Ben Sanderson and James Stevens from our real estate team discuss risks and opportunities for property investors amid changing work patterns, rising inflation and the race to net zero.
Read this article to understand:
- Why demand for high-quality office space in cities is still rising
- The impact of inflation on real estate
- The benefits of energy-efficient assets
Since Russia launched its brutal invasion of Ukraine in February, global fuel and food prices have spiked, and central banks have rapidly tightened policy in an effort to tackle inflation.
The economic shockwaves have been felt across the world, and real estate markets in the UK and Europe are no exception. Rising construction and borrowing costs have put some developers under pressure, and the gloomy economic outlook is weighing on valuations in some sectors. Meanwhile, scorching summer heatwaves have focused minds on the need to adapt the built environment to reduce carbon emissions and tackle climate change.
Some markets are faring better than others during this turbulent period. Demand for high-quality office space in central London is returning to pre-pandemic levels: vacancy rates fell from 8.5 per cent to 8.2 per cent in the second quarter, with the take-up of new space increasing at a faster rate than at any time since the fourth quarter of 2018.1 International demand for UK real estate also remains strong, with foreign investment accounting for over 70 per cent of new purchases.2 Singaporean sovereign wealth fund GIC is among the institutions to have made big investments in London office property in 2022.3
But the picture is complex, and investors must be discerning in their choice of assets as they navigate short-term economic challenges and longer-term structural shifts. In this Q&A, Ben Sanderson (BS), managing director, real estate, and James Stevens (JS), head of investment – global real estate, discuss key trends across regions and sectors.
How are real estate markets in the UK and Europe holding up this year?
JS: While there has been a negative pricing impact in some areas due to inflation and the rising cost of debt, certain parts of the real estate market are holding up well from an occupational and user-demand perspective. That is particularly evident among occupiers that want high-quality ESG-compliant space, or have business uses and activities that are less correlated with the macroeconomic challenges we have seen this year.
What effects are higher borrowing, construction and maintenance costs having?
JS: Had we not been through COVID-19, the rampant and almost unprecedented inflation we are seeing now would probably have given the market a greater shock. To an extent, I think we have been immunised to these kind of shocks by the pandemic; investors are taking a pragmatic view.
Costs have been so inflated that many projects have become unviable
It is true costs have been so inflated that many projects have become unviable; this impacts the economics for new supply coming onstream. There is also less certainty, and greater risk, for those that do embark on projects. Occupiers focused on environmental performance will have fewer assets to choose from and that will have an inflationary impact on rents.
BS: Some developers will come under stress because they cannot make construction stack up economically. We may see failures among mid-size contractors that are halfway through a development and find they cannot complete it at the agreed price.
We are in a time of real volatility. Just as high inflation seems to have come out of nowhere, the situation can change quickly. Ten-year benchmark government bond yields fell in July but moved out sharply again in August; while borrowing costs are rising today, it’s likely market rates will continue to be volatile. The short-term outlook is for further tightening by central banks, but this could change quickly if the economic growth outlook deteriorates sharply.
The consensus is for higher inflation and higher interest rates; our job is to look through that and understand how these risks are priced in a period when sentiment and markets are moving with a lot of variation.
How has performance varied across real estate sectors?
JS: If we take the office market, one noticeable trend is that some industries are looking for high-quality space to facilitate the development of talent. This is particularly evident in the legal profession, where many firms are concerned their people missed out on opportunities for career development during COVID-related lockdowns.
There is a race for space among occupiers to secure the best buildings
That is feeding through into major occupier demand for high-quality offices in the City of London [according to Jones Lang LaSalle data, legal firms leased 433,000 sq.ft. of office space in the second quarter, accounting for 22 per cent of the total].4 In a world of rising inflation and elevated construction costs, there is a dearth of environmentally compliant supply coming through, creating a race for space among occupiers to secure the best buildings.
Another interesting trend is the continued growth of the life sciences and biotech industries in the UK, which is driving demand for R&D and laboratory space. In the residential sector, meanwhile, rising house prices and interest rates mean increasing numbers of first-time buyers are being priced out; rents have increased as a result, particularly as there is now a tax disincentive for private landlords to own residential property, taking supply out of the market.
How are these dynamics affecting our investment strategies?
BS: Broad thematics are still important, but it has become more crucial to be discerning and select the right asset.
In the UK and Europe, we continue to focus our office investments in cities where people want to live, work and learn. This is about the vitality those cities offer. Industrial and logistics markets are driven by servicing those cities, while residential markets are influenced by changing commuter patterns. As people start to have more flexibility about where they live and work, some of the dominant regional cities will become more attractive on a price-point basis, especially as the cost-of-living crisis starts to bite.
