WHAT CAN BUSINESSES AND INVESTORS EXPECT FROM SHIFTING PROPERTY MARKETS?

This article is by Steven Oliver, Director at Peritus Group.

Dinah Washington once sang ‘What a Difference a Day Makes’, and whilst the property market doesn’t move at such a rapid pace, the last six months of 2022 saw a material shift in sentiment and values.

At the start of each year, we polish off our crystal ball and make our predictions for the year ahead, however before we begin predictions, I think it’s important to look at the headwinds we are currently encountering and the choppy seas we need to navigate.

If we cast our minds back, following the Global Financial Crisis (2008-9) one of the policy decisions made by Central Banks the world over was to reduce their relevant Base Rates to record lows. In the UK we saw Base falling from 5.75% in July 2007 to 0.5% by March 2009. This low cost of borrowing was designed to stimulate a faltering economy and we saw unprecedented moves to shore up (and partially nationalise) swathes of the banking sector.

Rates remained below 1% until 2016, but then we experienced the double impact of Brexit and Covid-19, which saw rates reduced further to 0.1% in March 2020.

This low-interest rate environment drove a huge growth in property values. A record-low cost of borrowing meant you could borrow more and pay less! Almost all sectors of the real estate market benefitted from the low cost of borrowing, however, the Industrial and Distribution sectors were the star performers with cheap debt coinciding with record demand levels for space and corresponding rental and value growth.

Prime Yields (property value divided by rent) for industrial and logistics properties fell to around 3% (essentially the lower the yield, the higher the value of the property). Prime office yields came in at around 3.75%, and

Source: JS chart by amCharts operational assets such as hotels, student accommodation, and care homes also traded below 4% yields. The fall in yield (leading to increased prices) was driven by expectations of strong rental growth and by the low returns available in the bond market. When government gilts were trading at less than 1% property yielding, even 3% was attractive. The availability of cheap debt at levels below property yields helped investors to leverage those returns - it was essentially the rocket fuel for property prices, however, it could not last forever.

What Follows Set The Tone For 2023 And Beyond

One of the side effects of the low-interest rate environment was inflation. However, we now need to add in this political uncertainty (three Prime Ministers in as many months) and a disastrous war in Europe as Russia invaded Ukraine. This caused huge spikes in the cost of natural resources (oil, gas) and led to a real cost-of-living crisis in the UK, which was not aided by Kwasi Kwarteng’s mini-budget, which led to a major slide in the pound against most of its trading partners, among other material issues. Inflation is, at the time of writing, at 10.7% (CPI).

The Bank of England responded by increasing interest rates with the Base Rate now at 3.5% as of December 2022 and the expectation of further rises and a market prediction based on SONIA (Sterling Overnight Index Average), which is the rate Banks lend to one another at - and which provides the reference rate for many real estate loans - reaching 4.73% in September 2023. This material rise in interest rates means that any borrowers who are not fixed will see their interest payments increase. On a £1m debt facility, the difference in interest costs between March 2020 and December 2022 is £340,000 pa (excluding any changes in the Banks margin).

And so, to our predictions. With a backdrop of high inflation (10.7% CPI) and much higher interest costs (3.5% Base Rate), we expect to see:

• The volume of property transactions in the market slow down materially.

• Reduced Leverage - Property Investors typically like to take on debt to buy properties to increase their returns, and the higher cost of borrowing means Banks and Lenders will be far more cautious about how much they wish to advance.

• Reducing Loan to Values (loan amount/ property value) from highs of say 60-65%, to around 50%.

• Refinancing issues – borrowers who took advantage of cheap finance rates will struggle to refinance their loans at the current interest rates and this may lead to a number of ‘distressed’ sales coming to market.

• Increase in loan defaults and repossessions will occur where borrowers cannot service their loan interest due to the cost of debt exceeding their rent. That said, we don’t expect this to lead to the failures in the market we saw in 2008.

• We believe that property yields will increase, which means prices will fall across most sectors with some sectors being hit harder (such as industrial and distribution).

• A strong focus on green credentials and ESG will mean it will be harder to finance property with a poor EPC rating.

• We believe the market outlook will be weaker over the next 12 months, however, this will also lead to opportunities for those ready to move quickly.

• Our view is that professional advice on debt and real estate strategies will be hugely important as navigating around the hundreds of lenders in the market and understanding their appetite and underwriting is essential. 