Restructuring portfolios: where do vulnerabilities in the UK property market lie?

The real estate industry has seen both tough times and profound change over the past two years. Despite economic and geopolitical uncertainty, the industry has shown great resilience, continuing its recalibration in our post-covid era, where online shopping has stepped up and remote working patterns seem set to fluctuate continually. 

Amid the cautious optimism our Real Estate 360° survey highlighted, can we expect 2024 to bring the rebalancing and recovery in investment activity that the sector needs?

Increased interest rates altered yield expectations – but 2024 brings stability 

The increase in interest rates throughout 2022/23 led to pressure on values and a change in yield expectations. Though this structural change is still filtering through the system, there will be clear winners and losers.

Prior to the increase in interest rates, there was significant yield compression. Investors backed a range of asset classes at low yields which, with the benefit of hindsight, reflected unsustainable asset prices. The interim correction has put downward pressure on prices and this, coupled with increased economic uncertainty, has undermined transactional activity from both a tenant and investment perspective, thereby compounding the pressure on values.

Subject to no external shocks, it appears the UK economy is entering a period of stability (compared with the past five years) with interest rates and inflation set to drop to 4.5% and 2% respectively by the end of 2024, thereby providing the foundations for an improving UK property market. Recent research by RSM found property experts expect values to increase by 3.5% on average this year. 

The forthcoming election, combined with all parties recognising the historic under-investment in housing and infrastructure, should see some post-election stimulus in both sectors. Therefore, the overall sector view should be positive.

Office and retail to unbalance balance sheets

Despite this turning point, a minority of assets will suffer from value impairments, driven by recent building cost inflation, behavioural and legislative changes. More than half of our Real Estate 360° survey respondents expect a growth in distressed assets. 

Two sectors exposed are the office and retail sectors. The former has suffered from the work-from-home culture, with demand and values bearing the brunt as users try to better understand their requirements. The sector is still going through a transition, but what is clear is that peripheral regional office schemes are suffering from weak tenant demand and subdued investment appetite. 

Historically, developers have invested in these peripheral assets with a view to converting them to residential. However, the investment rationale has fundamentally changed in the past couple of years. Today, accounting for build costs, retrofitting complexities and ESG requirements, the financial model for investors considering these opportunities may not add up. There were significant transactions in this asset class from 2018 to 2022 at values which are unachievable in the current market. Hence, we anticipate there will be a range of distressed transactions in this space over the next five years.

An area facing similar challenges is the retail sector. High profile failures coupled with the recent poor retail ‘golden quarter’ trading data continue to demonstrate the travails of the traditional British high street. While a wander down most UK highstreets is evidence enough of the issues, with empty stores to be seen in their droves – last year the British Retail Consortium reported that Britain lost 6,000 storefronts over a five-year period.

The options for landlords in many of these scenarios are very limited, with schemes needing repurposing. However, the issues in converting these schemes to alternatives are often expensive, laborious and overly complex. Therefore, we anticipate continued downward pressure on asset values in parts of the market, with increasing distressed transactions.

Inflation has increased build budgets beyond gross development values

In addition to the office and retail sectors, we anticipate that price inflation in the construction sector will have fundamentally undermined much of the investment rationale of schemes incepted from 2018 and currently being delivered. Double-digit cost inflation has increased build budgets significantly, ahead of historic contingencies and, in many cases, ahead of gross development values (GDVs). With demand limited, especially in the residential first time-buyer market, many developers and their lenders are ignoring the reality of the impairments they are facing. Though this bears similarity to a trend witnessed after the 2008 financial crisis, the circumstances are very different. While in 2008 we saw a base rate of sub 1%, today it is over 5%. As the majority of commercial property lending is not fixed, many borrowers’ interest costs on these asset classes will exceed 7% and, in lots of cases, will be more than 10%. With many borrowers struggling to service their debts, these interest accruals will accentuate impairments for both borrowers and lenders.

Critically, the inability to service debt will increasingly become a problem for lenders. The UK’s lending market has diversified, with many property lenders now dependent on private credit, typically derived from the US. Recent IMF and Fed statements indicate that US private credit is exposed to a deteriorating US commercial property market, with real concerns that impairments are not being disclosed. The probable trigger which will drive a tightening of the private credit market will be the inability to service repayments, ie from the underlying lending platforms to their institutional funders. This will be driven by underlying borrowers being unable to service debt to terms. As these funds are held by private credit, it is currently difficult to assess the level of challenges in this space. However, what we're hearing from the market indicates there is an issue which in all probability will impact the UK property sector later this year.

The UK property market will likely continue to face various challenges in the short term, however the medium-term outlook looks more settled. Subject to the outcome of the election, we also anticipate sentiment will improve with a more settled political climate and potentially legislative changes, which should benefit the sector.

Therefore, we anticipate divergent paths for the property sector but, overall, an improving climate for the majority of it. However, a minority of assets will face significant challenges. There is a plethora of options for problem assets, with a range of acquirers, funders and specialists being available to take these forward if the original investors wish to exit. This is an area which will potentially stimulate some of the transactional activity later this year.