Overseas investors are seeking short-term performance differential and long-term diversification in the U.K.
July 13, 2023 10 Minute Read Time
Impacted by the rising cost of debt, U.K. commercial real estate investment volumes are down year over year. Higher debt costs have removed a cohort of investors from the market, causing downward pressure on values dampening investment demand. The most recent investment data, however, suggest liquidity is returning to those parts of the market believed to have the strongest income growth prospects, such as logistics, residential and some prime retail parks. U.K. institutions are a significant driver of the rebound. The continuation of the upward trend will require participation from non-domestic investors. This piece examines the role of overseas capital in the U.K. market in the last 20 years and suggests that with U.K. returns poised to exceed global averages over the next five years, international capital could become a growing source of investment.
BackgroundOverseas investors account for a significant proportion of investment into and holdings of U.K. real estate. According to the IPF’s “Size and Structure of the UK Property Market” series, overseas holdings of U.K. commercial real estate have risen in value from £41 billion in 2003 to £156 billion in 2020 and by share from 14% to 31% over the same period.
There are many intangible reasons why overseas investors might choose to enter the U.K. real estate market, such as scale, liquidity, transparency, language and legal structure. Because many of these reasons are hard to quantify, in this paper, we focused on two that were quantifiable—relative performance (of the U.K. versus domestic and global markets) and diversification (versus equities and bonds). We find that relative performance is a strong driver for some, while diversification can be a benefit to most, if not all.
Relative PerformanceWe looked at the return differential between the U.K. real estate market and those of 10 overseas markets back to 2000 (where MSCI data was available). We did this both with and without adjusting for currency. We also compared U.K. returns with MSCI global real estate returns, with and without adjusting for currency. We then looked for relationships between relative returns and investment; specifically, we looked at relative returns versus purchases, change in purchases, net investment and change in net investment. All analyses were conducted with a zero-, one- and two-year lag on investment to determine whether outperformance by the U.K. relative to an overseas market leads to immediate or delayed allocation from that overseas market. Finally, we analyzed performance at the all-property level and for the office sector.
We gained the following high-level insights from our analysis:
- Correlations with currency-adjusted relative performance tended to be weaker than those without; if there is a relationship between relative performance and investment activity, it does not appear to take currency into account.
- Correlations with purchases appeared to be stronger than with the other investment measures.
- Correlations tended to be stronger for the office market than at the all-property level, suggesting that differential structures and sector weightings across markets might cloud relationships between relative performance at the sector level. Higher liquidity in large (>£100 million) lot sizes in the London office market may also be a contributory factor.
Figure 1 shows the correlation coefficients between real estate purchases and the relative performance of national and global offices versus U.K. offices, by country of investor origin, with purchases lagged zero, one and two years.
Figure 1: Correlation between purchases and relative return, 2000-2022
Correlations are generally slightly positive, but not especially strong, with a few interesting exceptions. One of these is between China-based purchases and U.K. versus China performance with no lag, the other is between U.S.-based purchases and U.K. versus global performance with a one-year lag. Figure 2 explores the China vs U.K. relationship in more detail, but an immediate observation is that the relationship is not as significant as might have been hoped and a case of correlation without causation. We do not believe that investment flows into the U.K. from China are the result of relative outperformance. The pattern reflects the ebbs and flows of geopolitical considerations and coincidentally happens to coincide, to some degree, with the relative performance picture. This may also be the case with other APAC countries where the timing of investment may have been the result of regulatory changes in investment in overseas real estate markets rather than relative performance.
Figure 3, however, shows a more compelling relationship between the relative performance of U.K. real estate versus the MSCI Global Index and purchases by U.S.-based investors. We show the purchases based on a synchronous (zero lag) with relative performance and with a one-year lag to relative performance. The dotted line indicates where the correlation shifts more from a one-year lag to zero lag. We conducted the analysis in this way, since the relationship appears to shift slightly after the GFC, around 2011. In the 2000-2011 period, the strongest correlation between relative performance and purchases is with the one-year lag—purchases follow relative performance in the preceding year. In the 2011-2022 period, however, there is an extremely strong correlation—a coefficient of 0.92—on a no lag basis between U.S.-based investor purchases and the relative performance of the U.K. versus the MSCI Global Index. The data demonstrates that purchasing shifted from responding to relative performance to anticipating it. With a significant proportion of U.S.-based capital having a global outlook, the driving relationship being the U.K.’s performance versus the Global Index (rather than the U.S. market) makes intuitive sense.
Figure 2: Relative performance U.K. vs China and purchases of U.K. real estate by China-based investors, 2009-2022
Figure 3: Relative performance U.K. vs Global Index and purchases of U.K. real estate by U.S.-based investors, 2000-2022
Performance, relative or even absolute, is not the sole object of allocation to an asset class. Another important determinant is how that asset class behaves compared to an existing portfolio. The portfolios of multi-asset investors are typically dominated by equities and bonds. The correlation between the domestic equity and bond markets in the 10 countries studied and U.K. real estate is shown in Figure 4.
Universally, correlations between U.K. real estate and bonds are weak, if not negative (as is the case with Canada, China, Japan and the U.S.) suggesting U.K. real estate offers a compelling diversification play. Correlations are all positive and typically stronger for equities, but even there, no coefficient exceeds 0.50, suggesting that adding U.K. real estate to a portfolio would diversify performance considerably.
Figure 4: Correlation between U.K. real estate returns and equity and bond returns, various countries, 2000-2022
Investment from U.S.-based capital into U.K. real estate has totaled $95 billion since 2000, well over a third of all investment from the 10 countries analyzed. As we have seen, it is heavily influenced by relative performance between the U.K. and the global real estate market. Our House View suggests that the U.K. office return over the next five years of 5.3% per annum will be ahead of the global figure of 4.0%, indicating that an inflow of U.S.-based capital might be expected at an above average rate over the period if the historical relationship holds. Within the five-year period, the U.K. is expected to offer the most significant above-par returns in 2023-2024, suggesting purchasing activity will be concentrated in those years.
As for other origination points of capital investing in U.K. real estate, the relationship between relative performance is less clear suggesting that those investors may be more motivated by other factors such as diversification, which as we highlighted is a considerable and enduring benefit to overseas investors.
Whatever the motivation, investors allocating to U.K. real estate in 2023 will be accessing a market that has arguably seen the swiftest re-pricing of any market in the world, which offers an extremely attractive entry point.