Investment

Real estate investment markets will gradually recover as the economic backdrop improves, but challenges remain as the market adapts to investing and financing in a higher interest rate environment.

Key Takeaways

1. Investment returns for real estate should improve in 2024, following 18 months of challenging market conditions. While the prospects for yield-driven capital growth appear limited, income returns will underpin an improvement in total returns, and a falling inflation rate increases the likelihood of positive real returns from property investments.
2. The divergence in performance across property types is likely to persist in 2024. The industrial and residential sectors are likely to benefit from better near-term prospects for rental growth and a greater investor appetite, while the office and retail sectors will continue to see polarisation based on the quality of assets.
3. Obsolescence of older office and retail assets will be a key challenge for the UK real estate market next year. The fall in values and rise in financing costs since mid-2022 will reduce opportunities to profitably refurbish or repurpose older stock until market conditions improve. This could impact progress towards more sustainable, lower carbon investment portfolios.
4. Real estate investment activity should increase in 2024 relative to 2023. However, investment volumes in cash terms will take more time to recover as investors trade at lower price levels in the wake of the downturn. Market conditions will provide investors with equity and the chance to execute counter-cyclical investment strategies.
5. Real estate debt markets will generate further headlines next year as more loans from the pre-pandemic period approach maturity. Higher interest rates will constrain how much lenders are prepared to lend at refinancing, and so some distress will emerge where existing loans cannot be replaced and more equity from the borrower is not available.

Performance likely to improve in 2024

Investment prospects to brighten in 2024

Real estate investment performance suffered over the last 18 months as rising interest rates led to yield increases. Investors face challenges from higher borrowing costs and reduced capital flows to the asset class. All property total returns have been low throughout 2023, and all property capital growth has been negative over the year and to date. 

Despite this backdrop, we expect performance in 2024 to improve. Value declines have stopped in some sectors and slowed in others. Although near-term prospects for any capital appreciation appear limited, income returns will underpin an improvement to the total returns from real estate investment portfolios. 

A declining inflation rate will benefit real estate, enabling the asset class to deliver positive real returns once more. High inflation kept the negative wealth effect from falling values to be greater than the nominal change would suggest. We estimate that capital values at an all property level have fallen by c. 30% in real terms since mid-2022. 

A key trend in recent years has been the divergence in investment performance across property types, as illustrated by Figures 3 and 4 for capital value trends since 2018 and annualised total returns over a one-year, three-year and five-year horizon. 

All sectors were affected by the recent downturn, but performance in the office and retail sectors has lagged the industrial sector. While we do not believe this can continue indefinitely, the industrial and residential sectors are likely to benefit in the near-term from better rental growth prospects and a greater investor appetite. 

Figure 3: Capital value indices, 2018-23

Source: CBRE UK Monthly Index

Figure 4: Annualised total returns, 2018-23

Source: CBRE UK Monthly Index

Obsolescence remains a threat for older assets

Social and environmental changes affecting the built environment mean the issue of obsolescence is high on the minds of decision makers, especially those in the retail and office sectors. 

Assets that no longer appeal to occupiers or investors, or meet regulatory requirements, because of their age, location, or specification, must be repositioned through either conversion or redevelopment. Such expenditure can only be justified from an investment perspective if expected returns outweigh the costs, including sufficient reward for the risks to investment capital. 

Several factors have combined to make the conditions more challenging for addressing obsolescence in 2024. The decline in commercial real estate values means that, currently, the reward from redevelopment is reduced in many cases, while increases in construction costs and interest rates have also put the viability of proposed schemes under pressure. 

This will create concerns for investors with more exposure to older assets as it will hamper progress towards more sustainable, lower carbon portfolios. Even if investors do not intend to reposition assets themselves, it will impact the prices that can be realised on disposals until conditions improve. 

However, the same factors should benefit existing, prime quality assets, and we could see the value differential between higher and lower quality assets increase further until market conditions allow more stock to be withdrawn and redeveloped or converted into more profitable uses. 

Investors likely to deploy more capital

Investment activity will need time to recover

We anticipate that investment activity will improve in 2024 relative to 2023, but it will take time for activity to return to the levels seen before the market downturn. Moreover, volumes in cash terms will take more time to recover than activity. This reflects the lower price levels of investments transacted at the bottom of the market. 

Several factors will affect investment patterns next year. Firstly, interest rates are key; we anticipate stabilisation and then a moderate decline in long-term interest rates in 2024, as the path for policy interest rates becomes clearer. This should alleviate the denominator effect that impacted flows to real estate from multi-asset investors as they sought to rebalance towards fixed-income investments during the steep rise in interest rates (and fall in bond prices) in 2022 and 2023. 

Despite this, we anticipate asset disposals in response to market pressures that have built up in the last 18 months. The higher interest rate environment has enabled more defined benefit pension funds to implement de-risking and/or buyout strategies that involve further restructuring of their portfolios from growth assets to liquid fixed-income investments. 

Borrowing costs will remain higher throughout 2024 than over the previous decade and this will affect transaction activity, reducing the role of leverage in asset acquisition strategies in the near-term. However, conditions will provide the opportunity for investors with equity to execute counter-cyclical investment strategies on behalf of their clients.  

Figure 5: Transaction volumes, yields and swap rates

Source: CBRE UK Monthly Index

The refinancing challenge will continue

We will continue to see headlines about refinancing of real estate loans in 2024. Many loans that reach maturity next year will have been originated in a different interest rate environment and in very different real estate market conditions. 

Data from the Bayes Business School UK Commercial Real Estate Lending Report indicates that 2018-2021 saw more than £175bn of debt originated against commercial real estate. While the maturity dates for these loans will be spread across the next few years, we anticipate that 2024 will be a crunch year for many borrowers. 

The first challenge borrowers face is the decline in capital values across the real estate market, with only a few sectors having seen significant increases in value in the years before the downturn. This has resulted in less collateral to work with at maturity. 

The second challenge is the increase in interest rates. This not only means higher interest payments; it also affects the capital that banks can provide to borrowers since the rental income from the assets must provide a lender with adequate interest cover at refinancing. Ultimately, this means lending at lower LTV ratios. 

These challenges will result in a funding gap in many situations, where borrowers must inject equity, find new sources of capital, or sell assets where they cannot bridge the gap between existing loans and the debt now available. Where asset values have fallen steeply, lenders have also had to make provision for losses, but we anticipate that challenges will reduce after 2024 as real estate markets recover and interest rates begin to fall. 

Where asset values have fallen steeply, this could lead to distressed sales and lenders will have to make provision for losses. However, we anticipate that challenges will reduce after 2024 as real estate markets recover and interest rates begin to fall.