Investors need to understand the economic drivers of each sector, region or area
Investors need to understand the economic drivers of each sector, region or area. For example, the future of work, and its impact on offices, is still uncertain: some occupiers are going “full hybrid”; others are more cautious. That will take a few years to work through. What is clear is that businesses want high-quality space that will help deliver net-zero targets. The newest, most flexible space is likely to do well, while older, less flexible space with net-zero challenges will do worse because there will be costs associated with upgrading it.
Similarly, the demand for laboratory space among life-sciences firms will vary depending on which teaching hospital or university is in the vicinity and its particular specialism. The picture will be different depending on whether you are in Cambridge, Oxford, Manchester or Edinburgh.
Investors everywhere want inflation protection – which areas offer the best prospects of this in real estate equity?
BS: People sometimes overplay the inflation protection real assets provide, but it remains present across most markets. There are pockets of the residential rental market that offer some inflation protection; although, with the cost-of-living crisis in mind, consumers will not be able to pay rising rents forever. The scarcity value in central London offices is beneficial for income and therefore inflation protection. Rents have gone up among logistics assets, but there is scope for them to keep rising, too.
Valuations across retail real estate are down more than 50 per cent since the beginning of the pandemic
JS: We are coming off the back of a period of where some sectors, such as retail, have been structurally challenged in terms of the substitution effect of online and what that has done to the value of retail real estate. Taking a crude, peak-to-trough measure, valuations across retail real estate are down more than 50 per cent since the beginning of the pandemic.
But, despite the cost-of-living crisis, people will keep on shopping for necessities, even if they switch to a different supermarket. This will drive turnover at the resilient retailers. There are also pockets of inflation protection built into markets that have been rebased over the last five or six years.
How has sentiment towards the UK among large international investors been impacted by the tough macro environment?
BS: The UK remains one of the most transparent real estate markets in the world, with the English language, rule of law and abundant liquidity. What is not fully clear is the impact of Brexit, in terms of exchange rate volatility and economic drivers. Is the UK now dancing to a different economic beat to the rest of Europe? That is still not settled.
Investors are showing a bit more caution around investing in the UK
Then again, many investors have always seen the UK as a separate category to their allocations to Europe, and Brexit probably just emphasises this. It is fair to say investors are showing a bit more caution around investing in the UK, but international capital is still the dominant source of capital in the market.
JS: Institutions invest in UK real estate for different reasons. One is wealth preservation: during periods of volatility, some people buy gold; some people buy London real estate.
Some international capital will invest outside of London for the yield pickup, because the margin you can get in the UK compared with similar assets in European cities is now inflated. It is worth adding Europe is not homogenous, and the relatively small scale of many markets outside Paris mean that an investment there involves taking a disproportionately large bet in a particular location or sector.
How does growing awareness of the climate crisis affect the outlook?
BS: It brings the net-zero agenda into starker focus. Investors now realise they must lock in net-zero commitments for 2030 and beyond, and the market is going through a period of price discovery to look at how it is going to execute that and the implications for brown assets and green assets.
JS: We will not hold buildings that do not deliver environmental performance, or where we cannot improve the environmental performance. That is front and centre in our investment process. While there is a large proportion of the institutional market that takes a similar approach, there is still a huge part of the real estate market that does not place the same emphasis on ESG factors, so inevitably there will be a price dislocation.
There is a real incentive for people to care more about the environment amid spiralling energy prices
The aspect that has changed recently, and its more prevalent in the office and residential sectors for the time being, is operational cost. Lower energy usage means lower costs. There is a real incentive for people to care more about the environment amid spiralling energy prices.
BS: If you price climate risk better than your peers, you will outperform; it is that simple. But the focus is also moving on to the ‘S’ and the ‘G’: social impact and governance.
For example, in the wake of Russia’s invasion of Ukraine, and the subsequent wave of sanctions, we have expanded our exclusion list and will no longer consider certain tenants. This is important, because occupiers not only worry about climate; they are also increasingly asking questions about which tenants they let space alongside.
Speaking of social impact, what role can investors play in urban regeneration and the UK’s wider levelling-up agenda?
JS: Some regeneration schemes have suffered because they have not taken into account the economic drivers of the location. The reason these urban areas existed was to fill an economic purpose, either in the pre-industrial or post-industrial age, and that purpose may have changed over time.
Investors can make a difference by investing at scale and across different sectors, and by taking a longer-term view
Investors can make a difference by investing at scale and across different sectors, and by taking a longer-term view. In Manchester, for example, we have repurposed derelict industrial space and provided a broad mix of uses, from television studios to offices to hotels. Taking this kind of holistic approach, rather than simply focusing on individual buildings, benefits the whole area and can provide civic pride and a real sense of place.
We have also adopted a holistic approach at a brownfield site in Rugby, Warwickshire, where we are working with a joint-venture partner to create a town with 6,000 homes and schools for the community. A long-term vision is needed to make this kind of development work: rather than a two-year view, we look at the project over a 20-year horizon.