Market dislocation series: U.K.
April 28, 2023 20 Minute
If you wait too long, the opportunity will be goneDislocation in global real estate investment markets has created opportunities for investors to capitalize on favorable mismatches between asset prices and long-term value. Because U.K. real estate repriced faster than other regions, we see a unique window of opportunity unfolding. We believe that we can capitalize on this lower price environment in our high conviction real estate sectors to create strong long-term portfolio value for our investors.
U.K.: fastest repriced major market globallyThe U.K. repriced at the fastest pace among major global real estate investment markets. Capital values declined sharply in the second half of 2022 primarily due to domestic political uncertainty, a subsequent spike in fixed-income yields along with high inflation and rising interest rates.
MSCI Net Initial Yields, %
Source: MSCI Quarterly Index, December 31, 2022.
There is growing recent evidence that outward yield movements have either stabilized or are moving in, suggesting the market may have overshot the repricing.
LogisticsThe trading price of logistics assets is inextricably linked to the price of debt and the risk-free rate. The macro volatility led to the rapid repricing in the sector even though the sector still has other strong fundamentals. This has created a mismatch between current pricing and long-term value.
In recent months, prime London industrial assets have traded at yields of around 4.25% to 4.5%1. These yields do not reflect the significant rental growth we believe the logistics sector still has ahead. The sector is supported by long-term structural demand drivers and a short-term development supply hiatus resulting from elevated construction and finance costs. Consumers continue to spend at pace not impacted yet by capacity restrictions of the sector to move goods in a timely manner. The headwinds from a potential U.K. recession are clear but they are not manifesting yet. In fact, leasing activity has improved over the past 12 months despite transportation and energy costs being more significant than rents for many tenants. As a result, we believe that some pockets of the U.K. logistics sector overcorrected. The opportunity for long-term investors to capitalize on these lower prices will be short-lived.
Affordable housingRepricing has likely bottomed in affordable housing—our favored segment of the U.K. residential market. Affordable housing is a natural recession hedge since rental apartments tend to be in higher demand during recessionary environments and affordability is even more critical.
New supply in this sector is constrained by high construction costs, inflation and borrowing costs. These macro and finance externalities have insulated affordable housing demand while rental growth in the regulated segment remains contained. Affordable housing is expected to outperform the big three real estate sectors in the U.K. over the first half of 2023.
Other sectorsThe same dynamics discussed for logistics and affordable housing are equally relevant to the U.K. student accommodation sector, which remains one of our high conviction sector plays. A lack of modern accommodation for an internationally mobile student population, as well as a demographic bulge in the domestic student age population support purpose-built student accommodation in top-tier university towns where demand is focused. The attraction of highly ranked British universities to international students (a 13% rise in the 2021/2022 school year) increased with the reintroduction of the post-study work visa, which allows international students to gain U.K. work experience after their degree. Demand for space should improve further with U.K. universities increasingly looking to diversify their international student exposure, attracting more students from Southeast Asia and Africa. These positive long-term fundamentals are expected to further bolster demand for student accommodation, while ongoing price discovery should create new opportunities to enter the market at relatively attractive yields.
In the retail sector, the bulk of repricing has already happened. There is now much more clarity on rents and the sustainability of that income. The office sector, on the other hand, is bifurcating with a growing divergence in fundamentals for best-in-class and everything else. Structural changes in the long-term role of an office headquarters in the context of hybrid and remote working trends will also continue to challenge the office sector. We, however, expect best-in-class offices with strong sustainability credentials to remain insulated from the problems in the larger legacy subsector.
Accessing dislocationWe expect the following catalysts to provide opportunities in our high conviction sectors in U.K. markets over the next 12 to 18 months:
− Secondary recapitalizations
− Refinancing events
− Development opportunities through strategic partners
Investing through an operating partner in GP-led secondary recapitalizations of existing funds can offer discounted entry points. We are already seeing attractive discounts available to recapitalize U.K. fund vehicles—aligned with our favored sectors—for investors who need to sell equity stakes. In the current market, three stimuli are typically prompting these recapitalizations: (i) the impact of denominator impacts on portfolios, (ii) closed-end fund vehicle maturities, and (iii) investor liquidity requirements due to worsening credit conditions. During a period of reduced finance liquidity as we are currently experiencing, investors have a window to recapitalize funds which own high quality assets at trough valuations and lock-in value-add returns without taking on property-level refurbishment or development risk. Secondary recapitalization strategies are highly attractive during periods of acute equity and debt capital shortages.
Refinancing will be a significant catalyst for near-term transactional activity. As individual assets, portfolios, as well as fund vehicles need to refinance, much higher borrowing costs and lower LTVs offered by lenders will often require forced sales or fresh equity injections. These opportunities are the consequences of the volatile macro environment over the past 12 months. With strong networks and a reputation of closing deals, we will be able to capitalize on and cherry-pick advantageous market opportunities.
Targeting motivated sellers also extends to developers who no longer have sufficient equity to hold or develop land while construction and borrowing costs remain high. We can create a JV structure to invest equity alongside a developer to share in the construction risk and development gain. This strategy maximizes the full spectrum of our “investor-developer-operator” capabilities. Our developer subsidiaries, Trammell Crow Company (TCC) and Telford Homes, are ideally placed to identify such opportunities in the logistics and residential sectors, respectively. In the current environment, this partnership approach will be highly effective. We have five decades of experience navigating turbulent macroeconomic environments and a depth of resources to identify and execute economically viable projects.
In summary, the U.K. is one of the most attractive real estate markets to invest in now due to significant price discovery allowing greater clarity. Understanding the fundamentals of each sector and subsector within the market will provide savvy investors with unique opportunities that only arise at a time of market dislocation and distress. We believe that now is the time to invest in U.K. real estate in our high conviction sectors.
1 Source: CBRE Investment Management, Knight Frank, March 2023