilised, better rental growth prospects in the medium-term should facilitate underwriting of new investments and expenditure plans for existing assets in the portfolio. Expenditure will be especially necessary to mitigate transition risks for assets where preparations for tighter future energy efficiency standards are yet to commence.

The performance of the listed sector in 2023 will also be of interest. As the share prices of UK REITs in 2022 fell some time in advance of the change in the private property market, investors will be watching for signs in listed property prices that indicate improving views of the prospects for UK real estate.

Activity to drop but not dry up

There is no doubt that economic and political uncertainty weighed on investment activity during 2022. While activity was strong in the first half of the year, volumes tailed off as investors grappled with the implications of lower growth, higher inflation and higher interest rates for prospective returns from all asset classes.

Rising gilt yields means that institutional portfolios are likely to be underweight in bonds relative to other assets such as real estate, and this could act as a brake on investment. However, while we forecast volumes to drop somewhat in 2023, the UK real estate market benefits from a diverse investor base.

Sources of capital in 2023

Domestic investment has accounted for less than 50% of total transaction volumes in recent years, with Asia, Europe and North America all supplying significant amounts of equity capital. The lower value of the pound relative to other currencies, especially the US dollar, may stimulate further inbound investment, despite slow growth domestically.

There has also been capital raised globally for private real estate funds that is still waiting to be deployed, especially for value-add and opportunistic strategies. The realignment of real estate prices at the end of 2022 means that 2023 may provide opportunities for this capital to enter the UK market.

Figure 5: UK investment volumes, £bn

Source: CBRE Research

Figure 6: Source of inbound capital, % of total invested

Source: CBRE Research, Real Capital Analytics

Debt markets remain resilient

The end of 2022 has been a challenging time for commercial real estate lenders and borrowers. Yet the debt market is better placed to weather a downturn in comparison with 2007-2009. The overall amount of debt relative to equity in the market, and the LTV ratios applied to new loans, have been lower.

As interest rates have risen and capital values have fallen, the relationships between interest and income, and between loan amount and asset value, have come under scrutiny. LTV ratios for new loans have reduced further to maintain adequate interest cover for lenders, and the total cost of debt has risen significantly.

Challenges in the year ahead

Borrowers that need to refinance in 2023 will face challenges if recent falls in value have eliminated gains made in the post-COVID recovery. Refinancing at a lower value and a lower LTV will require borrowers to inject more equity, or find further funding, if they are to retain assets. While we do not anticipate significant levels of lender enforcement, we do think that there will be a reasonable volume of lender-encouraged sale processes in cases where fresh equity is not available, to reduce leverage levels in existing loans.

Debt markets remain liquid, supported by the emergence of debt funds as key players in the UK lending landscape. Capital remains available for deployment in debt strategies, and higher interest rates will mean improved returns, if borrowers remain able to service loans in a higher rate environment.

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